While investing in Non-Performing Real Estate Notes, or NPN's for short, can be a great way to get secured, above average returns compared to the roller coaster stock market or 1% in a CD. Though like all investments, there is no guarantee you will make any money. Actually, if you are not careful, you can lose some or all of your investment.
We have put together a list of all the ways we can know of that you can lose money in the Distressed Asset Arena.
Ten Ways To Lose Money In Real Estate Notes:
1. Paying Too Much
We feel the #1 reason you can lose money in NPN's is paying too much for the note by not researching the true value of the property As-Is compared to move-in ready comparable prices, or comps., and adjusting your price accordingly. There is a saying; There is no bad note, just paying too much for a note.
Typically the property is not in a move-in ready state, so it will have a lower price, and if you don't take that into account, you will be pressed to many any profits when you go to sell it. The solution would be to either see if putting in $3-10,000 in light repairs would give you a $10-20,000 increase.
Other options are to rent it out for cash flow while hopefully, it appreciates. Then in a few years it can be sold for a higher price. Or sell it with owner financing to people with lower credit scores for a higher price, or sell that "loaded rental" with the tenant in it to an investor as a cash flow machine.
2. Wrong Location
By buying a NPN in a rural, blighted, or crime ridden location, even if it's in great condition, you will have a harder time to sell it when you need to, and might have to drop the price to just get rid of it. No family wants to live in the middle of nowhere, or a war zone, or without basic needs like grocery stores, gas stations, or general merchandise stores.
3. Not Visiting The Property
Imagine if you buy a note, and you find out that the house is no longer there! It could have burned down, or the city could have condemned it. This will result in a loss of most of your money, and the only thing you can do is sell the land itself for a much lower price than you paid. At least it won't be a total loss, the land does have value. It just depends if a builder will find the location good enough to invest in.
Or if the property is damaged, knowing the extent of the damage before paying for it is priceless as to saving you a lot of money. Sometimes it's better to walk from a smelly deal, than risk the investment if it's not making sense.
4. Not Confirming Your Lien Status
You are told you are buying a Senior or First lien on a home, then you find out that it's really a 2nd or Junior lien. This could be due to incompetence or neglect from the seller to know what they were selling, or a Junior lien could have foreclosed and if unchallenged, they are now the Senior lien holder and you are now a Junior. You still have claim to the debt, though now you are not first in line.
5. Not Checking For Lawsuits or Liens
One of the first things we do after we narrow a list of NPN's or REO's (Real Estate Owned or Owner has title.) we are considering to purchase, and before we pay for it, is we run an O&E Report (Occupancy & Encumbrances) which shows how many liabilities are attached to this property.
The homeowner could have been sued in the past, or owed Federal, State, or County taxes, and a lien placed on the property. This would result in you now being liable for paying that if you get them to sign a deed-in-lieu of foreclosure. Only a foreclosure on the property would possibly eliminate most or all of the lien's or encumbrances on it, considering IRS Liens have a 1 year redemption period where they can pay off the mortgage if they want it, though they really don't want the house.
6. Not Checking For Taxes
There are a plethora of taxes fees, penalties, and fines that can be imposed on a property at every level up the government hierarchy. From city fines for not cutting the grass, or leaving garbage around, you have any number of agencies that can penalize you from water, to power, to trash, to schools. You also have the county real estate taxes and fines you get for not paying them. If you ignore them, the county can sell the tax lien to someone else, and after a redemption period of usually a year, you could lose the property.
The State can also put a lien for income taxes, child support, and any number of issues. Then you have the Federal government that can put a lien on the property due to not paying your income tax. We just purchased a note that had $67,000 in total taxes, fines, liens, and penalties. We intend to foreclose to wipe them out, and possibly sell the house back to the homeowner.
7. Not Checking For Bankruptcy
Bankruptcy is not the end of the world for the note investor; many times they are a good thing. A Chapter 7 will eliminate all unsecured debt like credit cards, etc., leaving more funds each month to pay their house off that would have gone elsewhere.
A Chapter 13 is a repayment plan and typically the house payments are part of the payment plan. It takes 5 years to complete, and many people fail to complete it, resulting in them still owing the debt.
If you have a junior lien, and there is no equity, you can typically lose your entire investment if the lien is stripped in bankruptcy. They still owe the debt, though its unsecured, and you can get a judgment against them that will be on their credit. If they tried to buy another house or car in the future, that debt would still be there, and they would have to work something out with you to have the court mark it as paid in full.
8. Land Leases
Not Checking For Land Leases means you could lose your entire investment at the expiration of the lease, depending on the surrender clause. It's not your land, and if the owner wants to do something else with it, well, there is nothing you can do. Condo's & Townhouses can be considered a form of Land Lease in that you don't own the land, just the building.
9. Buying From Joker Brokers With Daisy Chains
We have seen people offering to sell notes that are number 5 or 6 in a chain of what we refer to as "Joker Brokers," and our policy is to not avoid them for many reasons, #1, they don't own the note, and to not deal with the owner is asking for problems. #2 is that they typically are getting it from someone else. And then, most likely, that person is getting it from somewhere else, and on & on, and this can go on for a bit, with each link in the "Daisy Chain" adding cost to the purchase price.
10. Buying From People Who Will Rip You Off.
Sadly, there are people who will rip you off in this business, and some still call the note business the "The Wild West." A rogue employee can convince you that they own the note, and to send your money to him. In order to avoid this, using an escrow to hold funds secure, combined with a document scrubbing service from a Document Custodian insures they "sign off" that the collateral or document file identifies that the seller of the note/mortgage really own it, and are not trying to rip you off. Then the escrow can be released, that is the only way to prevent this fraud.
These are ten different ways we have seen that you can lose money in the Non-Performing Real Estate Note space.