Note Sales are Taking Off!


As we have discussed in several previous StreetWise columns, the distressed asset pipeline, which has been clogged for nearly two years, is beginning to loosen up. Lenders and special servicers are faced with thousands of distressed assets on their balance sheets and in their portfolios, yet until recently, only a small number of these assets have made their way to the market.

Everything that has happened from a regulatory perspective has provided these entities with the ability to avoid having to make decisions relative to these distressed assets. These regulatory changes have included changes in the FASB market-to-market accounting rules, modifications to REMIC guidelines and bank regulators letting banks hold notes on their books at par even though they know the collateral is worth substantially less.

The Federal Reserve’s highly accommodative monetary policy is allowing for the recapitalization of the banking industry which is relieving pressure on lenders to deal with distressed assets quickly.

Additionally, the foreclosure process can be particularly long, cumbersome and complicated (particularly in states other than Texas and Georgia). Many holders of distressed assets are choosing to sell notes rather than wait for the foreclosure process to be completed which would allow them to sell the assets rather than the paper.

Note sales can take two forms. The first is simply a financial transaction in which a bank or special servicer will pool many disparate loans with disparate collateral spread throughout a state, region or the entire country. These loans will typically be sold to what we call a “financial engineer” which will look at each loan, determine where it is in the foreclosure process, what can be done to enhance the note’s value and how to maximize the value of the individual loans for resale. These buyers are simply buying on a percentage-of-par basis and are looking to make a profit on the slicing and dicing of these pools.

The other approach to note sales is to simply sell a single note, collateralized by a property or a portfolio of properties. The typical buyer here will be a real estate investor who is buying the paper to get to the title of the property and own the assets on a long-term basis. These buyers typically pay much more for the note than a financial engineer will because they don’t have to build a profit into the process of administrating the foreclosure process. This is the type of note sale transaction that Massey Knakal has focused on in our Special Assets Group.

If we look at the distressed assets that we have sold recently and are currently working on, 78 percent of them have been note sales as opposed to REO (“Real Estate Owned” is  a typical term used by lenders for properties they take title to after a foreclosure) sales.  We expect this percentage to decline as time goes on and the foreclosure process is allowed to finish. Our large percentage of note sales versus REO sales is not surprising when consideration is given to the percentage of recovery sellers are achieving on note sales relative to collateral value.

Collateral value is the key measuring stick by which we determine how effective a note sale recovery can be. I am often called by investors who claim that they want to buy distressed notes, however as soon as they tell me that they wish to buy paper at 50 cents on the dollar, meaning 50 percent of par value, I immediately know that they are not serious note buyers and let them know that they will be unsuccessful in this endeavor.

The reason I say this is because if the collateral value is only 40 percent of par, they will be overpaying at 50 percent and will lose money. If, however, the collateral is worth 90 percent of par, and they are only offering 50 percent, they are not going to be able to buy anything as savvy investors will certainly outbid them. Therefore, we see that par value is really irrelevant relative to what a recovery will be.

A much more important indicator is collateral value or what the asset is worth if the deed were to be delivered. When we are retained by an institution to sell a note, the first thing we do is calculate the value of the collateral. This amount is then discounted by a percentage which is derived based upon taking the entire scenario into consideration. The variables include how far along the institution is in the foreclosure process, whether the borrower is being cooperative and the quality of the documentation.

Clearly, if a foreclosure process is nearing its conclusion, it is a very different situation than if the foreclosure process has not even begun but the note is in default. Similarly, if a borrower is cooperative, it adds value to the recovery. We have done transactions in which the borrower had a completely adversarial relationship with the lender, such that we could not even gain access to the property. In cases like that, we may not even be aware of the the tenancy in the property. In a scenario like that, the discount for the note would be much more significant than if the borrower is cooperative and we have a sense of how the real estate is performing.

Additionally, it is important to do significant due diligence on the quality of the documentation that exists. All documents must be reviewed including the note, the mortgage and the intercreditor agreements (to the extent that there is subordinate debt on the property). A summary of all interaction between the borrower and the lender can also be helpful.

When marketing a note, we move down two parallel paths simultaneously in that we must not only perform due diligence on the real estate asset, we must perform due diligence on the documentation to fully understand what exactly it is we are selling. This takes tremendous amount of time and effort but is important to make sure that all participants in the transaction fully understand what they are stepping into.

