Whole Loan Mortgage (“Note”) Investing

 

Paper SDXS

 

Introduction

Today’s real estate and related asset market is an ever changing landscape of opportunities to participate in relative low risk good return investments.   The feature that most distinctly differentiates a whole loan mortgage or “note” investment from other investments such as bonds is the principal repayment method.  The timing and rate at which principal repayment occurs are major factors affecting a note portfolio or single note yield.   

SDXS has long standing relationships with banks and financial institutions which commonly offer to sell these assets as portfolios or single assets (“oneoffs”) at favorable terms and prices for suitable investment.  SDXS has an expertise in working with “distressed” loans which are loans that suffer from some form of issue arising from paperwork, real property physical defects or failure of the borrower’s obligations. This presents the ability to purchase these loans at discounted rates enhancing return and mitigating risk levels. Subsequently this create a profit margin greater than traditional cash-flow based investments when correctly managed.

Origin of Investment Return

The cash flow of a mortgage portfolio consists of scheduled principal payments, accrued interest payments, and unscheduled payments of all or part of the outstanding principal (“prepayment”).  It is by organizing and managing the structure of these prepayments that SDXS is able to capitalize on the discounted purchase price while utilizing the periodical cash flow of the asset or portfolio as operational income to continue to work the asset or portfolio to maximize returns.

The major profit controllable among these investments is the methodology used to forecast how quickly principal will be returned and the structure of execution by which each loan gets settled for the maximum value in accordance with that assets role in a portfolio or as a one off investment.

SDXS purchases loans and portfolios which have an income stream based on the individual borrowers monthly mortgage payments or lack there of.  This monthly cash flow is typically a fixed income in relationship to the duration of time where any given investment is kept in full without settlement or trade out.  This notion allows for an investment budget to be setup and an action plan can be deployed to select and execute disposition and settle decisions over the life of the investment under SDXS’s control.

Maximize Returns

A mortgage or note investment in today’s market has many moving parts.  Time and expense management are large factors in the potential return for any investment.  These costs are factors which can be offset by monthly cash flow or must be directly capitalized.

In single asset or one off investments the basics are fairly straight forward.  A performing loan, which is one where the borrower is paying should offset costs of mortgage servicing.  The consistency of the borrower’s payments will influence an investor’s capital demands in regards to protecting their interest in the investment.  Simply stated a borrower who is not paying at all will create a need for an investor to advance (pay on behalf of) payments which preserve the property and the interest given by the security instrument (mortgage or deed of trust).  This includes items like advancing for taxes, insurance and home owner association dues along with steps to preserve the property if vacant or abandoned by the borrower.

Returns can be maximized by an investor by managing the time and expenses that are allocated to any given loan.  This is no small feet as requirements for loss mitigation create burdens of time which result in increased expenses for the investor.  Planning correctly through a proper bid price and capital reserves is essential for an investor in order to prosper in this asset class.

SDXS does not encourage ideas of re-trades or resales with short term investment horizons.  This notion is not uncommon in the market place but time is drastically over stated.  Investors need to understand that their highest best use of the investment will take time and “flipping” is a game similar to investment roulette.  Sooner or later you will start to experience net loss.

Settlement Practices

SDXS assesses assets at the time of bidding and acquisition for highest best use for the maximization of return from the asset and portfolio.  Various factors contribute to the role each asset will play including the underlying property value, past payment history, potential future payment, borrower credentials and mortgage type.  This process creates an order to settlement target ideas that looks more like a set of iterations and less like a straight line. Disposition plans should always remain flexible while taking a conservative approach to the preservation of the capital invested.

For conversation sake we can break down ideas of disposition into two main categories.  This tends to assist the investor with an understanding of the purpose and outcome of the treatment.    It is always important for investors to have realistic expectations for disposition and outcomes so as to encourage proper decisions and not decisions based on bar stool banter.

In it’s simplicity the borrower is either going to pay or not.  We should pause here and talk about importance of a paying borrower.  A paying borrower is sort of the point of making a loan in the first place.  Paying borrowers can come in various forms.   Some pay as agreed in full.  Others fall a little short of the exact obligation.  Those borrowers will pay slowly or intermittently.  Loans where the borrower pays as agreed require no treatment.

As one could expect, understanding the borrower’s circumstances which cause payments to come in less than what are fully due and on time would be the next challenge.  Various life events can occur which create situations for borrowers to fall behind or struggle to keep up with payments.  Investors have two tools by which to work with a borrower on these matters – forbearance and modification.

When you forebear the terms of the note are suspended temporarily to some agreed manner.  For instance a lower payment might be allowed to be made and still applied to principal or interest.  A principal application would allow a borrower to catch up and may result in the investor receiving less interest income.  A interest application would allow a borrower to not fall behind but also not advance through their amortization schedule.  This can cause a balloon to form at maturity which may be an unintended consequence.  Both treatments should be used in care with short term and long term goals being looked taken into consideration.

When a loan is modified it is considered a new extension of credit.  This carries with it regulatory and compliance requirements.  A loan which may have been originated in the past may have been exempt from those new regulations which would now apply.  So caution is suggested.

A modification is a permanent change to the terms of the note.  Those changes can include changes in the balance due, the interest rate or the maturity date.  Generally speaking the changes are made to give some form of relief to the borrower.  Typically this results in lower payments or a deferment of demands made under the note terms like catching up accrued interest or advances.

