Mortgage Note Due Diligence: The Ultimate Guide
Richard Allen
Co-Founder at Paperstac - The Technology Powering Tomorrow's Mortgage Debt Trades
If you’re considering investing in real estate mortgage notes, then you know conducting due diligence is an essential part of the process. But where do you start? Welcome to the ultimate guide to mortgage note due diligence, designed to help you in your note investing journey.
In this guide, we’ll cover all the basics of?mortgage note due diligence. You’ll learn how to evaluate the underlying property, borrower creditworthiness, servicing notes, and payment history to determine whether a note is a sound investment. By following our due diligence guide and utilizing the tools and resources provided, you can gain confidence in your note investing decisions and increase your chances of success.
Join us on this journey to become a savvy note investor and learn the ins and outs of mortgage note due diligence.
What Is Due Diligence?
So, let’s start with defining due diligence.
Due diligence is the process a buyer goes through when evaluating an investment or an investment opportunity. It involves thoroughly examining financial records to ensure the investment is sound and worth pursuing. For mortgage note investing, due diligence can help you identify potential risks and opportunities associated with a particular note.
The Due Diligence Process with Real Estate Notes
Performing due diligence for real estate note deals can be complex, but the more familiar and comfortable you are with the process, the more efficient you will be in making an informed note purchase decision. You can earn passive income with performing notes or receive a nice lump sum profit investing in non-performing notes. You can even start your own note business.?
Here are a few things to consider before making a purchase when investing in real estate mortgage notes to help limit risk:
What Is the Underlying Collateral??
The due diligence process for note investing can vary depending on the underlying collateral or the type of real estate the note is attached to. So, your due diligence will depend on whether the underlying collateral is vacant land, commercial property, or residential single-family houses. This may seem like a no-brainer, but it’s a crucial element to consider when note investing due diligence.
Equity in the Property
If the note value is well below the property's current market value, this provides a good safeguard or protection if the borrower defaults or fails to repay the note. Sometimes, there is significant equity that covers a first and second note. This is why it’s a riskier investment opportunity if the note’s value is close to or exceeds the value of the property. In rare situations, a property’s equity may be sufficient to support both a first and second note, making the equity level a consideration when evaluating a second position lien.
Location Quality
A property in a desirable location will retain its value better than one in a less desirable location.?
Location is a diligence factor that helps you navigate risk.?
Will the value of the property be enough to cover the balance of the note, or will it provide for an advantageous exit strategy such as a deed in lieu or the sale of the note itself if the note defaults??
In other words, a higher-quality property with a strong equity position is a safer investment than a loan with a high loan-to-value ratio in a low-quality area.
Additionally, the regulatory environment can vary greatly depending on the location. Some states may have more favorable conditions for lenders, while others may have shorter or longer foreclosure processes. Therefore, location plays a significant role in lending practices and the application of regulatory measures.
KEY TAKEAWAY:
During the due diligence process, it is important to consider that some states have more lenient regulations, which make them more lender-friendly, while others may have notably shorter or prolonged periods for foreclosure proceedings. Therefore, location is an important factor when evaluating risk.
Important Tip: Knowing a state’s?foreclosure process?is a piece of your due diligence. You may write off a state completely because of the lengthy and costly foreclosure you would incur. For example, some note investors don’t purchase properties in New York or New Jersey because of the lengthy foreclosure timelines.
Borrower’s Ability to Pay
Borrower pay history is just as significant as the borrower’s overall creditworthiness or credit report when analyzing resale notes or non-performing notes.?
Even if they face financial difficulties, someone who has made successful loan payments for a long time is more likely to continue making payments.
Limit Risks Through Mortgage Note Due Diligence
First goal of any investment is to limit risk; the more you can achieve this, the better you are going to be at making informed buying decisions.?
Which is why it is important to do your research before you purchase notes. And take these factors into consideration before investing. In addition to this, to limit risk you also need to establish value, look at the digital documents, including payment history and servicing notes, as well as credit report to establish a story for the note, dive deep into the collateral files, and get a BPO.?
We break this down further for you by going over the note investing due diligence process starting with establishing value.
Mortgage Note Due Diligence – Establishing Value?
The first thing you want to do is have an idea of value.
Value?is one of the most important things, because at the end of the day, your investment is being backed by assets that should have adequate value.
You don’t want to buy a note that’s worth around 100,000 in principal balance, but the house is only worth 75,000. And if you go just off of the principal balance when you’re buying your note, it could come back to hurt you. So, what I like to do when I first start looking at a note is get an armchair value.