Another factor which greatly affects the recovery on a note sale is the extent to which the seller of the note is prepared to make representations. Some lenders have very complete files and are willing to make substantial representations about what they have and what they have done. Here , recovery is enhanced.  

There are, however, some lenders that will only represent that they own the note and have authorization to sell the note. They will not make any representations beyond this. I am often asked by a lender or a special servicer if a note can be sold under those circumstances. My answer is always that everything can be sold and everything has a price; it is only a question of what the highest price will be. Understandably, the more definitive the representations a lender is willing to make, the higher the final price and, therefore, the recovery.

Note sales have been dominating the distressed asset market recently and are becoming more and more popular. This is particularly true as distressed asset holders attempt to take advantage of the supply / demand imbalance that I often refer to in this column which provides the seller the ability to achieve pricing higher than what current economic fundamentals would dictate. There is significantly more demand than there is supply which is resulting in dozens of investors competing for each availability.

Under these circumstances, there is no wonder why distressed asset holders are eagerly entering the note sale market.                

Mr. Knakal is the Chairman and Founding Partner of  Massey Knakal Realty Services in New York City and has brokered the sale of over 1,050 properties in his career having an aggregate market value in excess of $6.2 billion.

21 Responses to “Note Sales are Taking Off!”

  1. 1 MB May 16, 2010 at 9:17 am

    I understand that the market is the market, but the whole note phenomenon seems so absurd. As you have said in previous posts, and as you have hinted at here, notes are not being sold today at any significant discount to the value of the actual collateral. By the time the note buyer has acquired the deed(either through the foreclosure process or through buying the deed), they’re into the property for just about what it’s worth, if not a little more. Buying a note is not the same as buying a property. It comes with a whole added set of risks and complications. The discount for taking these risks just doesn’t seem to be there. But hey, I’ve been wrong many times before, and missed out on opportunities many times before.

  2. 2 rknakal May 16, 2010 at 9:43 am

    Hi MB, Thanks for your post. Without a doubt, note prices are higher than they should be which is due, mainly, to the acute supply / demand imbalance. Many investors have raised funds to purchase distressed assets and, because there has been so little for sale, they are stretching to show some activity to the frustrated and impatient investors. There is no question that bidding is very aggressive for notes or any asset which is percieved to be distressed.

  3. 3 JBecham May 16, 2010 at 9:56 am

    Mr. Knakal, I have been an avid reader of StreetWise for over a year now. I just wanted to thank you for always sharing your cutting edge knowledge of what is happening in the market with us. I have only been in this business for 4 years and feel I have learned a tremendous amount from reading your blog. I know you are very busy and can’t tell you how much I appreciate your taking the time to share your knowledge. Also, I am blown away by the fact that you have sold over 1,050 buildings in your career. That is an amazing record! Thanks again, Joe

  4. 4 tk May 16, 2010 at 2:13 pm

    I’d like your thoughts re the state of the market for paper on parcels to be developed especially where some tenants remain and for sites where building has started and stopped after th builder started going vertical.

  5. 5 EdgarJ. May 16, 2010 at 4:16 pm

    Mr. Knakal, I agree completely with Joe B. above. I am a student at NYU and my real estate finance professor requires we read StreetWise and your Commercial Observer column every week. Thank you for the insights.

  6. 6 JM May 17, 2010 at 10:39 am

    Most lenders will soon realize that once US growth disappears, there’s little reason to lend more. That’s because new lending is just going towards paying off old debt, not investment in productive activities.

  7. 7 lighthouseas May 17, 2010 at 2:36 pm

    As expected, note sales are starting to open up. LNR just recently announced $1B in distress note sales and ING has begun selling distress loans it services via REDC auction. In speaking with colleagues at several special servicers, due to the volume of distress loans it is easier and more effective for them to sell the notes than go through the foreclose process. The special servicers have billions in distress loans and not do not have the man power and time to foreclose on each of the assets. In addition, they are seeing better execution as there is a plethora of investors out there looking for distress notes and they are starting to really compete with each other. We just closed on a note that received 5 bids that were $500M greater than initial ask with the winning bid being $1MM over.

    I agree with rknackel. There are guys out there that say they are investors and there are real investors. Anyone who says they want a 50% discount is not a real investor. The real investors look at the underline collateral to determine the real basis to make an appropriate bid.

    As usual, great post filled with valuable information. Your blog is one of the few that I visit frequently.