Both of these treatments can take advantage of the discount the investor has received when purchasing a distressed loan.  The motive for the investor is to realize the portion of the loan which they discounted in their purchase sooner or use it to their advantage to create a more successful borrower and that borrower’s capacity to pay into the future.

It is also important to note contrary to some conversations in the investment world that neither of these treatments are an exit strategy onto themselves.  I often hear this and it is an incorrect idea.  You do not exit your investment when you modify a loan or forebear a loan.  The investor is still invested.  These treatments are stage settings for a future exit which could be a borrower refinancing, pay to zero or a note sale.  Note sales in this setting are often misunderstood and we will deal with that concept in a future article.

In our second master category the borrower is not paying and will not pay.  This simplification takes into account that a non-paying borrower who wants to pay falls into the category above.  Generally these loans are considered to have exhausted all forms of loss mitigation.  The borrower either can not pay or does not want to.

This is then the easiest treatment to understand from an investor’s point of view.  The remedy granted by way of the mortgage or deed of trust is foreclosure.  We will go into the idea of foreclosure in a future article but it is important to correct a very misunderstood concept relating to foreclosure.  Foreclosure is NOT the taking back of the property.  The security instrument does not grant that to the holder.  What is actually occurring is the borrower’s right of redemption is being extinguished.  The holder does not have specific right to own the real property instead they have a right to use the property to recover their amounts due.  Again, more on this topic in a future article.

The process of foreclosing takes two forms judicial or through the courts and non-judicial through a power of sale.  These are the most costly treatments of a loan as they force the investor to make the most advances which can include advances for taxes, insurance, property preservation and legal fees amongst others.  Generally most advances can be included in the total due to the investor recovered from the sale of the property.  In this treatment time is an enemy of the investor as time will mean additional costs.

The investor can attempt to reduce the time it takes to complete a foreclosure provided the borrower cooperates.  Sometimes a borrower is willing to recognize they can no longer handle the obligations of the loan and will work with an investor to either deliver the deed in lieu of a foreclosure.  A deed in lieu of foreclosure is a viable treatment but one that should be used with caution as it ultimately the borrower needs to surrender the property under no duress or promises outside of the debt being satisfied.  Deficiencies can still arise from event though most of the time a deficiency is waived by the holder if the borrower delivers a DIL.  We will touch more on deficiencies at a later time.

Some readers may be wondering what happened to idea of “short” as a treatment.  That is a short sale or a short pay.  Shorts can fall into either of the two categories above.  A borrower who is or is not paying can be allowed to short sale their house or short pay through refinance or cash.  The term short simply means the loan holder will take less than what is due to satisfy their lien.

Typically a short pay through a refinance will only occur if there is some payment performance from a borrower.  This is logically due to the new creditor wanting a borrower who can meet the new obligations.  There have been various loan programs created and put to work in the market which will consider borrowers with varying degrees of delinquency and default for new credit.  Additionally, the borrower may experience a sudden windfall or simply raise money through friends and family allowing for a cash payment.  Again, in any setting where we have a short it requires the holder to agree to take less than the total amount due.

A short sale is probably one of the more common ideas and is understood fairly well.  A short sale is a sale of the property by the borrower, usually in the open market in a non-arm’s length transaction.  The note holder must agree to take less than what is due to satisfy the lien and allows the borrower to sell the property with clear and marketable title to a new buyer.

Risk Insulation

With the proper ideas and guidance investing in whole loan mortgages or notes an investor stands to purchase a well planned asset or portfolio and make returns.  Many times investors get involved in the purchase of these assets with little to no knowledge of the multiple moving pieces of the industry and their education costs them their return.  One of the core contributors to that is treating note investing like real property investing.

Real property is the collateral not the investment.  An investor will do well to understand real property investing and use that understanding in conjunction with other ideas related to note investing.  Note investing is rooted in finance and comes with degrees of legal and regulatory compliance.

SDXS pursues whole loan mortgage or note investing as the vehicle of investment because of the diversification of exit strategies which are present and the control of the liability regarding real property.  It is not a ‘cheaper’ way to invest nor is it a less risky way to invest.  No investment is without risk but SDXS believes a methodical and systematic strategy will help reduce investment loss and assist with maximizing investment gains.

More Information

Investing in whole loan mortgages or notes is not something new and is not typically considered an exotic investment.  For many years prudent investors have successfully invested in this asset class both on a one by one basis as well as portfolios or multiple notes or whole loan mortgages at one time.  SDXS is more than happy to provide one on one consultation and structuring to meet the investment criteria of each investor.  Please feel free to contact SDXS at CONTACT US with any questions or for further information.

 

2 Comments

  1. Rick Bradd
    August 19, 2015 - Reply

    Hey Dion,
    So glad you decided to move forward with the blogging, I am planning on following closely to continue learning as much as I can about the asset class. I have expressed this before but want to thank you for sharing your experience, i do appreciate it.
    Rick

    • August 28, 2015

      Thanks Rick! Glad to see you made it over. We are trying to setup a regular schedule of articles and stick to it. We are open for suggestions of material any reader would like us to address that pertains to the topic at hand. Thanks for visiting us and glad the information was informative.

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