Note Purchases

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Why Buying Loan Notes Isn’t the Same As Buying Real Estate

By: Patrick M. McGeehan

Editor’s Note: Beginning with this inaugural e-newsletter, real estate lawyers at McKenna Long & Aldridge LLP will alternate writing a monthly column that addresses various aspects of commercial real estate distress, ranging from best loan resolution practices to loss mitigation strategies.

In response to the depressed state of the real estate and capital markets, large amounts of capital are now chasing opportunities to purchase defaulted commercial real estate loans at a discount. Not since the savings and loan crisis in the late 1980s has the market expected a comparable volume of loans to be sold.

For savvy buyers, this is a chance to earn enviable returns. However, it also is an opportunity for those who do not fully understand the nature of what they are buying to lose money lots of money.

Depending on the quality of the loan documents and the history of the loan, the borrower may have defenses and claims that can seriously delay a foreclosure on the collateral and reduce the ultimate return to the loan buyer. Discussions at industry trade shows and seminars that focus on buying distressed mortgage debt often only address the need to price and evaluate the underlying real estate. While the real estate asset securing the loan ultimately is the source of repayment, a buyer of these loans must realize that he is not buying the real estate collateral.

Instead, the buyer is literally acquiring a stack of paper comprising the loan documents that embody certain legal obligations and rights of the lender and borrower. That is a fundamentally different asset from the real estate. Assuming there is no fatal flaw in the loan documents, the rights of the lender will include the right to foreclose on the mortgage and become the owner of the real estate. But depending on the facts and circumstances, that may be an easy path or a long hard road.

Modeling the masters:

A valuation methodology for purchasing defaulted mortgage loans should take into account, on a net present value basis or capitalization rate basis, both the cash flow and liquidation value of the real estate, as well as the expense and length of time it will take to convert the loan into ownership of the real estate collateral.

In the early 1990s, the Resolution Trust Corporation developed a valuation methodology, the Derived Investment Value (DIV) methodology. The DIV took into account all of the unique attributes of distressed debt that make valuing it different from valuing the underlying real estate.

Such factors included the length of time required to complete a mortgage foreclosure and the widely differing mortgage foreclosure procedures from state to state, depending on whether the process is judicial or non-judicial foreclosure.

Other important factors that the DIV methodology took into account included the length of time to recover the collateral out of a borrower bankruptcy proceeding, the time period to market and sell the real estate after foreclosure, assumptions regarding the availability of interim cash flow to the lender, and expenses that would be incurred by the lender in the entire process. These basic principles contained in the DIV methodology largely remain valid today.

Similarly, discussions of due diligence in connection with purchasing defaulted mortgage loans all too often focus only on the attributes of the underlying real estate and not the mortgage loan itself. Ultimately, the length of time and the cost of converting the paper into owning the real estate will depend on the specific attributes of the mortgage loan.

For example, are there material flaws in the loan documentation? Have events occurred since the loan was originated that have provided the borrower defenses and claims that can be used to contest a foreclosure? Are there title problems such as liens prior to the mortgage?

Most of these due diligence issues can be addressed by careful review and analysis of the loan documents and loan servicing files, including the relevant correspondence files, and through public record searches.

Bankruptcy risk:

One unique and important loan documentation consideration is whether there is a carve-out guaranty, also known as a springing guaranty. In effect, this is a guaranty under which the person controlling the borrower has agreed that he or she will become liable on a recourse basis for the loan, if certain bad actions are taken by the borrower. Typically, the guarantor under such a guaranty will become personally liable for the loan if the borrower files bankruptcy. A bankruptcy filing by the borrower is generally something the lender wants to avoid. The bankruptcy imposes an immediate prohibition, an automatic stay, against the pursuit by any creditors of their claims against the borrower, including a mortgage foreclosure by the lender.

At a minimum, the borrower bankruptcy will cause the lender to incur significant additional legal costs and may materially delay recovery by the lender of its collateral. Carve-out guaranties are behavior control devices that are intended to impose the adverse consequence of recourse liability on the person controlling the borrower so as to make it less likely that they will choose to put the borrower in bankruptcy.

These kinds of guaranties have been found to be enforceable by the courts and have proven to be an effective deterrent to bankruptcy filing and enhance the value of the mortgage loan.

Gauging the risk of whether the borrower will file bankruptcy is an important part of pricing a distressed debt purchase, and knowing whether or not you will have an effective carve-out guaranty as part of your loan documents is very important.

Of course, due diligence of loan documentation and files can only be conducted to the extent such items are made available by the seller for review. Hopefully, deficiencies in this regard can be addressed with adequate seller representations and warranties.

The loan seller should, at a minimum, confirm the outstanding balance of the principal and interest of loan and should identify the specific instruments that constitute the loan documents, including any loan document amendments.

Additionally, the loan seller should confirm the completeness of the due diligence file and identify any material correspondence to or from the borrower and to or from governmental entities regarding the real estate.

It certainly appears that 2010 will present great opportunities in the distressed debt marketplace for those who invest wisely. However, as with all strategic investments, buying at the right price is everything, and to do that you have to know what it is you are buying: a stack of paper comprising the loan documents that needs to be carefully evaluated.

Patrick M. McGeehan is a partner in the Atlanta office of McKenna Long & Aldridge LLP and leads the loan workout and creditors rights practice group. He can be reached at

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