What is an armchair value? It means going online, looking at the values provided by Zillow, maybe Redfin, Trulia, and if you are a real estate agent you should have access to NARRPR.?
There’s several other ones out there. PropStream is another example as well.
You want to go ahead and get an idea of value. Ask yourself, “What do I think the actual value of the house is?”. Now, when looking at value, you don’t want to just take what their value is. And you don’t want to rely on Zillow to provide you with a value estimate.
You want to use several resources to gather a value estimate.
List Of Websites For Gathering Comps on Surrounding Houses:
The following websites are great resources for gathering comps on surrounding houses to help you establish value when performing note investing due diligence.?
1.?Zillow?– don’t rely on what Zillow says, it can throw off comps. Look for what is for sale at the time and do comparisons. Search for what sold in the last six months.
2.?Realtor?– do the same process
3.?Trulia?– do the same process
4. Redfin – do the same process
5.?Narrpr?(must be a licensed broker)
6.?PropStream?– use this for trends in the neighborhood?
Focus on a range of possibilities rather than specifics. Think in terms of the?ARV(After Repair Value).?
Look for As-Is Value. This is not an exact science (assume that if the outside of the house looks bad the inside will look bad and vice versa).?
Use?Proxy Pic?– for doing drive-bys to understand how the homeowner values their home (emotional equity). Do this at the time of making an indicative offer.
Looking at what your competition is right now is equally important. Because you want to know what’s going on right now in that market.
Those are all important things. So, you want to have a good idea of value. That’s first and foremost.
Looking at the Digital Documents
Next, when running your note investing due diligence, you want to look at your financial statements or digital documents. You will have the seller upload all the digital documents to the platform, including the collateral files, the note, the mortgage, the credit report, the chain of assignments, the allonge, etc..
Ideally, you would like to have the origination file before you decide to purchase notes. These are all the documents that were filled out at the beginning, when the borrower applied. Credit reports are another helpful document to consider analyzing. Essentially, they are anything you could use in court if you ever had to fight this.
View The Payment History & Servicing Notes
Servicing notes will tell you about potential real estate note exit strategies and what’s going on with the loan on the payment history side. Begin by going through the payment history to establish a story for the note.?
Your goal in this part is to learn about the borrower and their payment habits. If you can obtain a payment history of 24 months or more, you can get a good picture of their payment cadence.
Past dues or missed payments might be patterns—at this point, jump into the servicing notes and see what happened there.
And as much as you’re trying to check the box, are they performing, or are they not performing?
Ultimately, you’re trying to discover the loan's story and incorporate all those inputs into your own formula. If I’m buying a performing note here, am I going to be able to set it and forget it, or is this a potential headache in the future?
Or, if it’s a non-performing loan, do I see some exit strategies that somebody else is not seeing because they’re not looking at the servicing notes?
Look for clues or patterns in the borrower's behavior. If you see inconsistency, try to rely on the servicing notes to corroborate why they may be making payments slowly.?
For example, if you start running into issues where, on paper, the borrower was showing that they could afford a $750 mortgage payment, but this says $950. And it puts the borrower debt-income ratio out of whack. Then, this is something that would be a red flag for me. Something that I would look at.
So remember, servicing notes and payment history are very important! They tell the story.?
Diving Deeper Into the Collateral File
Before making your final offer, you should have access to scanned images of the original collateral documents from the borrower. The note, mortgage, assignment, and allonge are important to review. You also want to review the title policy and the lender’s policy. Ensure that an actual lender’s policy is in place and can be assigned to you when you buy the loan.
Verify There Is A Copy Of The Mortgage and the Mortgage Note
It is important to verify that there is a copy of the mortgage and mortgage note. Essentially, the note is your promise to repay a specific debt, or an IOU. Mortgages are recorded in public records, so there should be a record.
If there isn’t a note, make sure there is a lost note affidavit (have an attorney from that state look it over so it makes sense). It’s important to mention that certain states, like Maine, require the original note.?In other words, if you don’t have the original mortgage note in certain states, you can’t move forward with buying the asset or foreclose.?
So, when you exercise due diligence, you want to make sure that you have the original note and then start at the beginning, with who originated the note and the mortgage. You want to be able to track every transfer to make sure there’s a corresponding assignment and a corresponding allonge to go with the transfer.
If you don’t have it, there’s a gap in the assignment. If your gap happens to be at the end, you want to talk to the seller and let them know what you are missing.
Note Investors Need To Know:
?? Who am I buying this asset from??
?? What’s the entity?
So, you can see the assignment going into their entity.
