5 Key Questions About Note/Loan Sales, Answered

There are myriad ways to invest in real estate - from direct property investment to REITs - but one dimension of the industry that has been steadily growing in popularity is note/loan sales.

What is a Note Sale in Real Estate?

A note sale (or loan sale; terms used fairly interchangeably) refers to the practice of acquiring some or all of a property's debt, as opposed to the asset itself.

While real estate debt has long been traded between financial institutions and private equity firms, individual investors and commercial real estate professionals have been getting into the game in a significant manner as of late.

Nonetheless, note sales can still be a somewhat novel investment class for even the experienced real estate investor. To better understand this investment opportunity, LoopNet engaged Will Sledge, senior managing director with the JLL Capital Markets and a member of the firm's loan sales team. Sledge answered five key questions about investing in notes and, along the way, dispelled some commonly held misconceptions. He also explained the advantages and disadvantages of investing in a property's debt and provided an overview of the prospective returns investors can currently anticipate.

1. What Are You Buying When You Purchase a Note/Loan?

Let's get the simple stuff out of the way first.

"When you acquire a note, you're essentially acquiring the loan documentation, which is collateralized by real estate," Sledge said. In other words, you're buying someone's debt, and that debt is secured by a specific property (or perhaps a portfolio).

Now, what you're actually getting in return for your investment varies depending on the condition of the loan you've purchased. If the loan is performing (i.e., the property is stabilized and its owner is able to make their debt payments in full and on a regular basis) "you are buying a stream of payments over time," according to Sledge. Instead of paying a bank or financial institution, the owner of the real estate is making their loan payments to you.

However, most loans that individual investors obtain are either sub-performing or non-performing (i.e., in default). "If you're buying a sub-performing loan, you have the ability to potentially restructure that loan with the borrower, keep a stream of payments in place and perhaps revive the borrower's ability to turn a struggling asset around," Sledge said.

If a loan is non-performing, you can still attempt to work things out with the borrower, but it's more likely that you're ultimately going to take possession of the real estate asset itself, "by either a deed in lieu of foreclosure or a foreclosure action outright," Sledge said. In either case, after going through the foreclosure process, you will now own the real estate outright - and you will likely have paid far less for the asset than you would have if you acquired the property directly.

2. Why Do Lenders Sell Loans Instead of Foreclosing?

One query that prospective investors may be pondering is why a lender would sell the note, instead of foreclosing on the property and taking possession of the asset.

One of the major motivating factors is speed. Loan sales typically transpire quickly - Sledge said that the timeline is generally 50 to 60 days from offering to closing. Alternatively, a standard commercial real estate sale will usually take six months, and that's after the lending institution goes through the foreclosure process. During that six-month period, the lender also "incurs its own host of legal, closing and carry costs that are involved in actually owning real estate and making sure it doesn't fall into disrepair," Sledge said.

Most of the lenders that sell notes are not real estate operators and contending with the daily performance of a property isn't their forte. From their perspective, simply selling the note and moving on is often the swiftest and cleanest solution.

3. What Are the Advantages and Disadvantages of Purchasing a Note Instead of the Asset?

So, as an investor, how do you benefit from purchasing a note instead of directly investing in real estate?

According to Sledge, that depends on what kind of loan you're purchasing. In the case of sub- or non-performing loans, the advantage is largely derived from the flexibility and additional options you attain as the debtholder.

For instance, "you have the option to go back to the sponsorship or the borrower and allow them some breathing room to recover the asset and bring it back to a performing nature." You could also "inject additional equity into the deal" or develop a framework with the borrower to stabilize the loan. If none of those options are feasible or appealing "you have the option to take the asset back," Sledge concluded.

If you acquire a performing loan, "your options are usually very limited," Sledge said. What you're gaining instead is stability. You can have a reasonable expectation that the loan will continue to be repaid in a regular (and profitable) fashion, and this income is accrued without the operational and logistical challenges associated with owning the property itself. And should the loan no longer perform as anticipated, you've just traded stability for optionality.

As for the disadvantages, the foreclosure process isn't always, or even usually, simple or easy. Accordingly, if you purchase a note, you may find yourself contending with scenarios such as borrower bankruptcy or extensive litigation. Investors will need to have the financial wherewithal and patience to contend with those potential outcomes.

4. What Are the Anticipated Returns From a Note Purchase?

Of course, this is probably the most critical question for most investors. Once again, it depends on if you're considering a performing loan or a sub- or non-performing loan.

Sledge indicated that performing loans typically provide unlevered returns of approximately 5% at the high end. For sub- or non-performing loans, unlevered returns are generally around 7%, but levered returns can range from the low double digits for more stable assets to a "15% to 20% return, depending on how distressed the asset is," Sledge said.

The notion of levered returns may have some readers raising their eyebrows quizzically, but it's true: you can purchase debt with more debt. In fact, it's quite commonplace to do so. "There's a multitude of national bank lenders, as well as debt funds that will lend to you on your note purchase," according to Sledge.

In such a scenario, the lender's lender just becomes another layer in the property's "capital stack," i.e., the hierarchy of parties that hold debt and equity in a real estate asset, indicating the order in which each receives income and profits. If you should default on your loan, your senior lender can usually secure the real estate for themselves, given that they are typically the foundation of the capital stack.

"It's a very efficient market, there's quite a lot of activity in it, especially for the larger deals," Sledge added.

5. Who Buys Notes (and Where Do They Purchase Them)?

According to Sledge, the audience for note sales in quite varied and, once again, depends on the status of the loan.

"It's everything from regional players that are 'passing the hat' to medium and very large private equity funds, as well as high-net-worth individuals that are buying it on behalf of family offices," Sledge said.

As with virtually any real estate-related transaction, "the size of the deal usually dictates what type of buyer is involved." He added that frequently the smaller transactions attract investors that are not real estate professionals. "[With] smaller deals [the buyer] could be a dentist," he said.

Sledge also clarified that not all, in fact not even most, note sales involve distressed assets or non-performing loans. "There's probably as much performing as there is non-performing debt in the market right now, and that's usually sold by the lender for a multitude of reasons. They may be rebalancing their geographic portfolio; maybe they want to move out of a market that they've been struggling to make any headway in, or they just don't like a particular asset class or product type anymore."

Nonetheless, the sale of most performing loans occurs between financial institutions or transfers from a financial institution to a private equity firm. Sub- and non-performing loans are the categories that most often attract interest from independent investors.

Where can investors find these opportunities? Many are available through brokerage firms and are acquired in a manner that's not too dissimilar from a typical real estate transaction. However, over the last year, Sledge indicated that online auctions have become one of the most prominent avenues for investors seeking note sales.

Online auctions are "a great, quick process [and] the results are usually very good. I've had a lot of success with auctions this year, and a lot of participation on the buy side," Sledge said.

He noted that the reserve price in a distressed deal "will usually be well inside of the debt amount." This means that "the delta between where you buy [the debt] and what's owed is just additional proceeds that the sponsor would be on the hook for, unless you foreclose them out and then you just have the real estate."

In the event that you do undertake a foreclosure, the eventual returns could be quite promising, Sledge indicated. "You'll have some value-add work to do, some leasing to do and then there will be a path to stabilization and over time, probably three years down the road, you can sell [the asset] and you'll recover a value well in excess of what you paid for it."

This article was updated on 12/12/2024