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With its allure of great profits, investing in distressed debt is in vogue – and enjoying popularity with many first-time investors, as evidenced by the proliferation of new, opportunistic debt-buy funds. Debt sale offerings are flooding the market at record levels due to tightening credit and the illiquidity crisis plaguing many lenders today.

But distressed-debt investing is not a game of interest rate swaps or even trading on loan fundamentals – there is another set of rules at play. The rule of caveat emptor reigns for those foolish enough to assume that just buying any loan at a discount will automatically generate a profit.

Acquiring debt is typically fraught with timing and expense issues, and a myriad of state and federal statute nuances. For example, upon securing a foreclosure judgment in New Jersey, the law overrides a loan’s default rate and imposes a going-forward rate of only 4%, unless one has the foresight to ask the court to grant a higher rate. Also, many states limit the legal expenses a lender can recover in foreclosure ($8,500 in New Jersey), and courts may or may not award a higher amount. Investors new to the distressed debt game generally assume that all penalties and fees reflected in the loan documents can be recovered, only to be surprised when the court disallows some of these charges as being excessive.

Many loans currently for sale were made with the lender’s motive to put out maximum dollars, while traditional equity, loan-to-value and borrower experience guidelines were often ignored. Recently, the integrity of some appraisals has been called into question with accusations that debt issuers and appraisers worked in collusion to inflate the property values. Investors would be wise to re-underwrite the loan and collateral before placing a bid offer.

Another overlooked but critical investing component is getting out and kicking the tires, as a debt investor may end up owning the collateral property. Therefore, to develop an appropriate exit strategy, it’s imperative to conduct a site visit in order to visualize alternative uses for a property, such as acquiring neighboring properties to make the deal work. If you can’t leave your desk to walk to the property and understand the collateral, be prepared to suffer losses.

Many buyers woefully underestimate the process and expense required to monetize a loan, as protracted litigation and court delays will bleed anticipated profits. When you’re tied up in depositions or providing testimony, you’re incurring opportunity cost of both capital invested and personal time. In addition to your time is the mounting legal expense that can quickly surpass $200,000.

An extra hurdle for distressed debt investors is inheriting someone else’s loan documents. One should not assume that just because the loan was issued by a major originator using a top law firm, that there won’t be errors in the documents. Many originators and their lawyers were under extreme pressure to expedite the securitization of many loans, and only performed a cursory review of loan documentation by junior staff.

A crucial component of a successful debt buy is being pro-active and strategically-minded. Investing in distressed debt is not a quick game of checkers, but more like a chess tournament, requiring multiple strategies and forethought. Your operating mantra should be, “Always working to enhance your debt” – via fees, expenses, late charges, interest rate increases – the kitchen sink! It is always amazing how much the original lender failed to charge the borrower – just make sure that you don’t miss the opportunity to “enhance” your position.

Also during foreclosure, some property owners will attempt desperate measures such as stealing cash flow. And after finalizing a foreclosure, many buyers make the mistake of allowing the auction/sale process to run itself.

Ultimately, we believe that substantial investment returns are waiting for those who are willing to quantify the market, adhere to a strict selection process and work creatively to tailor an appropriate monetization strategy to each unique situation.

The views expressed here are those of the author and not of Real Estate Media or its publications.

David McLain is a principal and chief investment officer of PalisadesFinancial, LLC, based in Fort Lee, NJ.

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