Protecting your investments requires thorough due diligence, especially in the world of notes and passive investing. In this episode, Chris Seveney talks about the critical due diligence requirements that investors need to understand. He explores the essential steps involved in evaluating potential investments, minimizing risk, and maximizing returns. Learn how to go beyond the numbers and assess the quality of notes, understand the intricacies of passive investment opportunities, and make informed decisions to safeguard your financial future.

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Due Diligence In Notes And Passive Investing: Protecting Your Investments

An Overview Of Mortgage Note Investing

We are going to start rebranding the show and getting excited about that. As we continue to record new episodes, some of them will start doing more deep diving into strictly the note space and not be only focused on passive investing, but the passive and active side of things. With that, I want to give a little overview of the mortgage note industry and the fundamentals of mortgage note investing.

People ask a lot about note investing, and I have recorded many episodes in the past about what we do. I want to remind people that we are a company, myself and several others, that runs a mortgage note fund. We’ve raised over $35 million. We look to create win-win solutions for investors and borrowers. We not only are experienced in distressed mortgage notes but the investor journey. We’re investors as well.

We’ve been there, done that over five funds. Our offering through Regulation A+ and Reg D allows for different investments into the same company. We buy notes and fix and flip them is what we like to say. We buy them a discount, underwrite the loan, and then try and create that win-win, which, unfortunately, we can’t do in every instance. Like anything in life, you win some and you lose some.

When people ask about mortgage note investing, we like to start at a very high level. You are not buying a property. You have the loan. There are two types of loans that we can deal with, which are performing where a person is making their monthly payments and then there’s non-performing where borrowers fail to meet their scheduled repayment obligations and the loan is in default.

 

Interestingly enough, when people talk about defaulted loans, most people think the moment you miss a payment, someone is going to be knocking on your door and threatening to rip you out of the house. The average loan we see in default is default by several years. It gets a bad rap. I saw this on Reddit where somebody got served a lawsuit for a $1,000 credit card bill that they owed from ten years ago that was charged off and then sold. Charged off doesn’t mean that you don’t owe it anymore. It means that the company’s not trying to collect it.

Fifteen years later, someone else comes and starts yelling and screaming at them, telling them, “You owe us money,” which gives a bad rap for the space but also, most likely, they can’t even collect on that debt and they’re trying to threaten the person. That leads to, “Chris, are you threatening people or calling them?” No. The question is then, “How do you make your money?”

How Investors Profit: Borrower Negotiations And Exit Strategies

Let’s walk through how we make money. There are two paths that we can go down. We buy loans typically at a discount, and then we have two strategies. We try to go through the borrower, which is to negotiate the payment with the borrower. If we can renegotiate a payment plan, we can generate cashflow from those payments.

After getting that cashflow, we’ve got multiple options. We can sell the loan as a re-performing loan. A borrower may sell their home, which pays us off. I am not seeing that as frequently now because they bought it at a lower interest and it has become much higher or they have the equity and they can’t go anywhere, or they refinance. When we see rates start to drop down again, we’ll see more refinances and get us paid off. That’s the perfect world scenario that we try for.

The other is if the borrower is deceased or can’t work something out, we’ll go through that foreclosure process. If we have to foreclose, we either get sold at auction or we’ll take ownership of the home, and then upon exit, we can sell the home. People have asked in the past, “Do you typically sell as is or renovate?” In the past, we have typically sold as is.

We’ve been spending significant time with a firm that does a lot of what I’ll call traveling contracting. They’re a traveling contractor. They flew to DC for a day, sat down, and went through their business plan and what they do. Some of these assets we might look to enhance them slightly to maximize the value. It is something we’re considering. We’re not tied to it. On certain occasions, that might be a better exit. As we see more defaults coming down the pipeline, more properties in distress, investors not potentially buying as much, and people looking for that single-family home, that is something we’re looking into. That’s a high-level strategy within the note space.

Due Diligence: Evaluating Loans, Borrowers, And Market Risks

You may ask, “It sounds easy, but how do you do it? How do you acquire stuff? What’s your due diligence on something like this? If I want to invest with 7E, what do you do behind the scenes to give me some confidence that you know what you’re doing?” It’s a valid question. We are investors. We want to be able to answer that question. When we invest in something, we want that question answered.

One is we try to target investments that have equity. What do we mean by that? Buying properties that weren’t newly originated mortgages, meaning single-family. Somebody bought a house in 2023 during default. What does that look like for us? For us, we want something that’s ten years old. Why? Maybe it was a $100,000 property back then. Now, it’s worth $250,000.

