A Practical Guide to Investing in Mortgage Notes

A Practical Guide to Investing in Mortgage Notes by Peter L. Mosca
[Note: To follow is an excerpt of an interview with Scott Bleazard, Sr. Vice President of Kingston Management Services LLC, a successful bidder of FDIC distressed assets, who discusses the intricacies of this asset, and provides guidance on how to achieve investment objectives via mortgage notes. To listen to the show archive or download an MP3, go to www.IncomePropertyInvestmentTalk.com/081909.]
Mosca: Can you start from scratch about mortgage notes, and tell us what they are, and why they are such a good investment because I think that most people aren’t even aware of the fact that these possibilities exist?
Bleazard: When I was thinking about the comments for this show my thought was many investors have deposited money in a bank. Many have invested in a bank. They have been a shareholder of a bank, they have invested in a REIT that has invested in a bank or in bank stocks. They have invested in a variety of companies either public or not that have been bank related or bank owned stocks or stocks that have banks within their portfolio. Any time you’ve done that, essentially you’ve invested in notes. The banks are managing those notes and that’s the conduit by which you invested in notes but the vast majority of the return of the bank is generated from the return that those notes are providing to that bank. So, if that bank stock does well it’s typically because that bank has a good portfolio of notes that are paying a good return to that bank. That’s how we've all at some point touched a bank note. The most simplistic form is if you have a savings or checking account that earns interest. In a large part, that interest that you’re paid on your checking account is being paid from the revenue generated by a bank note.
Mosca: How did you acquire these banknotes?
Bleazard: When a bank gets out of compliance with the FDIC, they come under some scrutiny from the FDIC. The FDIC starts to monitor their activity and mostly because some of those notes become nonperforming and the banks ratios, the lending ratios, the performing and nonperforming notes, and the assets that they have lent on become devalued. They become in a risky situation with the FDIC and when they become toxic, which is the new buzzword in our era today, when the FDIC goes in and determines that that bank no longer qualifies as a FDIC insured operating, fully functioning bank, they seize or close that bank. Then the FDIC looks to sell those notes.
Mosca: Scott, you just said “bad” loans, but I want everyone to understand unless I am misinterpreting by what you meant, that they’re bad loans to the bank that took over the assets only because then it prevents them, to a certain extent, from lending out money. They are excellent investment opportunities for the investors who are listening today, right?
Bleazard: A banker’s glasses are certainly tainted differently or colored differently than a typical investor. The basis in that note is what is so important. When a note becomes nonperforming to a bank it becomes very toxic to their books, and it becomes very difficult for them to keep their books in good order with the FDIC requirements. They call them a bad notes but it’s not by any stretch of the imagination a bad note for an investor. We bought performing, and nonperforming, residential, commercial, land, and development. We purchased those loans from the FDIC and they transferred those original notes, those original deeds, and those original files that came directly from that bank that made those notes to us and we have those in our control. Those are the same notes your listeners can view by clicking the “best of times” graphic in the upper left hand corner of your Web site at IncomePropertyInvesmentTalk.com.
Mosca: Let’s say I go to your portfolio and find a $500,000 loan that is a development of four properties, and it is a developer that I am aware of. Can I contact the developer and work out mortgage payments that match his budget and keep him and his employees working?
Bleazard: Absolutely. Not only is it being done but I do one or two of those every week within our portfolio. This is where it’s really personal. You can meet face-to-face with that individual and see the person eyeball to eyeball that signed that note. The two of you can communicate about the best way to meet his objectives and your objectives.
Mosca: I know the package was once a $Billion-plus. A number of investors have come in and purchased some of these notes. Can you please talk about those relationships Kingston has with investors?