  8. 8 rknakal May 19, 2010 at 7:04 am

    Hi Joe, thanks for your post and the kind words. As to the 1,050 sales, if you stick around long enough, that type of thing happens. Thanks again.

  9. 9 rknakal May 19, 2010 at 7:09 am

    Hi TK, thanks for your post. Clearly, paper trades at a higher percentage of collateral value the more complete the development is. We have sold notes on development projects where the building was, esentially, completed and the recovery was very high. We have also sold notes on developments where little was done or only partial construction was completed and the paper was definitely sellable, provided the discount is appropriate.

  10. 10 rknakal May 19, 2010 at 7:10 am

    Hi Edgar, thanks for your post. Real estate is a great profession. I wish you the best of luck in your endeavors.

  11. 11 rknakal May 19, 2010 at 7:12 am

    Hi JM, thanks for your post. Let’s hope growth gets back to stimulative levels.

  12. 12 rknakal May 19, 2010 at 7:15 am

    Hi Lighthouseas, Thanks for your post. I completely agree with all of your points. The market for notes is much better (from the seller’s perspective) than anyone would think.

  13. 13 SMM May 19, 2010 at 9:19 am

    Robert, I appreciate your assessment of the note sales market and approach. One critical issue I would include in your valuation is “borrower underwriting”. Depending on the stage of foreclosure, an understanding of the borrowers going forward motivation is important in pricing the note purchase. I have found that the due diligence provided by the note seller is typically dated and inadequate. The do not want to make any reps & warranties, but they want a price that does not take into consideration the risk of the unknowns.

    Additionally, the starting point for valuation between the parties lacks sense. Bankers are constantly valuing notes as a % discount on principal balance, payments in arrears and penatlies; the amount of money that is due from the borrower has little to do with the collateral value. We have seen lots of activity in bulk sales through the auction platforms, but negotiating individual or small pools of loan sals (up to 20MM) has been rare. Until the banks/special servicers get overloaded with defaulted loans, I do not see the lenders getting real. That said, when the flood of defaulted mortagages do hit the market, the banks will not have the workforce to address each asset and extreme discount pricing on bulk sales will be back.

    Are we on a slow boat to the days of the RTC?

  14. 14 Mr Grimes May 19, 2010 at 1:38 pm


  15. 15 Adam Luysterborghs May 20, 2010 at 7:56 am

    Our recent experience has included an increased number of requests to finance note purchases for “one-off” acquisitions by operators.

    As you state above, underwriting the legal risks/costs of gaining title, in the context of the full capital structure & budget of the deal, remains the over-riding challenge to financing these deals. Of course, note purchases that must be completed with all-equity should trade at a discount to those where a path to title is under-writable.

    So it appears like the successful completion of a foreclosure is the “value-add” play of 2010/2011, as opposed to operational improvements. By 2012, I predict a designation will exist for lawyers with this specialization/skill set and nominate “F.L.I.P.” (Foreclosure Litigator for Investment Purposes) for consideration.

  16. 16 rknakal May 23, 2010 at 8:10 am

    Hi SMM, thanks for your post. While I agree that banks and, particularly, special servicers are overwhelmed with loans in default, I do not expect massive quantities of loan pools to be sold due to the significant discounts which are expected on large pools. The sale of individual notes has seen a very high recovery rate relative to collateral value and I believe these sales will continue to perform well.

  17. 17 rknakal May 23, 2010 at 8:12 am

    Hi Mr. Grimes, thanks for your post. Who are you quoting?

  18. 18 rknakal May 23, 2010 at 8:16 am

    Hi Adam, thanks for the post. I would not be surprised if the designation you mentioned, comes to be. You get credit for its conception.

  19. 19 jon paul February 25, 2012 at 4:17 pm

    Does anyone know how to get the contacts of banks or resellers of notes that are in STRATEGIC DEFAULT (i.e.: payments are current but debt exceeds today’s collateral value by at least 30%). I am interested in purchasing these notes for owner occup commercial and non-conforming residential

  20. 20 we buy real estate notes March 16, 2012 at 1:19 pm

    Excellent post it was very helpful I will be able to relay the information too my family they will love your page. Thank You

  1. 1 High-end foreclosures are Top Tier Homes Rising | Real Estate Comapny | Orange County CA Real Estate Trackback on May 16, 2010 at 12:09 pm

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