This is a complete guide to non-performing notes for investors and brokers
If you're looking to be a direct buyer or a broker of non-performing notes then we put this guide together for you.
We cover 7 key non-performing note topics here and link to all the relevant articles that go in depth on the various topics around non-performing notes.
Consider this page your hub for all things "non-performing notes".
What is a Non-Performing Note Exactly Anyway
When we use the word note we're referring a "promissory note". A promissory note is the document that lays out the terms and conditions of the repayment of a loan.
Non-performing notes and non-performing loans are terms used interchangeably.
When a lender makes a loan on real estate the documents include the note (promissory note), the mortgage or deed of trust, and where applicable the allonge. Allonge is a fancy way of saying the attachments from the French, "it's a slip of paper attached to a negotiable instrument" - Wikipedia.
When you "buy the note" you are buying all of the rights (and responsibilities) of the lender. You become the bank.
Other terms for non-performing notes are:
- Non-performing loans
- Distressed loans
- Distressed notes
But the most common vernacular is simply "notes" or non-performing notes.
Why Buy or Invest in Non-Performing Notes?
This is one of the most often asked questions from folks who are just getting started. The simple answer is the discount - the discount and control.
Investors buy non-performing notes because of the discounts that come with "buying distressed assets" - those discounts mean more ways to profit from the investment and also mean that the principal in the investment is secure because the value of the collateral (the property) is so much more than the price paid for the non-performing note.
Investing in a note is not the same as investing in the real estate or business. You have a completely different interest in the property, you have the right to receive payments on the note and you have the right to collect when it is in default.
You also have the right to renegotiate the note with the borrower and you have the right to repossess or liquidate the property or collateral to collect what's owed.Lets get a little less obtuse and take a look at real non-performing note strategies. Each of these is one that I have either been involved in personally or that I have learned about from the investor using the strategy.
You can learn about these strategies from the investors themselves in the Academy.
How to Profit from Non-Performing Notes - 7 Strategies
- Rehab non-performing or sub-performing commercial notes. One private client I had only buys small balance non-performing commercial real estate notes with owner occupied property. That means that the owner is running their business out of the property. They have a small group of workout officers who then work with each borrower to get them re-performing through modifications and (rarely) forgiveness. When it’s not possible to get the assets re-performing they foreclose.
- Workout non-performing junior residential liens. A lot of non-performing 2nd position, or junior lien, buyers I know approach buying non-performing junior liens with the following strategy. Offer some principal forgiveness to the debtor, modify the terms, assist with refinancing.
- Government programs for rehabbing or paying off residential notes. My friend and associate talks about a number of strategies that his 1st position, or senior, residential non-performing note buyers employ in these two call - Hardest Hit Funds, other government backed refi programs.
- “Loan to own” on non-performing commercial notes. I’ve sold commercial notes to investors whose sole goal was to own and control the collateral and buying the mortgage note from the bank was simply the best strategy for achieving that goal. I’ve seen this note buying to property owning strategy succeed on retail strips, office parks, and construction projects.
- “Flip” residential notes as a ‘broker’. My friend Mike Ruscica, a full time note investor in non-performing junior liens, sometimes uses what amounts to an assignable contract approach to flipping notes.
- “Flip” re-performing notes. Just like you can buy a distressed property, you can buy non-performing notes from banks, get them re-performing, then sell the newly performing cash flow note to an investor. If you want to go the next level you can just sell part of that note to another investor (a partial) and you get a small windfall now and an income stream until the debt is extinguished.
- Buy unwanted special purpose non-performing commercial notes. I had another private equity client with a background in the oil and gas business and they focused on buying non-performing notes on gas stations and other properties in the fuel distribution chain. Why? Because banks generally don’t want to get into “chain of title” on a potentially “dirty” piece of real estate it’s more advantageous for the bank to sell the note and wash their hands of it and since this investor knew the business he didn’t share the same fear. We had one transaction with this investor where we sold the gas station at the foreclosure auction within 60 days of the investor taking ownership of the note and they made a quick $300,000 - without ever getting into the chain of title. How’d he do that? He’s got a note buying strategy. He knows his collateral, works with the borrower, and focuses on assets and areas that he truly knows.
The next natural question is...
Why Do Banks Sell Non-Performing Notes
Banks sell non-performing loans for any number of reasons. Here are some of the reasons I've seen.
I should point out that banks aren't the only sellers of non-performing notes (in fact you can find list of the different places where you can buy non-performing notes here) but banks and credit unions are where most non-performing notes originate. Almost anywhere else that you buy them means one or more middlemen and therefore higher pricing.
