REFM Analysis Framework Series: Distressed Commercial Mortgage Note Acquisitions

Want to learn how to model Note Acquisitions and get a robust Excel Template with which to do so? Attend our 2-Day Intensive in person or virtually on 4/21-4/22  (Training Main)

Acquiring a Mortgage Note is one way in which a real estate Investor can ultimately become the owner of a property.  The financial analysis that sits behind the decision to purchase a Note, and at what price, can be potentially confusing in that there are a lot of variables to consider and keep organized. What follows is an explanation in simple terms of the various elements involved in the analysis.

Overview: A Property is purchased with the use of a Mortgage, which by its nature is a lien on the Property. The Owner (mortgagor) of the Property, for inability or lack of incentive to, defaults on the Mortgage. As we know, the Chinese language character for the word Crisis also is the same one used for the word Opportunity… The Lender is in crisis because their anticipated annuity cash flow stream has been disrupted, and the Owner is in crisis too. So where’s the opportunity? Keep reading!

Players:  Original Lender on the Property (L), Original Owner of the Property (O), New Lender (NL), Investor (INV)

Obligations Under Mortgage Note:

• O is obligated to L to make scheduled debt service payments and repay loan by maturity date
• L is obligated to O to remove lien once loan principal balance is paid down to $0

 Obligations Under New Loan Used By Investor To Acquire Note:

• INV is obligated to NL to make scheduled debt service payments and repay loan by maturity date
• NL is obligated to INV to remove lien once loan principal balance is paid down to $0

 Progression Of Events *:  (* also see Alternate Scenario at bottom)

1. O defaults on its obligation to L through late-, partial- or non-payment
2. L issues Default Notice, and when L fails to cure within the period allotted, L issues Principal Balance Acceleration Letter
3. If L does not want to pursue Foreclosure against O, L can sell the Note to an Investor (INV)
4. Using a New Loan and equity, INV buys the Note at a discount to the Note’s remaining principal balance, and in so doing, becomes the new Lien Holder on the property (i.e., INV replaces L as Lender to O)
5. INV collects any property NOI, pays New Loan debt service with any NOI, and supplements the NOI-funded debt service payments as needed with INV equity
6. INV initiates Foreclosure process on O, and executes on its lease-up stabilization strategy (i.e., the restoration of value to the collateral)
7. Upon completion of Foreclosure, INV has become the new property Owner, and can pay the New Loan debt service from the property’s stabilized NOI
8. INV can sell property to next buyer if they desire.

Important Dates, ordered chronologically:

1. Original Mortgage Note Origination Date
2. Date of Borrower Default (assumed to be equal to Date of Final Debt Service Received)
3. Accrual Date – the date after Default at which the Mortgage Note begins to accrue interest at the Default Interest Rate (penalty rate)
4. Date of Asset Stabilization (could also be #5)
5. Date of Foreclosure Completion and Transfer of Title (could also be #4)
6. Date of Asset Sale

Cash Flows

• Property NOI eventually becomes insufficient to make scheduled debt service payments, or Owner, for one or more reasons, becomes unwilling to make payments
• Upon Owner Default and Owner’s subsequent failure to cure, property NOI now belongs to L, and eventually, to INV once INV becomes the new Lender
• Property NOI is used by INV to pay New Loan debt service

* Alternate Scenario: Deed in Lieu of Foreclosure

Rather than a lengthy foreclosure process, INV can negotiate with Original Owner for a cash settlement in exchange for deed/title, thus taking control of the property out of court. Original Owner is usually willing to negotiate this option because their equity position is diminished or gone and the Owner fears a court-ordered judgment through the foreclosure process, which can be assessed against the Owner’s personal assets.

Lots of moving parts! Kind of like a tuxedo. Learn how to determine pricing of Distressed Notes and get an unlocked Analysis Excel Model with our upcoming training in person or virtually on 4/21-4/22  (Training Main).