real estate promissory notes

REO’s and Real Estate Promissory Notes: Pre and Post Sub-Prime Crisis

REO’s (bank foreclosures) and note sales have long been a viable method for financial institutions to dispose of non-performing or underperforming loans.

During the S&L crisis of the late 1980s and early nineties, financial institutions would package their non-performing loans and sell them to debt funds, such as Whitehall (Goldman Sachs spin off), MSREF (Morgan Stanley spinoff) and Colony Partners, to name a few. The debt funds would swarm the banks with due diligence teams, and buy loans anywhere from 50 to 60% of the notional amount of the note. Most of the loans purchased were backed by land, real estate development, or operating properties.

Yet, pool sales of non-performing single-family mortgages were not prevalent then, as the single-family market was still relatively stable. Unfortunately, practices leading up to the Great Recession saw note sales become prevalent means of dumping bad debts. Financial institutions, investment banks and any other originators of single family mortgages saw them as a means to quickly dispose of their weakening mortgage portfolios in order to remain solvent. Banks trying to manage their bad debts needed to find an effective way to remove the drag on their balance sheet. This became a fertile ground for investors.

An Evolving Investor Landscape

As the 2007/8 crisis began to blossom, all types of investors popped out of the woodwork to “help” financial institutions with their bad debts. Some were very sophisticated buyers who could take several billion assets down at a time, while others were trying to purchase notes on a one-off basis.

William Rothman, who served as President of the Homebuilder Division – Major Loans for IndyMac Bank, recalls:

“The market could range anywhere from 10% of the note value to as much as 80% of the note. The market for discounted notes was inefficient, and the buyers’ expertise in closing varied with experience and capital.”

However, as the crisis dragged on, the market became very efficient, wherein pools of discounted notes traded within basis points. Investors developed programs and processes that could evaluate pools of notes quickly and efficiently. The better-capitalized banks put out large single-family mortgage pools for sale, and now had the tools to complete a transaction within 30 days. The biggest investors included debt funds, investment banks, and boutique shops specialized in residential note acquisitions.

The pools with better yields were diversified by location, note amount, and cost to rehabilitate. A good balance of all three drove higher yields for the seller, and more efficient execution for the buyers. Banks that were teetering on the edge were bad candidates for note sales, as the losses would push them below their Tier 1 ratios despite providing some needed liquidity to the banks. The FDIC was unwilling to let any bank dip below their Tier 1 capital ratio without putting heaving reserves on their deposits, and significantly hampering their capital raising efforts, which ended up being at a deep discount.

“Many times, the banks didn’t have the infrastructure to work or dispose of their portfolios, and the sophisticated buyers understood that, and could buy a pool at a steeper discount than if the bank had the appropriate staff in place to manage the non-performing loans,” adds Rothman.

“Many of the banks without a workout group in place were caught in indecision; their portfolio would degrade because of inaction, they would not be able to transact and were therefore compelled into a forced sale or takeover by the FDIC.”

Onward to a new real estate promissory notes market

Today, the factors that made REO assets so readily available are no longer in place. The Dodd Frank legislation was enacted July 21, 2010 and although the Act has not been fully implemented to date, the ability to repay, and qualified mortgage standards were implemented Jan.10, 2014, with the intent of preventing the underwriting of loans that were foreclosures in incubation.

Bank settlements reached on February 9, 2012, based on presumptive mortgage fraud, and improper servicing have provided consumer relief in the form of principal forgiveness on primary mortgages, refinancing assistance, assistance on short sales, and DIL (deed in lieu of foreclosure.)

As a result of QE (Quantitative Easing), housing prices have recovered. According to the Q2 data released in August by the Federal Housing Finance Agency (FHFA), the HPI is within 1.6% of its March 2007 nominal peak, and off 15.5% from its November 2006 real peak.

So where is the inventory?

According to Realty Trac, the inventory of non-performing notes is 4x the total number of foreclosures sold in 2006.The relative glut of non-performing notes to REO’s can be explained by GSE (Fannie Mae, Freddie Mac) incentives, which encourage banks to sell more troubled loans than foreclosures.

Real estate notes for the average retail investor

Retail investors can increase their probability of success investing in real estate promissory notes today and beyond by adopting a few strategies:

  1. Understand the six variables that affect the value of a promissory note.
  2. Understand the economics of the note sale, and evaluate it against the current and projected future interest rate environment.
  3. Understand the mechanics and processes of third-party servicing and loan modifications.
  4. Do not invest in an area or product you do not understand. Stay with investments that you can explain to someone who is not in the real estate or investing business.
  5. If it seems too good to be true, it is. Trying to outsmart the market is a broken play. The market is littered with the carcasses of investors who were “contrarian investors”. The successful contrarian investor understands trends, and does not invest by gut feel.
  6. Do your homework! The investor who spends time conducting due diligence will generate above-market returns over time. Taxes, title, and blight are the common problems that kill most note investors. Simply stated, be alert to properties that are in blighted neighborhoods, have delinquent taxes, or suffer from title problems. Remember, investing in real estate notes can be a risky proposition. Therefore, your returns should match the risk profile.

For more information on buying and selling real estate promissory notes, we invite you to read this cash flow investing article.

Contact us any time to discuss your specific situation.