Bleazard: We like to help them find a good deal, and let them know what they really have. That is the fundamental question. An investor will come to me after they found a $400,000 note on the Web site. The investor looks at the collateral, understand the real estate, talks to some real estate brokers for ideas as to current value is, what the projected value is, what the entitlements are, and all of the typical due diligence of real estate.Now, it’s time to buy that note. The first thing you need to know or understand is what you have. Do I have a first link position, do I have a second link position, do I have a subordinated position, do I have an interest only know, do I have a principal and interest note, and what are the terms and conditions of that note? You can get that by reading the note and by getting a title report on that property. We typically hand off an investor and a note to one of the title companies in the market where that note is securing the collateral of a piece of real estate in this case. They sit down with the title officer. They look at the prelim. They identify where they’re at in the process or where they're at in the lien chain and they recognize that they are either in first, second, or third, whatever the case may be and then they evaluate the borrower. They look at his financial wherewithal and his worth through a series of non-disclosures and non-circumvents and all of these other legal documents we have executed prior to this and you are able to look at a lot of that collateral.
Mosca: So, everything that we’ve talked about stresses the importance of getting on our Web site, checking out the virtual deal room, and completing a form and an exert will get in touch with you?
Bleazard: Every investor has their motivation. The vast majority of investors that I sit with want to own real estate and the note is simply a means to an end to own the real estate. They buy the note, they talk to their attorney, our attorney or whoever is handling that foreclosure, and they prosecute that foreclosure as quickly as possible and they own the real estate. That's the vast majority of my investors.
Mosca: I know some people out there must be thinking this is just mind boggling and I still don’t understand the process, and scratching their heads saying this is not for me but that’s not the case is it?
Bleazard: It’s really not. I need to backup for one minute and explain why it’s such a great opportunity. If you are trying to buy a piece of real estate, specifically we will start at the bottom of the chain in ability to finance. The easiest property in America to finance right now is a single-family, residential home under $200,000. You can go to a mortgage company, apply for a loan provided your credit worthy and you have a good job or whatever the case may be, you can borrow money for that. Probably 95% of the money you can borrow in most cases. If you want to invest in a condo or a house and use it as a rental, you are probably going to have to put 20 or 30% down. The bank takes the note and they finance that property.
If you go to a piece of land, you may have to put the 50% down. All of the styles and types of collateral vary at what you can go borrow from a bank to purchase that asset, the difference being the cash you have to invest. In the case of a note, it's all cash. There are very few, if any, well I shouldn't say if any because there are those that do it, there are very few people that will finance a note. What that means is you can get the highest and best realization on a house that you can sell when someone can finance 90%, 95%. On a note purchase because you have to use all of your cash in order to make that transaction, the value is the greatest. What I mean is, a typical note will go for considerably less than the value of the underlying asset because financing a loan. This is where cash is king. This is where an investor can come in and pick it up because there is no financing option.
That's why they are such a great value. The risk is you not being able to own a property because your note was in an inferior position and because of all these problems. That's where the due diligence comes in. Now, I will answer your question. You purchase that note and you've done your due diligence. You identify that it's in first position through a law firm that you selected, through a title company that you've met with and consulted with, through a variety of consultants that can help you navigate those storms.
Once you on that note, you can either continue the process of the foreclosure that we've started if we’ve started it or you can start your own or you can do any other modification that we've talked about. If you want to own that real estate, you go to a title company, you go to a good real estate attorney that can sit down with you and explain his process and his fees and that can range from $600-$6000 depending on the complexity of the foreclosure and then typically in 120 days you can own that real estate.
You can perfect that note or close on that individual company, contractor, developer, whoever and on that real estate at the courthouse steps on that final day at the foreclosure sell when the attorney stands in front of the courthouse on the steps and says this note held by this person is being foreclosed on. If anyone is there to dispute it than they have to dispute it now which the dispute period has been over at that point. We are going to sell this property and they start bidding on it. You have the ability to bid up to the entire face value of that note and on that real estate back and you don't have to pay anything because you own the note. You are a creditor, you are the bank at that point and own that note. In 120 days with very little interaction, a couple of notices that they file and some publications and you are standing at the courthouse in you own that piece of real estate for a considerably discounted amount because of the fact that you used your cash to purchase that note 100 days prior.
Mosca: What is your golden nugget for today?
Bleazard: Do not be scared of notes. They are one of the best opportunities today and are going to continue to be. Every week there are banks being closed. Every week that means more notes are available, more opportunities are available for those that have education and understanding of how to purchase, foreclose, and own, and possibly modify. Don’t let your mind be your biggest hurdle in this investment. It’s the greatest opportunity out there right now.
Published: September 17, 2009
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