Purchasing Notes Secured by Real Estate

8/10/2019 Purchasing Notes Secured by Real Estate

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Authors:

Clifton M. Dugas, II

[email protected]

+1.214.939.4953

Eugene F. Segrest

[email protected]

+1.214.939.4991

Matthew Lopez

[email protected]

+1.214.939.5683

K&L Gates is a global law firm withlawyers in 33 offices located in North

America, Europe, Asia and the MiddleEast, and represents numerous GLOBAL500, FORTUNE 100, and FTSE 100corporations, in addition to growth andmiddle market companies,entrepreneurs, capital marketparticipants and public sector entities.For more information, visitwww.klgates.com.

Distressed Real Estate Alert

September 22, 2009

Purchasing Notes Secured by Real Estate

Introduction

Many investors are once again looking to purchase real estate-secured notes at a

discount from face value in order to capitalize on the steadily declining real estatevalues prevalent in todays market. If history is any indication of what we can

expect as a result of the current downturn (e.g., investors profits from the RTC days

of the 1990s), investors may indeed be able to profit from the downturn in todays

market and the resulting pressure on banks to get certain assets off their books.

Prior to closing on a typical real estate note purchase, an investor must determine,

through financial due diligence, (i) whether the borrower and/or guarantors of the

note being purchased have the financial capabilityto honor the note, or (ii) whetherthe value of the collateral exceeds the amount paid for the note together with

incidental costs. Either or both of these questions must be answered in the

affirmative in a loan purchasers determination of whether the transaction will be

profitable and thus worth the risk of a borrower default. The investor must also

analyze the underlying collateral for title issues, lien priority, materialmens liens,

environmental and architectural concerns, etc., in preparation for ultimately owning

and operating the property, should the borrower default on the note and the investor

elect foreclosure as its remedy. While an investor seeking to purchase a single note

or a pool of notes may think of itself as simply an investor in the traditional, financial

sense of the word, it is essentially a mortgage lender, real estate purchaser, financial

analyst, real estate operator and due diligence expert all wrapped into one. A

successful purchaser of real estate notes must possess expertise in all of theforegoing areas or be prepared to engage third parties who are experienced in such

transactions.

It is important to remember the parties goals as a backdrop to the note purchase

transaction. The ultimate goal of the party selling the note is either to remove a bad

asset (i.e., a defaulted, underperforming, or soon to be defaulted loan secured by real

estate) from its balance sheet or to sell the distressed loan (or even a fully performing

loan) at a profit. The purchaser in a note purchase transaction will seek to make a

profit by (i) receiving a payoff from the borrower in an amount exceeding the

purchase price of the note, or (ii) foreclosing on and liquidating or operating the

underlying real estate in manner that renders income to the purchaser that exceeds

the purchase price of the note.

The keys to limiting the investors liability during the note purchase process and

enhancing the likelihood of an eventual profit to the investor are through due

diligence and careful documentation of the transaction. An investor purchasing apool of real estate notes must analyze the transaction as though it were purchasing

the underlying collateral securing the notes. Considerations and issues differ

depending on the type of note and the type of collateral securing the note.

Moreover, engaging counsel experienced in these types of transactions may help

investors avoid potential liability. This alert includes a discussion of the various


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September 22, 2009 2


types of transactions an investor may expect to see

in this environment, as well as a general description

of the issues relating to real estate note purchases.

The Note Purchase and SaleAgreement

The first step in a purchase of notes secured by real

estate is the negotiation of a note purchase and sale

agreement. The parties to a purchase and sale of real

estate notes should strive to use a contract tested in

previous transactions. The contract should be fair to

each party and should include all specifically

negotiated deal points.

Any investor should, through its counsel orotherwise, make every effort to obtain as much

information as possible on the notes and thedocuments governing the underlying loan before

executing the contract. The more information an

investor can gather at the outset of the process andprior to entering into the contract, the better able it is

to evaluate any resulting implications and

incorporate them into its purchase price offer for the

notes, as well as mitigate the risk of reaching animpasse (due to the necessity of a major purchase

price adjustment mid-contract) after incurring

significant due diligence expenses.

A well-drafted loan purchase and sale agreement is

the parties greatest tool in ensuring a successful

transaction. The contract should provide for the

sellers agreement to unconditionally sell the note

and transfer all governing loan documents relating to

the note, including, without limitation, the deed of

trust or mortgage encumbering the real property, any

assignments of leases and rents, any guaranties, and

any other documents securing the underlying loan.

