Should You Take the Risk on Problem Loans?

TAMPA, FL—There are profits to be had buying problems loans—but there are also plenty of problems to be had. Should you take the risk?

That depends, in part, on your risk appetite. One key to making smart problem loan acquisitions is due diligence.

GlobeSt.com talked to real estate attorney Ron Cohn of the Arnstein & Lehr firm's Tampa office. He specializes in helping lenders reduce their commercial real estate-related risk from a legal perspective, while working on a lender's behalf when a commercial loan goes into default. You can still read part one of this exclusive interview: Will This Lending Strategy Become the Norm?

GlobeSt.com: What are some things buyers should look for in their due diligence when looking to buy bad loans?

Cohn: The basics need to be covered, and covered well. Make sure any potential issues related to the state of title—the priority of the mortgage in relation to other liens on the collateral—has uncovered any potential issues. One of the most important steps in such due diligence is to understand the status of the real property taxes due and whether a tax deed application may already be pending, so you can factor those issues into your pricing and projections.

It is also important, when possible, to take the time to physically inspect the real property collateral in detail, again to uncover any potential issues. Review of the seller's appraisal of the property is a must, along with a Phase I environmental report, if one exists. If the Phase I indicates possible contamination issues, the investor should consider retaining qualified environmental counsel to review the report and advise the investor as to the scope of the problem should the investor elect to go forward with the loan purchase.

GlobeSt.com: When you buy a problem loan, are there things you should do to mitigate the downside risk related to the borrower's ability to pay?

Cohn: First, make sure there is a clear path to foreclosure or collection if the borrower's payment performance deteriorates. The loan documents need to be carefully reviewed to be sure they outline in detail what will happen upon a default and when. This is critical if the situation worsens.

GlobeSt.com: With all these issues, are buyers taking a good risk in buying these problem loans?

Cohn: That can only be assessed on a case-by-case basis. That said, there are a lot of quality deals out there, with a number of loans tied to quality properties being sold at significant discounts in relation to the collateral's value. 

Of course, loan sale portfolios tend to be like a box of strawberries, with the luscious red ones on the top and the less-palatable and possibly even rotten ones on the bottom. The buyer needs to balance the good with the bad to determine if a particular portfolio can be made profitable as a whole.

Having done the proper due diligence, and with a true understanding of how you can effectively cover your downside risk, buying one of these loan portfolios can be a smart move.