In 2018 I started finding fewer investments that met my criteria.  I had pivoted from flipping houses to building houses and it wasn’t the right fit for me.  It felt risky.  Heck, it was risky.  I didn’t get compensated much for buying well and buying well is my strength.

I was looking for a way to create value that did not depend on the market itself going up.  In other words, appreciation is great, but I couldn’t depend on it.  My solution for part of my portfolio was to move up the capital stack.  By this I mean, rather than owning real estate I’d be the lender.  There are two paths you can go down as a lender.  You can buy newly originated loans, or you can buy existing loans.

I wanted potential upside in the market but with controlled downside.  To express this goal, I bought a basket of nonperforming second mortgages.  A non performing mortgage is a mortgage where the borrower has stopped paying.  I know what you’re thinking but stick with me here.  These were non performing second mortgages behind performing first mortgages.  If nonperforming loans are a niche, this is a niche within a niche.

A performing mortgage is a mortgage where the buyer IS current on their loan.  There’s an important signal buried in a non performing second behind a performing first mortgage.  More often than not, your buyer doesn’t want to hand the keys back to you as a lender.  Instead, the signal is that they want to keep their property, but don’t have the money to pay both the first mortgage and the second mortgage.

                                                                                                                                                                                                                      My Hope: Let’s Make a Deal

My goal was to try and re-work the second mortgage in order to make the borrower’s total monthly payments affordable to them.  A work out could take a number of forms.  I was open to accepting a lower monthly payment along with a reasonable size loan paydown, a negotiated loan payoff, a short sale, or a deed in lieu of foreclosure.  All of these were ways that I could generate alpha regardless of what the “market” did.

Here is what the basket of second mortgages looked like: 

• Vacant single family house in small town Pennsylvania
• Occupied house in Jacksonville Florida
• Occupied house in Tampa Florida
• Occupied house in Orlando Florida MSA
• Occupied house in Miami Florida
• Nonowner occupied duplex in Lawrence Massachusetts

There’s another nuance here.  Each mortgage was at least a little in the money.  By this I mean, if I take the value of the property and I subtract the balance due on the first mortgage there was equity left over that covered at least some of my note purchase price.  This helped protect my downside in the event that a borrower filed for bankruptcy as I’d be a secured creditor and therefore would have to be included in a bankruptcy plan as opposed to an unsecured creditor that could, and often does, get wiped out in a foreclosure.

In this post I will explore one of these mortgages.  I’m going to redact addresses here out of respect for the borrowers.  The note securing the house in small town Pennsylvania was originally a $48,000 loan.  But by the time I looked at it, the payoff had risen to $83,000 because of late fees, arrearages, accrued interest etc.

                                                                                                                                                                                                                     

Due diligence on a second mortgage involves a few steps.

1.   Determine the value of the subject property.  I usually have a few conversations with realtors in the neighborhood and Venmo one of them a little money, to take exterior photos of the property and to give me a back of the envelope opinion of value.
2.   Determine the payoff on the first mortgage.  Generally sellers will provide a recent credit report but it’s worth getting an updated credit report.  Trust but verify.  I want confirmation that the first mortgage is performing.  If it were non performing my position could get wiped out in a foreclosure.
3.  Confirm that I have clean title.  This involves not only reviewing the original title report but also making sure that all of the assignments and allonges that have happened between origination and my purchase are in good order.  A note is a negotiable instrument meaning it can be sold and resold.  Think of assignments and allonges as two sets of documents moving in tandem with each other.  A deed of trust or mortgage has an assignment (or if sold multiple times assignments) that corresponds to it.  The note has an allonge (or if sold multiple times allonges) that corresponds to it.
4.  I want the note seller to represent that I will receive the original note as part of my purchase.  Without an original note you need to get a lost note affidavit from whomever lost it.  It’s a big hassle, but that’s for another write up.

My 401K plan bought this note in Small Town Pennsylvania for $10,000 in the fall of 2017 from a fund being liquidated–forced sellers are great counterparties not only because you can get pricing but also because you tend to avoid adverse selection problems–lemons.

At that time the payoff on the first mortgage was ~$180,000 and the house was worth ~$200,000.  I had equity in the collateral (the house) to cover my full purchase price.  But very soon I would be spending more money.  A lot of the money I would be spending would be capitalized on the unpaid balance the borrower owed but, assuming the house value stayed flat, some of it could be out of the money–exceeding the value of the property.

I paid a servicer $95 a month to fully service the loan, including reaching out to the borrower–more on this below.  I also would quickly begin spending money on legal fees.  Unfortunately, you have to immediately initiate the foreclosure process when you buy a second mortgage.  Why?  I need to be the first to begin a foreclosure or I will risk getting wiped out by a first mortgage if it initiates default first.

When you buy a non performing mortgage that was originally made for owner-occupied houses, RESPA is in effect.  I hired a third party licensed servicer to handle ALL communications with the borrower.  Well, assuming they could reach the borrower.  She wouldn’t answer the phone.  We had a door knocker sent in an effort to get her to return the servicer’s call.  No answer.  I didn’t want the house back but would take it if I had no other option.  The servicer sent letters.  They never got through to her.

Unfortunately, we were never able to make contact with the owner.  The foreclosure sale took place in March 2020 and was among the last sales prior to the COVID foreclosure moratoriums went into effect.  Why did it take 2.5 years?  Each state handles foreclosures differently.  In Pennsylvania, it was a sheriff or constable that had to provide service to the borrower.  Turns out they’re not keen on foreclosing on the people in their community.  It took forever and a day to complete service, then it took forever and a day (March 2019) to get judgment entered against the owner.  The sale was originally scheduled for August 2019 and was delayed until March 2020.  

But I got paid to wait.  My downside was protected by my cost basis but my upside was only restrained by the payoff amount on the loan.  In other words because of late fees, arrearages and accruing interest, the borrower owed $83,000 on the second mortgage.  Should the value of the house rise 25%, my 401K plan would have captured all of this upside.

Following the foreclosure, we hired a locksmith and entered the house.  It was vacant.  It was in good condition.  There were some paint cans and it looked like the previous owner was trying to renovate the house.  This was consistent with the photo attached to this article that I realtor took when I was diligencing the collateral back in 2017.  It looked like the owner was renovating the property back then.  I don’t and didn’t like the feeling of being associated with someone’s failure like this but that’s what happened.  We spent $2,400 paying the town back the borrower’s unpaid utility bills and a couple thousand on paint and carpet.

I hired a local realtor who rented the house last August for $1,850 a month rent.  Given our cost basis of $19,000 our payback period was roughly 14 months as we are also paying property insurance.  I reached out to the tenant this past weekend and they intend to renew the lease for another year.  I’m still trying to work something out with the lender on the first mortgage.  Zillow now pegs the value of the house at $309K.