When airline tickets to Kathmandu go on sale, we don’t just hop on a plane to take a stab at climbing Everest. 

It takes years of experience in the mountains, on the rope and in unyielding environments to build up the skills, knowledge and physical ability to climb Everest. A climber would mitigate extensive risk after putting in this initial time and effort (or doing their training due diligence) before attempting to climb Everest.

Similarly, we wouldn’t want to jump into the purchase of a non-performing note without an extensive amount of due diligence, no matter how good the price seems.

Time spent in this stage of the game provides massive benefit for the potential returns from a note. And we take that time, just as a savvy real estate investor would spend the time inspecting a property and learning about the market, or a climber would tackle Mount Blanc or Mount Kilimanjaro before heading to Everest. 

However, performing due diligence on a potential non-performing note is totally different from other forms of real estate in that we must learn about three key areas:

• the physical property (or asset)
• the borrower
• the paper trail that connects the two. 

Without a keen understanding of the details in that paper trial, a land mine could go unnoticed. And we’ve seen and heard about these land mines.

We’ve seen clean paper trails and exciting google earth imagery, until a local agent reported that the asset was actually a burnt-down shell of a house (#5). We’ve seen recent renovations, only to find a cobweb of legal recordings and lawsuits (#7). Or the there’s always the perfect property but with no one around to rent or buy it (#2).

By performing a deep dive of due diligence, we set ourselves up for guiding the note to the best exit strategy for all parties involved.

Let’s take a look at the top ten due diligence steps in purchasing a real estate backed note.

Due Diligence Step #1: Location

Some states and counties can be incredibly costly in both time and money to work through a foreclosure of the lien if it comes to that. New York state, for instance, can take up to five years to foreclose on a property. Some note buyers specialize in these areas, but with a clear strategy and workout costs that account for money sitting in a foreclosure process for longer than 6 months.

Due Diligence Step #2: Location

Population. If we take back ownership of the home via Short Sale, Deed in Lieu or Foreclosure, we want to make sure we have a home that is either rentable or sellable for the fair market value (see #4). Properties in extremely rural areas can be hard to rent or sell, leading to our money sitting stagnant for longer periods of time.

Due Diligence Step #3: Location

Ok, we promise there is more than just location, but it is definitely important here. We are, afterall, talking about real estate.

Even if we’re in a foreclosure friendly state and highly populated area, is the home across the street from a train track? Or at the end of an airplane runway? Always think about the potential exit strategy of owning the home (although we aim to get borrowers to get back on a payment schedule first). Would we want to hold this home as a rental, or would it be a potential flip? Our neighborhood analysis is critical to understanding if this exit strategy will work. And we always make sure that this exit strategy will work.

Due Diligence Step #4: Fair Market Value

We make sure that the value of the home meets, or better yet exceeds, the value of the note we are purchasing. Our borrower may be under water (owe more than the value of the house) but we, as the bank, should never get ourselves underwater. The fair market value is ultimately how much equity is in the deal and is our securing collateral for the note purchase.

Due Diligence Step #5: Real Time Property Condition

Initial property condition due diligence can be done via Google Earth, but watch those image dates! We need boots on the ground to verify that, yes, the home is actually there and in good condition. We get a local professional to acquire photos and report on the condition of the asset, the neighborhood, and any other pertinent information.

Due Diligence Step #6: Borrower 

We find out everything we can about the borrower via legal and ethical means. Partnering with a legal team that specializes in getting to know the borrower’s background is critical since much of this information is gathered by reading between the lines in the paper trail. 

Knowing if they have applied for bankruptcy Chapter 7 or Chapter 13 can be hugely helpful. Also knowing if they are employed, have a family, the history of their payment schedules and what their general story is can mean the difference between likelihood of reperforming our note (getting the borrower back on track) for greater returns or not.

Due Diligence Step #7: Chain of Ownership

Do we have a clean Chain of Ownership to Deed or Title? Are there missing pieces in the history of the chain of ownership that need to be filled in prior to purchasing the note? The last thing we want is for a historical owner to come lay legal claim on our lien because of some missing documentation. An eye for fine detail in reading through documentation is absolutely required in this step.

Due Diligence Step #8: Encumbrances

Are there other senior liens related to unpaid taxes, municipal bills, code violations, unpaid maintenance bills, etc? Even if we are buying a first position lien, there can be other bully liens that can jump in front of us. If we don’t take care of those, either before or after the purchase of the lien, we can be foreclosed on as the bank and lose everything.

Due Diligence Step #9: Position

Are we buying a senior or junior lien? It’s important to know since senior lien holders get paid first if the home sells, and then junior lien holders get whatever is leftover, if anything. Junior liens can come with high interest rates but do so because they are higher risk.

Due Diligence Step #10: Rents Rates and Laws

We research the market rents in the area. If we do take back ownership of the home and it’s not a good time to sell, we want to make sure we can rent the home and still make great cash on cash return. Also, knowing if we’re in a landlord or tenant friendly state can help shift our strategy. This last step is all about thinking through as many potential exit strategies as possible and going after the one that makes the most sense (and greatest return).

Conclusion

We are ready to tackle Everest now! Oh wait…we are ready to make an offer on a note. Wrong due diligence process.

That long list of just the top 10 due diligence steps we perform when purchasing a real estate backed note probably sounds like a lot of work. It is! Luckily, it is the kind of work we love.

Ultimately, if these steps are followed (as well as several more) then the notes we purchase will more likely fall into our favorite exit strategy: helping the borrower get back on track with payments (re-performing) and keeping their home. And while we love this type of detail-oriented work, why choose to invest in notes for this reason: to keep more people in their homes who need a little more personal attention and support than their bank is able to provide. Of course, the high returns make us pretty happy too.