Understanding Real Estate Secured Note Purchase Transactions

Since its inception in 1978, SettlePou has represented every imaginable type of party in real estate, lending, and commercial transactions. In that time, there has arguably never been a better environment for the opportunistic acquisition of real estate assets than the one that exists now.  However, given the current status of the real estate and financial markets, parties seeking to take advantage of these circumstances must use non-traditional methods to acquire the real estate assets that they covet.  One such method is through the purchase of notes secured by the desired real estate – whether commercial mortgage-backed securities (CMBS), commercial bank, or private notes.  

SettlePou represents all manner of buyers in these transactions – from large private funds to individual investors.   In evaluating a real estate secured note purchase, buyers must determine whether (a) the borrower and/or guarantors of the note being purchased are capable of honoring the terms of the note, and (b) the value of the property securing the note justifies purchasing a non-performing note (in the event that the purchaser ultimately forecloses on the borrower’s interest and becomes the owner of the property).  Generally, for collateral to justify purchasing a non-performing note its value must exceed the amount paid for the note plus the expected incidental costs of acquiring the collateral under the terms of the loan documents.

A party investing in real estate secured notes must be prepared to wear two hats throughout the purchase process: that of (i) lender, and (ii) real estate investor.  The due diligence associated with evaluating a note purchase must first determine the lender’s obligations and rights under the loan documents (including whether any further advances are due to the borrower), whether the borrower has any notice or cure rights which need to be addressed, and whether the lender has its full anticipated scope of remedies upon a borrower default, among other concerns and any lien priority issues.  As a potential real estate investment, a proposed note purchaser must also address issues familiar to a more traditional real estate acquisition, such as title, environmental, and property management issues like leasing, among other issues.

The actual acquisitions process is fairly straightforward – at least in the initial stages – in that the purchaser will enter into a Note Purchase Agreement with a lender that has determined, for one of many reasons (including poor note performance, the note being under-secured, or pressure from regulators) that it must divest itself of the note. While the process has some similarities with a purchase and sale agreement that would be utilized in a traditional real estate transaction, there are also many differences. For example, a Note Purchase Agreement will often contain far fewer of the assurances to which purchasers of real estate are accustomed, for example, far fewer (if any) representations from the seller as to the status of the property.

In non-CMBS transactions, the loan files and documentation may be fairly bereft of records and historical data or have poor organization or retention of correspondence with the borrower, leading to lack of comfort as to the status of the property and, potentially, the note itself. In contrast, due to extensive regulation and oversight, CMBS transactions typically are more heavily detailed and complete in documentation, with up-to-date property records.  This reality is one with which the note purchaser must become comfortable.  However, the typical transaction generally involves a discount on the face value of the note, giving the purchaser an opportunity to offset the potential risk.

A carefully drafted Note Purchase Agreement is essential to ensuring a successful transaction.  The contract should provide for the seller’s unconditional agreement to sell the note and transfer its rights under all other loan documents relating to such note, including the loan agreement, deed of trust, assignment of leases and rents, all guaranties, and any other loan documents.  A purchaser must ensure that it can enforce the terms of the loan documents and exercise all remedies against the borrower, including foreclosure, deficiency collection, and actions against guarantors. 

The Note Purchase Agreement should contain certain provisions to specifically identify the interests assignable to purchaser.  First, the agreement must clearly identify all loan documents and require that seller deliver such original loan documents at closing, including the seller’s loan file with all correspondence.  The agreement must also provide for an assignment of the original lender’s title policy, for which purchaser will obtain a policy transfer endorsement from the title company. 

As with a standard real estate purchase contract, the Note Purchase Agreement must identify an adequate inspection period in which the purchaser can perform all due diligence on the loan and property, and allow the purchaser to terminate the contract.  The loan file must either be delivered to purchaser for review or made available for review at seller’s offices.  To aid purchaser’s due diligence review, in addition to access to the loan files referenced above, the agreement should require delivery of seller’s existing property due diligence materials including a survey, copies of all leases, environmental reports, and other collateral assessment records.

Finally, the Note Purchase Agreement must provide certain protections to purchaser regarding the status of the loan.  Ideally, the agreement will require the seller to deliver a certified payment history related to the note through the closing date and contain a provision whereby the seller represents and warrants: (a) that seller is the current owner of the note and there is no prior assignment to any third party, (b) that seller has no further financial obligations under the loan, such as further distributions or escrow requirements, and (c) that the note is free and clear of all claims and liabilities.

Understanding the key concerns and concepts involved in the purchase of a real estate secured note is only the first step.  A potential purchaser must also understand the key differences between various types of note products, and be prepared for the possible paths that note ownership can follow after closing a purchase and how purchaser’s ability to exercise its rights as the new lender may be affected.

This article serves as the first in a series of three articles which will further address note purchase transactions.  While this article addressed the general implications and structure of a note purchase transaction, part two of the series will address the processes and structure of both CMBS and standard commercial note purchase transactions.  The third installment will address several common strategies used by note purchasers to realize a return on their investment, as well as potential pitfalls that can result.

By: Jeffrey J. Porter, Jeff Mosteller and Brian H. Baker

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