Such a transfer obviously includes with it all of the

sellers rights to enforce the terms of the loan

documents and exercise all remedies against the

borrower, including, without limitation, the right toforeclose on the real property collateral, commence

deficiency actions, and assert claims against

guarantors. Moreover, the contract should contain

provisions requiring the seller to fulfill various

obligations as a condition to the purchase, such as:

1. Clearly and specifically identify and deliver thenote, the deed of trust, the assignment of leases

and rents, the UCC financing statements, the

guaranty, the SNDA agreements and any other

documents and files relating to the note,

including the loan file and the correspondence

file;2. Provide for an assignment of the original

lenders title policy coupled with an

endorsement bringing the policy up to date, as

well as copies of all exception documentsreferenced in the title policy;

3. Provide for delivery of sellers existing surveyof the real estate collateral and state a

mechanism by which the investor can obtain an

updated survey, if necessary;

4. Clearly state the time for a feasibility study

period whereby the investor can adequatelyconduct all due diligence and, if necessary,

terminate the contract without any liability

other than the independent consideration

bargained for under the contract;

5. Require the seller to deliver a certified paymenthistory related to the note through the closing

date; and

6. Contain a provision whereby the sellerrepresents and warrants, at a minimum, (i) that

seller is the current owner of the note and that it

has not been previously assigned, (ii) that there

are no unaccounted for escrow payments heldby seller, and (iii) that the note is free and clear

of all claims and liabilities.

Due Diligence Process

(a) Generally

The due diligence process is perhaps theinvestors most crucial undertaking in connection

with the real estate note purchase transaction. It

is during this stage that the investor can truly

determine whether the price to be paid under the

contract justifies the risks associated with the real

estate note purchase. The only way the investorcan do this is by meticulously analyzing each

aspect of the purchase, including review of the

loan documents, the real property collateral for

the note, the financial condition and solvency of

the borrower and any guarantors, and the

financial condition and solvency of the seller. If

during this process the investor discovers an

unacceptable risk (assuming its attorney has

appropriately drafted the contract), it can


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surrounding the note is beyond the scope of

this article; however, the main issues a note

purchaser should pay particular attention to

include:

1. Security for the note (with the notereferencing the deed of trust, as

discussed below);

2. Maturity date and interest rate;

3. Order of application of anyprepayments;

4. Right of holder to accelerate upondefault (allowing the note purchaser to

seek the full amount due in the event

borrower fails to meet its paymentobligations); and

5. Recourse or non-recourse status of thenote.

(iii) Deed of Trust or Mortgage

The deed of trust or mortgage constitutes

the security for the note and is the legal

mechanism by which the note purchaser can

obtain title to the real estate encumbered by

such deed of trust or mortgage. This

document plays a crucial role because it

allows the note purchaser, directly orthrough its trustee under the deed of trust,

depending on the state, to obtain ownership

of the property, whether through judicial

(court-enforced sheriffs sale) or non-

judicial (public sale) procedures. The

mortgage or deed of trust should

specifically give the lender the right toforeclose on the underlying real estate in the

event of the borrowers failure to make its

payment obligations under the note or for

any other material default under the note,loan agreement, or any other loan

documents. A determination by the notepurchaser of the priority of the lien grantedin the deed of trust or mortgage is of

paramount importance since a first lien on

the property allows the note purchaser to

institute foreclosure proceedings upon theborrowers default (without regard to the

application of sales proceeds) and

subsequently receive title to the property

through foreclosure generally free and clear

of any inferior liens. Any senior liens,

however, should be reviewed to determine

order of priority and to assess any risk that

the sales proceeds from foreclosureproceedings would be insufficient to pay

the borrowers debt to the note purchaser

after satisfying the senior lien. In addition,

the note purchaser should, at a minimum,

review the deed of trust or mortgage to

ensure it contains:

1. The identity of the borrower,beneficiary and trustee (including

addresses);

2. A specific description of the

indebtedness under the note (theamount of debt secured);

3. A due-on-sale clause (triggering thefull amount of the indebtedness

becoming due upon a sale or other

disposition of the real propertycollateral);

4. The right to foreclose through judicialor non-judicial foreclosure

proceedings, depending on the state;

and

5. A satisfactory legal description of thereal estate.

The note sellers title insurance policy

should also be reviewed in order to confirm

that the lien is insured at the priority level

that the note buyer believes it is acquiring.