Property values typically have gone up over time while your loan balance has gone down. Let’s say that the loan balance is only $75,000. That is a 30% approximate loan-to-value. If we’re able to pick up that loan at $50,000, we’re at a 20% investment to value. We invested $50,000 secured by a $250,000 asset. We’re not in the business of hitting grand slams on every deal. We get singles and doubles.

We have a lot of people who will tell you, “Your returns are only 8% to 10%. I can get 20% in a multifamily.” You can, but remember that when they have significant leverage, leverage enhances the outcome. I’ve seen a lot of multifamily deals go bad where that outcome is a complete loss. We’ve seen some that win.

Where does it end up at the end of the day? I bet you it is pretty close to the same place we’re at like all real estate investments or everything. Everything reverts to a mean of 8% to 10%. We like to define ourselves as going down the lazy river and you might like the rollercoaster ride. That’s completely up to you and your personal preference.

Bidding On Loans And Identifying Red Flags

That’s what we target. We do that by buying loans. People ask and want to understand the process. It is very similar to buying a house. There’s a preliminary bid based on a spreadsheet. I’m trying to buy real estate, which you have to go look at and then put offers in. There is a lot of paperwork. We get a spreadsheet, send an email back, and say, “We want a bid of $100,000 on this,” or keep it in Excel, copy and paste, and say, “Here are our bids.” It is a much easier process. It can be done from anywhere, which makes it so nice. They may counter or accept. There’s still no paperwork signed. You might sign a letter of intent. Some will require it but others won’t. It’s an old-school handshake business deal.

 

Unfortunately, we had two assets we had under the agreement. We even had an LOI. We were ready to close and the seller pulled them because “the buyer says they’re going to pay off the loan,” which they’ve said three times. I’m waiting for them to come back to us again and say, “We’re ready for you to buy these now.” Honestly, I’m going to give them a single-finger salute because that’s not how you should be doing business.

Once you get them under the agreement, there is that due diligence period. It’s like an escrow period. It takes about two weeks to do your due diligence. After you’re done with your due diligence, either accept it or fade. You’re like, “A property needs a new HVAC system. I’m going to deduct $10,000 from the property because of this,” and then close. The moment you close, you’re the lender of the property. You don’t own it. You don’t own the property. You’re a lender. Toilet breaks and roof leaks are not your problem. Remember that.

You’ve gone through that process. How do you know what’s a good loan versus a bad loan is a question we get asked a lot. For any investment opportunity you go through, make sure you do your due diligence. We like to do what we call the three Ps, especially in note investing, but in any type of investing, this is relevant. One P is Property. Where is it located? What type of a location? What is the condition of that property?

You also want to make sure you have a clear title to the property. There are no outstanding taxes, liens, or violations. You also want to understand what lien position you are in on that property. What’s the value of the property? Anything you invest in, you want to know the condition, structure, and value. We deep dive into not only the physical property but the chain of title of the property and make sure that it is clean.

Another P is Person. In any investment, you want to know who you’re investing with. It is the same thing when buying a note. Who is this borrower that our servicing company is going to have to deal with? We will run what’s called the skip trace where we can see their criminal history and a little bit of their financial history. As part of the due diligence, we’ll get to see their mortgage payment history. We’ll see servicing notes, which will show the history and conversations throughout time.

In any investment, you want to know who you're investing with. The same goes when buying a note. Share on X

What’s interesting is a lot of these borrowers think that that information doesn’t transfer. They’ll be like, “This old servicer told me this.” We’ve been involved in some disputes back and forth where they didn’t realize we had all that information. It ends up they find out we do, so then it changes the outcome significantly or how the process gets dealt with.

There’s the Predicament. In non-performing, those servicing notes will tell us if they are not paying because of death, divorce, or job loss. What situation occurred? In any type of investment, it’s the same thing. What is the purpose of the investment? What are you investing in? Based on everything you know, where do you think the outcome is going to run? It’s good to understand the model and the proforma. Are they using rosy-colored glasses or are they being conservative?

New sponsors always seem to do best-case scenarios. For us, when we underwrite things, we don’t underwrite the best-case scenario. We underwrite and buy based on the worst-case scenario. What does that mean? That means that we base it more on foreclosure. If it forecloses, pretty much, we think we know where that’s going to end. If we do better than that and work something out with the borrower, it typically enhances those returns.

That is something important to understand because when you’re dealing with non-performing loans, there’s a lot to manage, especially in that legal process. It starts with the borrower sending a demand letter, having the servicer try and work out a solution, and seeing if we can get them on some type of payment plan.

