Distressed assets

Buying Into Distress

Don’t discount due diligence when purchasing troubled loans.

A struggling commercial real estate market has led to unprecedented levels of nonperforming commercial mortgage loans. While lenders weigh their options, investors with capital are contemplating where and how to invest. This article discusses the typical loan purchase process and some of the advantages and disadvantages of buying nonperforming commercial real estate loans.

The principal parties involved in a loan sale are the owner of the loan — the lender or its assignee — and the buyer. If the loan has been securitized, the buyer likely will need to negotiate with the master servicer or special servicer for the loan. In some cases, a loan sale adviser or broker is hired by the lender to manage the marketing and bidding process.

Due Diligence Process

Careful due diligence of the loan and collateral property will help buyers decide whether to bid and at what price. Unfortunately, due diligence periods are brief. Generally, buyers have 10 to 30 days to conduct due diligence prior to bidding or entering into a written agreement for the sale and purchase of loans. Prior to receiving any documents and information from the lender, prospective buyers must sign a confidentiality agreement. Most agreements prohibit prospective buyers from contacting the borrower or any guarantor, indemnitor, tenant, or property manager.

In carefully reviewing the loan documents, buyers should confirm, among other things, the financial terms of the loan including the amount, the interest rate, the monthly debt service, and the monthly escrow and reserve requirements. Buyers also should check the loan documents for unusual provisions or future funding requirements, full or limited guaranty, or an environmental indemnity.

Buyers should confirm that the owner of the loan is in possession of the original loan documents, has the authority to transfer and assign the loan documents, and that no third party has a right to purchase the loan.

Buyers should obtain the following items from the owner for review:

• chain of allonges to the promissory note and assignments to loan documents;
• existing loan title insurance policy;
• most recent property survey;
• inspection, environmental, and other reports relating to the collateral property;
• property rent roll and financial information;
• financial information of borrower and guarantors/indemnitors; and
• property insurance certificates.

Buyers also should review:

• a title update to ascertain, among other things, whether real estate tax assessments have been paid and if there are any liens;
• an assignment endorsement with respect to the existing title policy; and
• Uniform Commercial Code, judgment, bankruptcy, and municipal lien search results with respect to the borrower, any guarantors or indemnitors, major tenants, and the collateral property.

Buyers must find out if foreclosure or receivership proceedings have been filed and the status of the proceedings. The buyer should understand the foreclosure process in the jurisdiction where the property is located and know whether and to what extent any encumbrances, such as ad valorem taxes or construction liens, have priority over the mortgage lien.

Loan Documentation

In a typical loan purchase transaction, the owner of the loan and the buyer enter into a loan sale agreement in which the owner agrees to transfer and assign the loan and the loan documents to buyer in as-is, where-is condition, without recourse, and with only limited representations and warranties from the owner. The representations and warranties provided by the owner in a loan sale agreement vary, but they generally are minimal, especially if the loan has been securitized. Typical representations and warranties relate to the outstanding principal balance, escrow and reserve balances, and ownership of the loan. Buyers often must provide an indemnity releasing and holding the owner harmless from any and all claims with respect to the loan and the loan documents and an agreement that the owner will have no further servicing obligations. At the closing of the loan purchase, the owner will assign and deliver the loan documents to the buyer.

Pros and Cons

A principal advantage of a loan purchase is that a loan may be purchased at a discount and provides an opportunity to acquire title to the collateral property (scrubbed of subordinate liens) through the foreclosure process. In some states and under certain circumstances, a buyer could reduce or eliminate the transfer taxes normally due on a property sale.

Among the chief disadvantages of a loan purchase are the limited due diligence opportunity, which makes it necessary for the buyer to factor unknown risks into pricing, and the limited representations and warranties, which often leave a buyer without meaningful recourse. Additionally, lender liability issues may travel with the ownership of the loan. The buyer also bears the risk of the foreclosure process and borrower bankruptcy that would not be present in a purchase of the property itself. Since state laws governing loan purchase transactions vary, buyers should consult legal counsel with loan purchase experience.

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