If they’re brokering it, you may have to have discussions with them. However, a good note investing strategy means you really want to see a full, complete chain of assignments.
Note Investing Due Diligence on the Paperstac Platform
If you are a buyer in a closing on Paperstac, verify that the seller has entered everything correctly after they have completed the closing data step and generated the Assignment & Allonge as draft documents.
Ensure that the buyer's name on the last Assignment matches exactly with the seller's name on the next Assignment.
Ensure the notary who notarized the Assignment previously had an active license (this will show on the Notary Stamp).
Verify that there was a transfer stamp on the note (sometimes, this can show up on the back of the note). The stamp will read “paid to the order of _________”
Lastly, make sure there is a title policy with the collateral file.
Ensure the last person on the chain of title?is the person selling you the loan.
Remember to focus on the details—focus on that from the beginning.?
Titles & Property Taxes
An O&E report is a crucial report that note investors utilize to aid in their due diligence. One of the first steps in your note investing due diligence should be to order an Owner & Encumbrance or O&E title report from a title search company after your initial bid on an asset or assets is accepted. It can typically cost just under $90 and is well worth the cost.?
Generally, this report contains the results of the following informational searches:????
?? Information on vesting?
?? Assignments and mortgages?
?? Liens from the federal, state, and local governments?
?? HOA encumbrance/lien?
?? Judgements in civil cases?
?? Any foreclosure proceedings.?
?? Property information
?? Deed from the current owner
After this is done, you can do some research on the tax side. You want to review and make sure all property taxes are paid.?
Information For A Note Investor To Check
Check the O&E Report for county property tax delinquencies.
You can always call:
The?title and the taxes are important aspects?of mortgage note transactions that?should not be overlooked.
Getting a Broker Price Opinion?
This is why it is so important to verify all the details, including the value. How do you do that? You can contact a local real estate agent in the area where you’re doing the evaluation or get a (BPO) broker’s price opinion.
A broker’s price opinion, or BPO, is a real estate broker or another qualified individual’s determination of a property's value. Generally, a broker knowledgeable of the local housing market typically performs BPOs. A BPO assigns a dollar amount to a property based on specific characteristics. A BPO does not always represent the market worth of a property, nor does it show an official appraised value.?
Get Eyes On The Property
However, a broker's price opinion can help you get the most accurate information about a home’s valuation. In other words, they verify the value and examine the property, so you can get pictures of the property and a clearer estimate of its value and story.
This is important! If the collateral turns out to be a demolished property, it becomes more difficult to recover your initial note investment or return a profit. A BPO can get a glimpse of that private property.?
The BPO will go through the Owners and Encumbrance Report or search title, mentioned previously. They will make sure that everything you look at, they can see. And see if there are any sort of red flags that pop up when they do their full-on title search. With title searches, you can go with one owner, two owners, or a foreclosure search.
Obviously, the more in-depth you go, the more it’s going to cost and the longer it’s going to take. So, keep that in mind when you’re planning.
You Make Money On The Buy
Real estate note investments fall under the typical real estate adage. Anytime a note investor does research, they are putting themselves in a position to make the most money possible in their exit. As a result, most due diligence steps focus on removing potential risks or mitigating risks that cannot be completely eliminated in an investment.?
Helpful Tips for Note Buyers
Initial Due Diligence For Mortgage Note Investing?
Initial due diligence for note investing will differ from one real estate investor to the next. Before submitting initial bids, one note investor, for example, will hit on a few key components of their due diligence. On the other hand, a newer investor may conduct extensive due diligence with mortgage notes during this early period before putting in an initial bid.
Basics Of Mortgage Note Due Diligence?Initial Process
A few basics for performing initial due diligence for mortgage notes include:?
Due Diligence Checklist For Mortgage Note Investing
Wrap Up
In essence, due diligence is fundamental in mortgage note investing. Crucial for both individual investors and those running a note investment business. This guide aims to provide a solid foundation for conducting thorough due diligence, essential for minimizing risks and making informed decisions. It provides a comprehensive checklist and effective strategies to enhance the investment process.
Sellers typically offer a week for reviewing individual notes and over a month for larger collections. As investors gain experience, the due diligence process becomes more intuitive, streamlining the buying experience. This guide serves as a valuable resource to navigate the complexities of mortgage note investing, encouraging informed, strategic choices, and paving the way for successful investment outcomes.
For more information on conducting due diligence on mortgage notes, check out our video below. Subscribe to our YouTube channel for more helpful content on mortgage notes and real?estate investing!?
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