SettlePou’s Real Estate Section has, for the past few years, been very active in assisting its clients in acquiring real estate assets through opportunistic purchase of real estate secured promissory notes. In response to our clients’ inquiries we published three articles which detail the processes involved in these transactions in SettlePou’s periodic newsletters. We have consolidated these articles into this single publication for ease in understanding these processes.
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.
CMBS Real Estate Secured Note Purchases
In the first installment of our three-part series of articles addressing the intricacies of real estate secured note purchase transactions, we addressed the general implications and structure of a note purchase. While the general framework we outlined in part one holds true for all note purchase transactions, prospective purchasers of commercial mortgage backed securities ("CMBS") notes must be aware of additional issues that make these transactions unique. In order to better understand how CMBS note purchases differ from standard portfolio loan purchases, one must first understand the structure of CMBS lending.
In a CMBS transaction, commercial mortgage loans of varying size, property type and location are pooled together and transferred to a trust. The trust then issues a series of bonds, which are purchased by investors, and each month the principal and interest payments received from all of the pooled loans is paid to the investors in tiers as bond payments based upon the priority of the investor’s bond. The document which controls how these loans are pooled, serviced, paid to the trust and otherwise handled is called the Pooling and Servicing Agreement ("PSA").
The primary party responsible for operating a CMBS pool is called the master servicer. The master servicer manages the flow of payments and information and is responsible for the ongoing interaction with each performing borrower. So long as the mortgages which make up the pool perform as intended, the trust will continue to operate under the Master Servicer. However, if a borrower fails to meet its payment obligations, or defaults under a separate covenant of its loan, the trust will assign that loan to a special servicer.
The special servicer is responsible for servicing the defaulted loans, whether such servicing involves a workout with the borrower, the acceleration of the debt, foreclosure of the lien, or the sale of the debt to a third party. Because purchasers of CMBS notes will generally be targeting defaulted loans, the special servicer will be the primary party with whom a purchaser interacts. In addition, one other party will have broad discretion over the fate of non-performing debt in the CMBS pool – the trustee.
Although the trustee’s primary role is to hold all the loan documents and distribute payments received from the master servicer to the bondholders, the trustee is often also given broad authority over the management of the loan pool under the PSA. Generally, the trustee will be an active party in the sale of any non-performing asset from the trust.
Purchases of CMBS notes can fall into one of two paths. First, CMBS pools often have classes of securities with certain prioritized rights, including a right of first refusal on the sale of any assets in the pool. If a priority investor elects to exercise its option, no other party will have the opportunity to purchase the non-performing asset. However, if the right of first refusal is assignable by the priority rights holder, a prospective note purchaser may be able to negotiate with the priority rights holder to have the purchase rights assigned to such prospective purchaser. In this scenario, certain notice requirements pursuant to the PSA must be satisfied and the special servicer and trustee will need to consent to the assignment of rights and ultimate sale of the note.
The second path results when no purchase option exists or, if it does exist, is not exercised. These sales tend to more closely mirror unsecuritized note sales. The special servicer will typically accept bids from prospective purchasers which account for not only the price of the note, but also the purchaser’s proposed due diligence timeline, requested representations from the seller, and other terms which will be unique to each offer. Once the bidding process has closed, the special servicer will consider the proposed offers and select a winning bidder. Upon approval from the trustee, the note purchase can begin in earnest, including any due diligence review and final closing document negotiations.
Once a transaction for the purchase of a CMBS note has closed, the purchaser is the holder of the note and the rights which accompany it. The note no longer has a CMBS character, because it is released from the confines of the PSA upon sale. A purchaser may proceed with post-acquisition activities as it would for any note which had never been part of a CMBS pool.
In the final installment of our three-part series on note purchases, we will evaluate the options available to a note purchaser post-purchase, highlight issues which can arise in servicing the note as its holder and in seeking to enforce rights in the property securing the note, and discuss some potential pitfalls for a note holder.
Real Estate Secured Note Purchases – You’ve Purchased the Note, Now What?
In the first two installments of our three-part series of articles addressing the various issues that arise in connection with real estate secured note purchase transactions, we first discussed the general framework and issues related to all note purchase transactions and then looked more specifically at issues unique to the purchase of commercial mortgage backed securities ("CMBS") notes. This article explores the options available following the acquisition of the note, and identifies some potential pitfalls that note purchasers should be prepared to address.
So, you’ve purchased a note secured by real property – what to do now? A purchaser acquires the note for any number of reasons, but it will (nearly) always lead to dealings with the borrower. Upon the completion of the note purchase, the purchaser typically sends the borrower a "hello" letter, putting the borrower on notice that the purchaser has purchased the note and providing the borrower with the contact information for payment and notice purposes pursuant to the loan documents. The purchaser will likely have determined how it intends to proceed with (or against) the borrower.
If the borrower declines to cure defaults and offers no agreeable methodology for settling claims, the primary option available to a note purchaser is to institute foreclosure proceedings to acquire title to the real property. A noteholder should be prepared for the borrower’s efforts to thwart lender’s attempts to secure its rights under the note such as seeking a restraining order or filing bankruptcy. Prior to undertaking foreclosure proceedings or other actions against the borrower, the noteholder should assure that it has analyzed all third party relationships and other property related matters (indeed, these activities are best undertaken prior to the purchase of the note as detailed in our prior newsletter articles). The completion of a foreclosure sale can, under certain circumstances, have unintended and potentially disastrous results. For example, certain leases may be terminated by a foreclosure unless preemptive actions are taken, thereby potentially impacting the value of the asset. If the noteholder has taken the proper precautions, it can exercise all of the remedies available by complying with all requirements imposed by the loan documents and applicable laws related to the foreclosure of real property, such as notices to borrower, filing of the foreclosure action, and undertaking the actual sale, for instance.
Immediately after the completion of a foreclosure sale, the noteholder will stand as the owner of the property and should immediately take all activities to secure the property and its valuable elements. For example, the noteholder (as the new "landlord" under any leases related to the property) should contact all tenants informing them of its acquisition of the property, directing that rent payments and notices to landlord be sent to the noteholder. In this regard, it is important to review the provisions of the leases prior to taking any actions to determine any specific language which needs to be included in the letter to assure that the leases are either retained or terminated pursuant to the specific case facts and desires of the landlord.
It should be noted that dealing amicably with the borrower is often possible, and the particular circumstances of a relationship with the borrower may eventually lead to a settlement of a payment of the note at a discounted amount or a "friendly foreclosure" which will save all parties time, money and aggravation. An option available to all lenders is to determine if any workout can be achieved with the borrower. Given some of the pitfalls and delays which can be involved with the other options available to the purchaser, these types of borrower-friendly transactions can often be the best case scenario, as they can be more expeditious and economical than the more contentious alternatives.
We are hopeful that our three part series has been helpful in addressing the opportunities which can be realized in the acquisition of promissory notes which are secured by real property. The interested reader should understand that these articles have been general in scope given the depth of substance and the varying fact situations potentially involved in these transactions. We encourage any reader which has specific interest and inquiries to contact the authors at their convenience.