1. Banks sell notes to avoid unknown liabilities
Sometimes a lender will have a non-performing note on an asset, like a gas station or an old factory where they don't want to foreclose due to the possibility of the existence of environmental contamination of the land.
Once a bank gets into the "chain of title" there's the possibility that they open themselves up as a target for future liabilities, litigation, etc. A smart (and litigious) person goes after "the money". Obviously that's the bank.
If you can think of reasons that the bank might not want to get into the chain of title then so can they.
2. Banks want to avoid excessive legal costs and long foreclosure processes
Different municipalities have different laws regarding foreclosures. If a bank has a pool of non-performing loans in an area where they know that a lot of long, drawn out foreclosures will be required then it can be more advantageous to sell the note.
3. Banks don't always have the same flexibility and workout options as private investors
Banks don't always have the same kind of flexibility that you and I would have in terms of how we would approach a loan workout because they're regulated.
Remember, banks are highly regulated, that means that "the box" within which they must work to "rehab" or restructure a loan is not as malleable as that of a private investor or fund.
4. Selling non-performing loans is fast
A bank can sell and close on a non-performing loan sale in under a month. That means they're refilling their coffers and eliminating a ton of man-hours, legal fees, and months of effort. Consider what's involved in foreclosing on a property, probably "booking it in" (meaning that they buy the note back at auction), then listing it and selling it.
Consider all these expenses banks face if they don't sell the non-performing note:
- Legal fees for notices
- Auction fees
- Property preservation costs
- Municipal compliance costs
- Realtor fees
- Market price risks
The list goes on. Once a bank adds up all the costs and time that it can take to deal with foreclosing on a lot of non-performing loans you can see pretty quickly what the advantages are to simply selling notes.
Where to Buy Non-Performing Notes
- Direct from banks
- Direct from credit unions
- Special servicers
- Hedge funds
- The FDIC
- Private Note Holders
Buy Non-Performing Notes from Banks
We track all the late and non-performing loan portfolio balances for every bank in the US. Here's a video about how that works.
In any significant financial transaction the deal is going to happen between people, if you want to buy non performing loans you're going to need relationships with people who are selling them. A lot of people want to stop right here, they don't like that answer, they want an 'easy button'. The truth is there are easier ways to source notes but here's the truth:
If you're not buying direct from the originator you're paying a premium
That's a fact. Why? Because a few things happen here:
- The note broker has to make a commission
- You are going to compete against other qualified buyers
When you're buying non-performing notes _direct from the originator, from banks,_ you have less competition and no fee for the middleman.
The middleman earns his fee by finding the lenders selling the non-performing notes.
Buy Non-Performing Notes from Credit Unions
There are more than 7,000 credit unions many of them have non-performing assets. We track non-performing loans and foreclosed and repossessed assets for every credit union in the US. Working with credit unions is very similar to working with banks with a few differences.
- Credit unions are very sensitive to their reputation, most of their loans are with members, they're not excited about selling to predatory note buyers (generally)
- Credit unions are small... You are most likely going to talk to the president, call there first.
- Credit unions are regulated by the NCUA rather than the FDIC
You can learn more about buying non-performing notes from credit unions in the academy.
Buy Non-Performing Notes from Special Servicers
A servicer is an entity that handles the administration of a loan on behalf of or in partnership with the owner. A special servicer handles the administration, collection, workout, and sometimes disposition of problem loans.
We maintain a growing list of loan servicers, special servicers, BPO and REO asset Management companies here
This is a big enough question that it's got it's own article. You can learn about where to buy notes here.
Buying Notes from Hedge Funds
Hedge funds buy large pools of non-performing loans from (typically) the largest banks. There are a few "exits" that hedge funds use.
- Foreclosure and then sale as REO
- Workout (loan modifications)
The last of these is where you can find opportunities. Hedge funds can buy much larger pools than most investors. When they do they're able to slice up the pool and find different ways to make a return on different sets of loans.
After a fund has run its course and made its returns it will look to clear the rest of the assets off it's books and move on. If you want to source notes from hedge funds, sadly, they don't have to make public reports like banks and credit unions because they're not insured.
You can find lists of hedge funds with real estate assets if you google for it, expect to pay a few thousand dollars for it.
Note Brokers AKA Loan Sale Advisors
There are a few online sources where you can buy non performing debt like DebtX as well as other note brokers and intermediaries (some of whom are BankProspector subscribers). Other note brokers and loan sales advisors include Mission Capital, CBRE (sometimes), Cushman and Wakefield (sometimes) and increasingly a long list of smaller independent players in the market.
