Part 1 of 2

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SAN FRANCISCO-Real estate recessions have proven to both breakand make great fortunes. Banks, the FDIC, and CMBS servicers nowhold more than $140 billion in troubled loans, and that number isgrowing. Many investors are seeing that $140-billion problem as areal opportunity to buy defaulted loans at a deep discount in orderto acquire the underlying real estate on the cheap. Three expertsat Manatt, Phelps & Phillips LLP recently spoke withGlobeSt.com about buying a loan to own, how to account for therisks and how to know what you are buying.

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How do you know what you are buying?

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Clayton Gantz, a partner in the San Francisco office, tellsGlobeSt.com that while it seems relatively straightforward toevaluate a market before you buy, “you are not buying a market, youare buying a loan in order to acquire a unique asset.” Assets, hesays, can have many interesting quirks such as environmentalcontamination, leases with kick-out clauses, tenant improvementrequirements, or structural problems resulting from deferredmaintenance. “If the asset has construction in progress forexample, the downtime from initial default to your acquisition mayhave allowed weather to damage the work in place and thieves toremove the plumbing and wiring. And if you’re buying a mezzanineloan, so that the collateral is a company rather than real estate,you will inherit all of the liabilities of that company, not justthose that show up on a title report,” he says.

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

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Can you actually foreclose?

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

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He explains that the law deems the current holder of theoriginal note to be the owner of the loan, regardless of who holdsor has been assigned the mortgage or other loan documents. “Whenthe loan has traded hands several times, the original note andother loan documents may be difficult to find,” he says. “Manyborrowers in this recession have successfully avoided foreclosureby demanding that the noteholder produce the original note, whichit could not do.”

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In private-sale foreclosure states such as California, “it maybe possible to get the title company to complete a nonjudicialforeclosure based on a lost-note affidavit and indemnity,” saysMuller, “but in this environment the title companies areincreasingly leery of proceeding without the original note unlessthe noteholder is a reputable institution.”

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Muller adds that “foreclosing on the loan does not necessarilymean that you will end up with the property.” Foreclosure is doneby public auction, he says, “which means that others can show up atthe sale and, potentially, outbid you if you are not willing andable to put up your own cash beyond the face amount of thenote.”

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

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Does the borrower have defenses, offsets, orcounterclaims against the lender?

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In theory, according to Steve Edwards, a partner in the OrangeCounty, CA office, if the promissory note is negotiable, and if itwas in fact negotiated (endorsed) to the loan purchaser, thepurchaser should own the loan free and clear of any offsets ordefenses that the borrower may have against the selling lender. Butmost note buyers, he says, do not rely on this legal principlebecause “it works only if the note is not overdue and if the notebuyer was unaware of the offset or defense, and it’s difficult toprove you were unaware of something, especially if you did anyreview of the lender’s files.”

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Prudence, then, he says, “dictates that you look hard to seewhether the borrower has claimed that the lender did somethingwrong, relieving the borrower of the obligation to repay all orsome of the loan.” For instance, Edwards points a few key questionsto keep in mind: Has the borrower claimed that the lenderwrongfully called a default? That the lender failed to honor itsobligations to make advances or release cash collateral, resultingin damages to the borrower? That the lender, by extending andpretending, has created a reasonable expectation of more of thesame? That a lender on a California-secured loan has offset theborrower’s bank account or other money not pledged as collateral,or otherwise violated the one-action rule and thereby inadvertentlyreleased the deed of trust?

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

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Natalie Dolce

Natalie Dolce, editor-in-chief of GlobeSt.com and GlobeSt. Real Estate Forum, is responsible for working with editorial staff, freelancers and senior management to help plan the overarching vision that encompasses GlobeSt.com, including short-term and long-term goals for the website, how content integrates through the company’s other product lines and the overall quality of content. Previously she served as national executive editor and editor of the West Coast region for GlobeSt.com and Real Estate Forum, and was responsible for coverage of news and information pertaining to that vital real estate region. Prior to moving out to the Southern California office, she was Northeast bureau chief, covering New York City for GlobeSt.com. Her background includes a stint at InStyle Magazine, and as managing editor with New York Press, an alternative weekly New York City paper. In her career, she has also covered a variety of beats for M magazine, Arthur Frommer's Budget Travel, FashionLedge.com, and Co-Ed magazine. Dolce has also freelanced for a number of publications, including MSNBC.com and Museums New York magazine.