A real estate investment can take many forms. The most common is ownership of the fee-simple interest, which means the investor owns the real estate outright, including the land and the improvements (i.e., the building). Sometimes, the investor will just own the ground and have the improvements owned by the tenant, who pays the tenant ground rent. Sometimes, the investor will just own the improvements, collecting rent from the occupant of those improvements and paying ground rent to the owner of the underlying land. And sometimes, the investor will decide to take ownership of the debt position, commonly known as the loan. With a historically high amount of loans maturing over the next 18 months, the opportunities to purchase potentially troubled loans will blossom. But all that glitters may not be gold; this month, we are going to discuss some of the pitfalls that investors need to be aware of when pursuing this type of real estate investment.
One of the first potential pitfall that needs to be understood is what exactly the buyer is acquiring. Buying a loan is much different than buying the real estate. The owner of a mortgage simply owns and controls the document known as the mortgage. And while the collateral of the mortgage most likely is the underlying real estate, the buyer of a mortgage needs to carefully and completely review and understand that document. The mortgage will include various legal rights and obligations of both the borrower and the lender (i.e., the investor), including events of default, remedies and rights as well as process to foreclose. If the investor’s end game is to own the real estate, this document will go a long way in determining how easy or difficult that path may be.
Assuming there is nothing included in the mortgage that would seriously harm the investor’s ability to foreclose on the real estate, the next step would be to determine the underlying value of the mortgage. This process is much different than valuing the real estate. A mortgage is the right to receive a series of payments for a fixed period of time that are necessary to amortize a present value that is discounted back at a stated discount rate. Ordinarily, determining that present value is a simple financial discounting application. However, in this instance, the process isn’t so simple. There are numerous factors that need to be taken into consideration, such as the length of time required to foreclose, the potential costs associated with such an action, the status of cash flows during this time (i.e., is the property’s cash flow providing a surplus or a deficit) and the value of the underlying real estate both currently and at the expected point of successfully completing the foreclosure process. The investor also needs to recognize and adjust for factors such as real estate and capital market conditions, blemishes on the title, notices by any municipal or government entities and presence of other liens, both superior and inferior to the investor’s position.
One of the biggest risks is also one of the hardest to predict – a bankruptcy filing by the underlying borrower. Before we discuss some potential protection against this, let’s first talk about what this will do. A bankruptcy filing will bring the foreclosure process to an immediate halt – any and all claims against the borrower by any creditors, including the lender/investor, will be put on hold until the bankruptcy filing is either dismissed or discharged. For the investor pursing (or in control of) a mortgage in this instance, the potential to incur additional cost and additional delay is significant.
Now let’s discuss the potential protection. Loan documents will sometimes include a passage known as a carve-out guaranty. If this is present, then there is basically a guarantee present that is being provided by either the borrowing entity or an underlying person that controls the borrowing entity. While this may not eliminate the bankruptcy filing, it will provide a direct path of recourse should a bankruptcy filing occur.
Buying a loan can be a very successful real estate investment strategy, but it certainly comes with a different set of risks. Again, the wave of loan maturities over the next 18 months is unprecedented in terms of volume. Having a solid understanding of the potential pitfalls can make the difference between riding the surf or crashing on the beach. Ira Krumholz CPM