Distressed Note and REO purchases (part 2)

Part 1 of this series dealt with representations and warranties that are typically provided in distressed note purchases and distressed REO purchases.  This post gives an overview of some of the diligence issues that must be addressed in purchases and sales of (whole) distressed notes.   (Other issues arise in the context of sales or purchases of participations in notes, which are not addressed in this post.) Why do due diligence?  When a lender chooses to sell, rather than to enforce, a distressed note secured by CRE, it may have made that decision for any one of a number of reasons.   For example, the lender's regulator may have decided that the lender is carrying too many distressed real estate loans, and may have told the lender it needs to quickly rebalance its portfolio.  Or the lender may need to improve its liquidity quickly, and may determine it can do so faster by selling one or more distressed notes rather than by enforcing them, then selling the distressed REO after it is foreclosed upon by the lender.  Or it may have decided to get out of a given type of lending business, and therefore to sell all its loans in that line of business.  It may be rebalancing its risks geographically, or based on changes in the market.  Alternatively, the lender may need to improve the overall quality of its portfolio quickly.   Or it might be selling to change its yield and duration risks.   It might be selling the note due to its merger with another lender.  Another reason a lender might sell is because it thinks it will have a tough battle with the borrower to enforce the note, and does not want to commit the time or money.  Or the property may carry with it liabilities of one sort or another:  for example, foreclosing on a retirement home or a hospital may create public relations problems for a lender; or the lender may simply not want to, or have the resources to, manage certain types of property, such as land not yet subdivided; or a property may have environmental problems that concern a lender.   Or, in a declining market, the lender may decide it ultimately can collect more in a fast note sale (or lessen its costs -- such as property taxes and other costs it must advance -- to hold the declining property) than in a slow foreclosure (and possible bankruptcy). A potential buyer simply does not know why a lender is selling a distressed note, and so it needs to do diligence at two levels to understand and price the risk it is taking by buying the loan: 

• First, it must do diligence to determine the status of the note, the other loan documents, the borrower, any guarantor, and the relationship and actions to date taken by the borrower and the selling lender, because the buyer will be stepping into the shoes of the selling lender; and
• Second, it must do diligence to determine the status of the real property and any other collateral securing the note as if it were buying that property, so that it can understand, evaluate and price the current value and possible risks inherent in foreclosing upon that collateral.

1. What interests in the property collateral are encumbered by the loan?
2. What is the value of these interests?  Are they sufficiently valuable that if the note borrower fails to pay the note, the buyer can collect the amount owed by foreclosing on the land or taking other allowed liquidation actions?
3. Who owns the property collateral? (Generally, it should be owned by the borrower.)
4. What is the property used for? (This information is very important in determining the value of the land and the likelihood that it is environmentally contaminated.)
5. Where is the property located? And can it be located with specificity on a survey? Has it been subdivided (so that it can be resold after a foreclosure if necessary)?
6. How has the property been used in the past? (Also very important when determining environmental risks.)
7. If it were to have to foreclose, what use could the buyer make of the land?
8. Does anyone other than borrower (and typical easement holders, like utilities) have any rights to all or parts of the land?  If so, could such interest holders block buyer's use of the property after a foreclosure?