Recent headlines have revealed distress in the real estate market, which may lead to opportunities for investors willing to take a bit of risk.

There are many examples all over the country of groups with debt looking for off-ramps and upcoming maturity dates where borrowers need an exit. These have been coming in all real estate product types, whether a Class A office tower, a Class A shopping center or large multifamily projects. The stories of distressed borrowers — and anxious lenders — are abundant.

While the acquisition of real property is the most widespread and traditional form of real estate investment, due to changing interest rates, the lack of available capital, both debt and equity, and changes in underlying valuations among product type, investors may consider whether the purchase of a mortgage note secured by real estate offers a worthwhile alternative to traditional real estate investment.

This article provides an overview of the concept of note purchases in real estate, its advantages, risks and strategic considerations. This strategy is not for the faint of heart, but opportunities abound.

Understanding Note Purchases

A note purchase is a type of transaction whereby the holder of a promissory note secured by property sells the right to receive repayment from the borrower under the note along with the security interest in the property that secures such repayment. In other words, instead of buying the property itself, investors purchase the promissory note and the mortgage.

The sellers of notes can be private entities (such as a seller that took back financing to its buyer at the time of the acquisition of the property), banks or other lenders. Often, banks supply the market with notes to reduce their risk and drop problematic loans from their portfolios. These transactions may involve an immediate lump-sum payment by the purchaser at a discount to the note's stated face value or the value of the loan.

Reasons to Purchase

There are many reasons a note purchase may be an attractive form of investment.

A purchaser may view the expected cash flow or collateral as more valuable than the discounted purchase price of the note, meaning the investment theoretically recognizes profit and boosts the yield of the note without expending resources to develop or acquire the underlying real property that serves as collateral.

The purchaser becomes the creditor and is entitled to receive regular payments from the property owner (the borrower under the note), subject to the terms of the note and associated loan documents.

Depending on market conditions, real estate notes may be offered at discounted prices, particularly if the borrower is distressed or the note is not performing.

Although the purchaser of the note, as creditor, should expect to collect passive income from the borrower, if the borrower defaults, the investor may enforce remedies to collect its collateral, such as foreclosure or a deed in lieu. This can provide an opportunity for the investor to acquire the underlying real property below its market value, producing a higher return upon successful resolution.

In addition to reviewing the provisions of the note and other security documents creating and perfecting the lien, as with any other real estate investment, a note purchaser must carefully evaluate the underlying property. The note purchaser should also be aware of the associated risks and consider certain strategic factors to increase the likelihood that the investment is worthwhile.

Risks Associated with Note Purchase

Default Risk

Just like any debt instrument, investing in real estate notes carries the risk of borrower default. If the borrower fails to make timely payments or defaults on the loan, the investor may face a loss of income or principal.

Depending on the purchaser's strategy, this could be a desired outcome, but either way the purchaser must have a clear understanding of the risk it is assuming with regard to the borrower's performance.

Some would argue to buy distressed debt only where there is leverage over the borrower and where the borrower may want the opportunity to get out of its circumstance either through a deed-in-lieu or a foreclosure.

Market Risk

While notes provide a level of diversification, they are still influenced by broader market trends. Economic downturns, changes in interest rates or fluctuations in property values can affect the performance of real estate notes. The purchaser must have a clear understanding of how these factors may affect the value of the note being purchased.

It is important to know your strategy going in: Are you holding this note or do you desire to exercise your remedies to get to the underlying collateral so that you understand how these market factors affect you once you have closed on the note?

Strategic Considerations

Due Diligence

Conducting thorough due diligence is paramount when investing in real estate notes. This includes assessing the creditworthiness of the borrower, evaluating the property's value and condition, and reviewing the terms of the note. A note purchaser will typically conduct the same due diligence that it would if it were originating the note or buying the property.

However, an important exception is that the purchaser of the note will not have the opportunity to inspect the physical property the same way that a purchaser of real estate does. If the note seller is a bank or other financial institution, such seller is not likely to have access to the property nor a level of familiarity sufficient to give meaningful representations or warranties as to its condition.

Title

A purchaser must also review the underlying property's title to understand the rights of any other parties in the collateral and, importantly, whether it is encumbered by any other monetary liens.

It is critical for an investor to determine whether there are any superior liens and how the rights of any such superior lienholder affect the validity and priority of the lien that the investor is purchasing.

When an investor purchases a note secured by real estate, there is typically an existing lender's title policy that the seller of the note acquired at the time the note was created.

Rather than procure a new title policy, a note purchaser can often seek an endorsement to the existing lender's policy that adds the purchaser as an insured and updates the date of the policy to the date of the note purchase. Such endorsement may also protect the purchaser against matters that have arisen since the original policy was issued.

Importantly, a thorough review of the existing lender's policy will be required to ensure that the coverage is consistent with the purchaser's requirements.

If the policy is in proper form, issued by a reputable underwriter, and otherwise satisfies any concerns related to the underlying property, obtaining an endorsement to such policy will protect the purchaser at a much lower cost than the expense of obtaining a new policy. To the greatest extent possible, you want first-lien priority and should look for first-lien debt, rather than subordinated debt or mezzanine debt.

Exit Strategy

Having a clear exit strategy is crucial for note investors. Whether this involves holding the note to maturity, selling it to another investor or foreclosing on the property, having a plan in place helps the investor effectively manage the investment and optimize returns. Important considerations include the condition of the borrower, the market valuation of the property, comparable sales and lease opportunities, and the forecast of interest rates and other financial trends.

Legal and Regulatory Risks

Investing in real estate notes requires a thorough understanding of the legal and regulatory environment. Failure to comply with regulations or properly enforce loan terms can lead to legal complications and financial losses. Investors should take steps to avoid the potential pitfalls of operating in a highly regulated industry.

Understanding Available Remedies

Whether an investor's strategy favors a note's passive income or targets acquisition of the underlying property, understanding the foreclosure process and other applicable laws is critical.

If a borrower defaults, the note holder must have a clear understanding of the procedure for acquiring the collateral to avoid stumbling when exercising such remedies. The appropriate procedures, rights of the parties and recovery available will be governed by the loan documents and applicable federal and state law.

Know the Borrower's Rights

It is also critical to understand the rights of the borrower under the loan documents and applicable law. A lender liability claim, bankruptcy filing or assertion of other borrower rights may impede the original strategy of an unprepared note purchaser.

The note purchaser, as a creditor, may face liability for failing to follow the appropriate procedures when exercising remedies or otherwise mishandling borrower disputes. Similar to the note purchaser's rights and remedies, the borrower's rights and remedies will be governed by the loan documents and applicable federal and state law.

Conclusion

Note purchasing offers investors a compelling alternative to traditional real estate investments, providing opportunities for diversification, passive income and potential capital appreciation. However, it is not without its risks, and investors must conduct thorough due diligence and employ risk management strategies to help maximize their chances of success.