FDIC Loan Sales
Loan Sales Marketplaces
There's a whole crop of loan sales marketplaces or 'MLSs' of sorts that are cropping up. LoanInterchange.com, LoanMLS.com (more to come on this topic in the future)
How to Buy Non-Performing Notes
This is a big enough topic that we've got a complete guid on how to buy notes. It doesn't matter if you're buying performing or non-performing notes, the process is the same. In this article we walk you through how to buy notes from offer to close.
How to Value Non-Performing Notes
Finding the value of non-performing loans is one of the most often ask questions we get and to be honest the answer isn't as easy one.
The difficulty in finding the value of non-performing notes is 3-fold.
- The note
- The collateral
- The borrower
First you need to understand the nature of the note.
- What is the UPB or unpaid principal balance?
- What is the interest rate?
- What's the default interest?
- What covenants are there?
- What other liens are there and in what priority?
Second you need to consider the collateral
- What do we know about the value of the property (assuming this is a non-performing real estate loan)?
- Where is it located?
- What is happening in the local market?
Third, what do we know about the borrower?
- If there's recourse (in the case of a commercial note) if the borrower someone you can collect from?
- Is the property used for the borrower's personal business or residence?
- Are there mitigating circumstances for the borrower that lead you to believe you can get it quickly re-performing?
As you can see the number of factors in finding the value of a non-performing loan get complex quickly.
Additional questions that you need to ask about a non-performing loan if you want to assess its value have more to do with you and your investor's needs.
- What strategy are you using?
- Are you aiming to own the collateral?
- Will you try to get the loan re-performing or do you aim to own the real estate?
Answers to these questions will drive the the answer to "what is the value of this non-performing loan... TO ME".
Which is key.
The best answer that I have with regards to value comes from my friend and advisor Pat Blount. He put together a program called LASER, the Loan Acquisition Suitability Evaluation and Rating system.
In this system the goal is not to answer "what's the value of a non-performing loan" as much as to answer what is the value to you as the buyer or even should you buy the note at all.
I know that some people won't be happy with this answer so let me say that you can and should also be looking to the market to see what active participants are paying and for which types of loans.
The FDIC lists the strike prices for their pools of assets and you should join the bank direct group on LinkedIn to discuss the matter with your peers.
So as to not leave you hanging completely I'll tell you that we've seen as little as 6 cents on the dollar on non-performing junior residential notes and as much as par on commercial non-performing notes ('par' means face value).
It's not uncommon to hear high 50s on pools of residential 1st position notes and even in the 80s on non-performing commercial notes but none of these are hard and fast rules and each acquisition should be evaluated independently based on what you know about the asset(s) in question.
How to Calculate Non-Performing Notes and NPN Ratios
Non-performing loans are loans that are 90+ days late and still accruing interest AND loans that are in nonaccrual.
What is a Nonaccrual Loan?
Nonaccrual loans are late stage non-performing loans which "no longer have any hope of being repaid according to terms". Non-accrual loans cannot be counted as accruing interest.
Non-Performing Loans vs Past Due Loans
Loans can be past due without being non-performing. Banks report loans at 30-89 days late, 90+ days late and still accruing, and nonaccrual.
Credit unions report smaller units of time and more of them (1-2 months late up to 12+ months late). In either case loans are considered non-performing after they are 90 days late.
Non-Performing Loans to Loans Ratio Calculation
In order to get a non-performing loans to loans ratio you add the 90+ day late loans to the nonaccrual and divide by the total portfolio.
(P90 + NA) / Portfolio = NPL ratio
Example: ($1MM + $1MM) / $20MM = 10% NPLs to Loans
A non-performing loans ratio of greater than 6% is considered high.
Who Wrote the Non-Performing Notes Guide?
Hey there! My name is Brecht Palombo and I'm the president of distressedpro.com
I've been very fortunate to have been involved on many sides of the non-performing notes business. Most of my professional experience with non-performing notes has been as an agent of the seller and as an auctioneer.
I've sold non-performing notes for banks, sold them at foreclosure auctions, and sold them back to the bank (through foreclosure) and then sold their REO (bank owned property).
I've had a front row seat to see how lenders make decisions to sell non-performing notes but in addition to that I have interviewed dozens of experts with experience at one end or the other of the non-performing note business including hedge funds, regulators, bankers, wholesalers, flippers, brokers, and private investors - we put this altogether for you here and throughout the site.
Below is a table to contents for this (rather large) page. At the bottom of this page you can find links to other resources where we've gone in-depth into different aspects of working with banks, and notes, and specifically non-performing notes.