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Buy a Loan-to-Own, and Price it Right

By Natalie Dolce

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Part 1 of 2

SAN FRANCISCO-Real estate recessions have proven to both break and make great fortunes. Banks, the FDIC, and CMBS servicers now hold more than $140 billion in troubled loans, and that number is growing. Many investors are seeing that $140-billion problem as a real opportunity to buy defaulted loans at a deep discount in order to acquire the underlying real estate on the cheap. Three experts at Manatt, Phelps & Phillips LLP recently spoke with GlobeSt.com about buying a loan to own, how to account for the risks and how to know what you are buying.

How do you know what you are buying?

Clayton Gantz, a partner in the San Francisco office, tells GlobeSt.com that while it seems relatively straightforward to evaluate a market before you buy, “you are not buying a market, you are buying a loan in order to acquire a unique asset.” Assets, he says, can have many interesting quirks such as environmental contamination, leases with kick-out clauses, tenant improvement requirements, or structural problems resulting from deferred maintenance. “If the asset has construction in progress for example, the downtime from initial default to your acquisition may have allowed weather to damage the work in place and thieves to remove the plumbing and wiring. And if you’re buying a mezzanine loan, so that the collateral is a company rather than real estate, you will inherit all of the liabilities of that company, not just those that show up on a title report,” he says.

Unfortunately, Gantz says, “unless the borrower in possession is cooperative, which is not likely, it will be difficult to do physical due diligence on the property or the company. So, he says, “you will need to make some insufficiently educated guesses about its condition, and to discount accordingly.” He adds that one thing to also watch out for is the ongoing lender obligations that the buyer will assume, such as funding additional construction draws and accounting for cash collateral. 

Can you actually foreclose?

One question to keep in mind says Tom Muller, a partner in the real estate and land use practice group, is whether or not the seller of the loan actually has the original, wet-ink signed promissory note. “If not,” he says, “you may not be able to foreclose at all.”

He explains that the law deems the current holder of the original note to be the owner of the loan, regardless of who holds or has been assigned the mortgage or other loan documents. “When the loan has traded hands several times, the original note and other loan documents may be difficult to find,” he says. “Many borrowers in this recession have successfully avoided foreclosure by demanding that the noteholder produce the original note, which it could not do.”

In private-sale foreclosure states such as California, “it may be possible to get the title company to complete a nonjudicial foreclosure based on a lost-note affidavit and indemnity,” says Muller, “but in this environment the title companies are increasingly leery of proceeding without the original note unless the noteholder is a reputable institution.”

Muller adds that “foreclosing on the loan does not necessarily mean that you will end up with the property.” Foreclosure is done by public auction, he says, “which means that others can show up at the sale and, potentially, outbid you if you are not willing and able to put up your own cash beyond the face amount of the note.”

The good news, Muller explains, “is that you can credit-bid up to the face amount of the note, so if you are outbid you’re likely to be made more than whole, but this can be disappointing if you’ve spent the time, energy, and due diligence money in order to get the property.”

Does the borrower have defenses, offsets, or counterclaims against the lender?

In theory, according to Steve Edwards, a partner in the Orange County, CA office, if the promissory note is negotiable, and if it was in fact negotiated (endorsed) to the loan purchaser, the purchaser should own the loan free and clear of any offsets or defenses that the borrower may have against the selling lender. But most note buyers, he says, do not rely on this legal principle because “it works only if the note is not overdue and if the note buyer was unaware of the offset or defense, and it’s difficult to prove you were unaware of something, especially if you did any review of the lender’s files.”

Prudence, then, he says, “dictates that you look hard to see whether the borrower has claimed that the lender did something wrong, relieving the borrower of the obligation to repay all or some of the loan.” For instance, Edwards points a few key questions to keep in mind: Has the borrower claimed that the lender wrongfully called a default? That the lender failed to honor its obligations to make advances or release cash collateral, resulting in damages to the borrower? That the lender, by extending and pretending, has created a reasonable expectation of more of the same? That a lender on a California-secured loan has offset the borrower’s bank account or other money not pledged as collateral, or otherwise violated the one-action rule and thereby inadvertently released the deed of trust?

Check back in a few days for part 2 of the loan to own series, which will include more on topics like if a borrower is going to oppose foreclosure or file bankruptcy protection.

Categories: West, Distressed Assets, San Francisco