The nonperforming note market
In a healthy economy and market, most mortgage notes are performing with just a small portion being classified as nonperforming notes. Before the current pandemic, March saw record lows for mortgage delinquencies with just 3.6% of all residential mortgage loans being in some stage of delinquency.
But in times of economic hardship, delinquencies increase, and this puts pressure on the lending institutions that hold the note because they have less money coming in each month. For large lenders, this can cause an imbalance in debt and reserve ratios and reduce liquidity. For smaller investors in the private market, it could mean the note is too much of a liability, too time-consuming, or too costly for them to want to deal with and manage on their own.
It's common practice for lenders -- like a bank, credit union, or lending institution, as well as a private investor (someone who created a private mortgage note or owner-financed mortgage) -- to sell mortgages on the secondary market or to other investors whether they're performing or not. It's a routine part of business that provides upfront liquidity for an asset that's normally repaid slowly over time. While most performing loans are sold at par, or close to face value of the mortgage debt, when a loan is delinquent there's often a discount associated because the loan is a distressed asset.
In result, the nonperforming note can be purchased at a discount, which can range, based on who's selling the loan, from a 40% to 80% discount off the current market value or unpaid balance of the mortgage, whichever is less. This helps reduce the burden of the delinquent loan while providing much-needed liquidity to the seller.
What it means to invest in nonperforming notes
When someone says they invest in nonperforming notes, it means they purchase individual notes or groups of loans that aren't paying, and they then work to find a resolution to either get the borrower paying again or liquidate the asset through alternative options, such as a deed in lieu of foreclosure.
Because the nonperforming note is purchased at a discount, the note buyer has more flexibility to work with the borrower to find a profitable and beneficial resolution. This can include offering a forbearance plan or creating a formal loan modification, reworking one or more terms of the original note to be a more affordable monthly payment for the borrower.
Alternatively, if the homeowner no longer wants the home, the lender can provide a deed in lieu of foreclosure, where the borrower deeds the property to the lender in lieu of the lender foreclosing. This helps the borrower move on from the home without a foreclosure on their record and allows both parties to move on from the note quickly and easily.
In a worst-case scenario, the note investor can pursue legal action, called foreclosure, to regain title to the property if the borrower is unable to or uninterested in working with the lender or the property is already abandoned. While most nonperforming note investors don't want to foreclose, it's a part of the business model. Investors interested in buying nonperforming notes should understand how foreclosure laws work in their state and budget for the time and cost associated with the foreclosure process.
If the note owner ends up with the property through either a deed in lieu or foreclosure, they can do what they want with the property, which could include:
Why invest in a nonperforming note?
Really, it all comes down to the discount. In real estate, they say you make money when you buy. The larger the discount in relation to the property value or value of the asset, the more room for a profit and greater potential to earn a better rate of return. While not always the case, double-digit returns are fairly common when you buy and manage a nonperforming note correctly.
Investing in nonperforming notes is also a way to help the economy during challenging times. When large institutional lenders are inundated with delinquencies, their loss-mitigation departments become overwhelmed. In many cases, requests for foreclosure alternatives are missed or denied because they don't fit into their specific lender's requirements. That means borrowers aren't able to receive the help they need. When a note is owned in the private market, investors have more flexibility because of the discount they received when they bought the note. In most cases, this results in better borrower outreach and adaptable loss-mitigation resolutions for both parties.
What are the risks of investing in nonperforming notes?
Note investing can be complex. There are a lot of variables to consider when valuing a note and underlying collateral, especially if the loan is nonperforming. While most note investors hope for a positive resolution and want to avoid having to foreclose at all cost -- sometimes, it's just not possible. Foreclosure can be costly and time-consuming, especially if the borrower contests, litigates, or files bankruptcy.
Investors interested in pursuing this investment strategy should have a thorough understanding of how to conduct due diligence on the loan itself, the borrower, and the underlying property while remaining compliant with current national laws and regulations for that state.
Laws vary from state to state and will dictate whether or not licensing is required in order to own a note in that state, what the rules are for contacting the borrower (especially if they're in bankruptcy), and what the foreclosure process is like in that state. This adds a layer of complexity that often requires outside council and sophisticated knowledge. For this reason, it's important to have a solid foundation of real estate investing and knowledge of how to invest in notes before diving into the nonperforming note investing market.