Investors think of it as a win-win strategy: buy a distressed loan at a big discount, and if the borrower pays, the investor earns interest at a favorable rate and recovers the principal at a profit.
If the borrower doesn’t pay, the investor forecloses and takes a property worth a multiple of the invested cash.
“It can be a very successful strategy, but it requires an investor with liquidity, not just for the purchase of the loan but also for the cost of repositioning the asset and carrying it until it makes money or a resale market develops,” says Erica L. English, a shareholder with Katz Barron Squitero Faust.
However, says English, this strategy carries some significant risks and the investor must be prepared for the possibility of a lengthy foreclosure battle.
Smart Business spoke with English about the risks and complications that can arise in distressed loan deals.
What risks are involved with distressed loan deals?
There is a very limited opportunity to conduct due diligence on the property and the borrower. The universe of data normally available is the contents of the selling lender’s files and any publicly available information. The loan buyer normally does not have discussions with the borrower or access to the property or the borrower’s financial data. Moreover, few loan sellers will make significant representations or warranties regarding the loan, the borrower or the property, and most sellers will deal only on a ‘no recourse’ basis. Only a handful of basic representations are customarily made, including that the seller owns the loan free of encumbrances, that the loan documents being conveyed are all of the documents governing or securing the loan and that the documents have not been modified. The loan payment history and balance information is also provided.
What kinds of due diligence can be done?
If the seller has been diligent in administering the loan, the file will contain a rent roll and financial statements from the last calendar year, the last quarter ended and, possibly, the last month ended. However, other property data, such as environmental and engineering studies, are likely to be stale-dated to the time of the loan origination. The investor will rarely be afforded the opportunity to do fresh engineering and environmental inspections on the property. If the collateral is a project under construction, it will be essential for the investor to receive copies of the consultant’s reports on the status of the project and an updated report prior to committing to the deal.
Aside from the lender’s files, the investor can mine the publicly available data on the property and the borrower. The status of record title should be examined from the date of the loan title insurance policy and behind the policy, as well, in order to catch any title defects that may have been overlooked in the policy. The amount and payment status of real estate taxes should be investigated, as well as any accrued code enforcement fines. Building permit files and inspection records can provide additional information.
A careful study of the loan documents themselves must be done. The investor should have a clear understanding of any forward funding obligations, such as construction disbursements, and what the default triggers and remedies are. The evaluation should include a usury analysis.
Is a loan buyer affected by claims a borrower might have against the selling lender?
If the loan is in default at the time it is purchased, which is almost always the case with distressed loans, the buyer cannot achieve ‘holder in due course’ status. This means the buyer is subject to all of the defenses that the borrower might have against the selling lender and perhaps its predecessors. The borrower may bring lender liability defenses, such as those related to errors in funding or other defects in loan administrations, against the loan buyer, even though the buyer itself is not at fault. Often, the selling lender’s files offer few clues as to the existence of these defenses, particularly if no foreclosure complaint has been commenced or answered by the borrower.
The Florida loan statute of frauds offers protection to lenders and loan buyers by requiring that all agreements related to the lender’s obligations under the loan must be in writing and signed by the lender in order to be enforceable against the lender. This reduces the risk of the borrower claiming rights based on alleged verbal inducements or agreements by the lender, but leaves open the risk of lender liability claims based on other facts and theories.
What about borrower defenses based on the Truth in Lending Act?
If the collateral is residential property and the loan has been outstanding for less than three years, the loan should be examined for Truth in Lending Act (TILA) compliance. Investors often don’t realize that they can be held responsible for TILA violations committed by the loan originator if the violation is ascertainable from the documents. If a violation exists, the consequences can be disastrous. The borrower’s remedies include rescission of the security interest in the collateral, which essentially leaves the loan holder with an unsecured note.
There is another issue if residential property is involved. Some ordinances have been passed in which foreclosing lenders are required to maintain and repair properties while the case is pending and, following certificate of title and prior to resale, to obtain inspections of the property. Upon completion of required code upgrades, the lender is required to obtain a new certificate of use and/or occupancy for the property. This cost of satisfying these requirements can be substantial and adds an element of risk to the investment.
Erica L. English is a shareholder with Katz Barron Squitero Faust. Reach her at (305) 856-2444 or ELE@katzbarron.com.