If we are, that’s great. We can modify the loan, get 6 to 12 payments from them, and sell that back on that secondary market. If you can’t, then we talked about how you go through that foreclosure process. That could lead to what’s called a deed in lieu, which is they give you title to the property. Sometimes a borrower may sell that property or potentially take it through the foreclosure process. Those are things to understand.

Investment Trends And Opportunities In The Note Market

Some questions that get asked a lot as well as things that people need to understand on the passive side of things are the differences between the types of investments. Is it something that’s going to provide stable, more consistent income or is it you getting paid once a year? Is there a profit sharing potential or is it a straight return? We launched our newest fund that has profit sharing in it, which has been a huge success so we’re giving upside to the investors.

Funds will do better in more volatile times. Share on X

How is your asset correlated to other assets? For us, we’re not correlated to the stock market. Job loss is typically what correlates most in the note space. The big differentiator is note funds will do better in more volatile times. If people are thinking in the next several years, there’s more volatility in the markets. In buying non-performing stuff, volatility typically leads to that, which provides more opportunity.

How are the returns risk-adjusted? What does that look like from an investment standpoint? How much leverage do they have? What are they targeting? How does that look? How passive do you have to be? Are you active or are you passive in that? One of the things that we talk to people about is, “What’s your team? Is it internal or external?”

For us, we have a lot of vendors. We have external vendors that we use as well as servicing companies. For example, in investor relations, we do that in-house. Our asset management, we do that in-house. We have an in-house accountant but we have third-party auditors, tax returns, and everything. By being able to control all of that, we got our financial reports done on time. We’re not waiting on others to get that stuff done. We’re already working with our auditors to get our audit done. There is a lot there that can be brought up in regards to in-house or external.

There’s one that they claimed to be a note fund but they didn’t invest in notes. You were receiving a note. On their website, they had different staff. They had CFOs and all these other people. None of them work for the company. The CFO was a bookkeeper. That is something to be considered. There’s another fund that we’ve seen. We received a pool of non-performing loans from seventeen assets of theirs. On their website, the individual in the fund started real estate in 2020 and claims to have almost 800 units under management, $130 million in assets, and done 125 full-cycle deals. I can tell you with straight confidence that that is pretty much BS.

In their portfolio, they’ve got these units I was looking at. They claim that there are 28 of them. They only own 17. Every single one is in default. Not only is it in default, but they’re $3 million in default, and the property’s only worth about $2 million. They’ve got another asset in Hawaii that they owe $15 million on and it’s being foreclosed for $6 million. This company does not own nearly what it says it owns on its website. They may have been a “co-GP” but not even close.

I think this is an opportunity people should look at. Given the current market conditions, there are growing opportunities in the asset class we're in. Share on X

They are going under but they’re still out there raising money. It blows my mind. It’s one thing to have bad deals and so forth, which we all have them. We’ve had some notes that haven’t gone well and so forth, but we try to keep our information as accurate as possible. I did some deep due diligence on this company because they keep the same name for all their assets. They add a tail to it. It’s XYZ Virginia, XYZ Maryland, or whatever the case may be. It frustrates me when I see people doing this type of thing.

The Future Of Note Investing And Market Growth

I will get off my proverbial high horse and get back into the crux at hand. Start out talking about due diligence. This is the stuff and the questions that people need to ask. People, unfortunately, learn a lot of this too late. Aleksey Chernobelskiy on LinkedIn provides tons of great content. There are websites out there as well that you can learn about some passive opportunities and stuff. People ask questions back and forth. I’m active a lot on BiggerPockets.

I want to share all of this information, relay it to people, and toot our own horn because we have our fund, and it’s our note fund. It is an opportunity people should take a look at because where the market conditions are, there are growing opportunities in the asset class that we’re in. There’s also a lot of continued demand for alternative investments within the space. People are moving away from traditional commercial real estate or multifamily and getting that diverse portfolio.

We offer some profit sharing for a limited time to investors. It’s not throughout. It’s very limited for the number of people. Once it fills, it’s gone. We want to provide people with the opportunities that are out there. If you want more information, go to 7eInvestments.com. You can get more information about our offering. If you’re looking to be a little bit more active in the note space, feel free to reach out.

We are going to be sponsoring, managing, and overseeing the Paper Source Note Convention from September 18th to 20th, 2024 in the Phoenix area. I hope you enjoyed this episode as we continue to provide great information and content and start focusing more on the paper side of things. Thank you all. Enjoy and take care.

 

Important Links

• Christopher Seveney on LinkedIn
• 7e Investments on Facebook
• 7e Investments on Instagram
• Aleksey Chernobelskiy on LinkedIn