(iv) Real Estate Collateral

With respect to any real property collateral,

the note purchase transaction should be

treated as a traditional real estate purchase.

The note purchaser should perform an

onsite inspection of the property secured bythe deed of trust or mortgage and determine

whether an updated survey is required. To

limit the note purchasers liability, an

environmental site assessment of the

property should be obtained, and the note

purchaser should ensure that the current use

of the property is in compliance with

zoning and other governmental restrictionson the property. Additionally, it is essential

that the note purchaser obtain a new


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appraisal of the real property collateral, so

that it may get an accurate understanding of

the current value of the land and

improvements relative to comparableproperties in the local market. The

appraisal will show the approximate market

value of the property, but not necessarily

what the note purchaser could expect to

receive at a foreclosure sale. The note

purchaser should also obtain architectural

reports and any other third party reports

during this stage. Finally, the note

purchaser should analyze any income

stream from the property and ensure that the

purchase price justifies the risk relating to

such income stream in the event the note

purchaser ultimately owns the property viathe foreclosure remedy under the deed of

trust. Analyzing the foregoing issues will

mitigate any chance of the note purchaser

being exposed to unknown, and potentially

costly, liabilities relating to the property.

In addition to undertaking typical title and

survey due diligence that one would see in a

standard real estate acquisition, the note

purchaser must also secure an endorsement

to the original mortgagee policy of title

insurance. In most circumstances, the note

purchaser will not secure a new mortgagee

policy because it will be insured as a

successor or assign under the originalpolicy. The note purchaser can realize a

cost savings by bringing the sellers existing

policy up to date through an endorsementfrom the sellers original title company.

This allows the note purchaser to enjoy all

the protections of the original title policy

without incurring the full cost of a premiumon a new policy. When issuing the

endorsement, the title company will reveal

all new liens against the real property, ifany, arising after the date of the originalpolicy. The endorsement from the title

company coupled with an estoppel

certificate from the seller should adequately

protect the note purchaser from any

unknown claims to title that would affect

the note purchasers lien under the deed of

trust or mortgage.

(v) Financial Analysis of Borrower

and Seller

The financial solvency of the borrower and

any guarantors of the note is important to

the note purchaser for several reasons.

Determining the solvency of the borrower

allows the note purchaser to assess the

likelihood that the borrower can remedy

any current or future default under the note

or other loan documents. The note

purchaser should analyze the borrowers

financial statements to determine if it is incompliance with any financial performance

covenants and/or reporting requirements

pursuant to the loan agreement (e.g., net

worth requirements, debt-to-income ratios,etc.). Implicit in this analysis is a

determination of the likelihood of whether

the note purchaser will ultimately be forcedto foreclose on the property. By

determining the amount of equity the

borrower has in the property (by comparing

a recently appraised value of the propertyagainst the current loan balance), the note

purchaser can determine the likelihood of

default and foreclosure, with the more

equity held decreasing the possibility of

borrowers default, and vice versa.

The financial solvency of the seller should

also be analyzed in case any issues relating

to the loan arise subsequent to the sale.

Although todays market typically calls for

loan sales to be held on an AS IS WHERE

IS basis, the seller may, in some instances,

have ongoing lender liability due to errors

in calculating escrow payments made under

the loan agreement related to the note. This

liability can be transferred to the note

purchaser upon the purchase of the note

and, although the purchase and sale

agreement will provide for seller to

indemnify the note purchaser for such

claims, the note purchaser will want to be

certain that the seller has the financial

ability to do so. Analysis of the sellers

financial solvency should include

researching any litigation related to the

seller and the property, Uniform

Commercial Code and tax lien searches,


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mortgagor complaints and regulatory

inquiries associated with the loans.

Real estate note purchases have once again becomethe opportunity of choice for clients to profit from

the uncertainties in the real estate market, defaulting

borrowers, and declining real estate values.

Understanding the process as a whole and

appreciating the risks associated with owning the

underlying real estate is key to success in these

endeavors. We have extensive experience in this

arena and would be happy to provide assistance inthese transactions.

For more information contact Eugene Segrest,

Clifton Dugas, or Matthew Lopez.

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K&L Gates is a global law firm with lawyers in 33 offices located in North America, Europe, Asia and the Middle East, and represents numerousGLOBAL 500, FORTUNE 100, and FTSE 100 corporations, in addition to growth and middle market companies, entrepreneurs, capital marketparticipants and public sector entities. For more information, visit www.klgates.com.

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Purchasing Notes Secured by Real Estate