Cash Flow Business Tip of the Week- Bad Notes to Good Notes

badtogoodWith a little ingenuity, you may be able to change the terms of an apparently bad note and turn it into a good note.

There are a number of circumstances where a real estate note can be modified to turn a bad situation into a good one. Here are some common modifications:

Extend the time period of the note. This is called forbearance. Suppose you are offered a note that is in default. The payor has missed some payments or has stopped paying. You could buy this note at a deep discount. So you go to the payor and get her to agree to a modification of the note. The modification extends the term of the note (adds years) and lowers the payments. She now has payments she can afford. You discount the note based on the new terms.

Transfer the responsibility for payment of the note. This called delegation or assumption. You find a problem note. You talk to the payor and learn a member of his family is willing to take responsibility for making payments on the note, so the current payor will not lose his home. You arrange the modification for the note; then you buy it.

Change of interest rate or other terms of the note. These changes can be made so that the payor will be able to handle the debt, stay current with the payments or act as inducement to the payor for other modifications that will make the note attractive for purchase.

MODIFY, NOT CREATE

Remember that we are talking about modification of the note, not the creation of a new note. A new note should not be created under these circumstances, because the date on the new note will differ from the mortgage or trust deed that secures it. This could cause problems on reconveyance or foreclosure. You must create a written modification, which is attached to the note. This is called an allonge. The provisions of the allonge become part of the original note.

Before the modification of the note takes place, be sure that a title insurance company will reinsure the continued priority of the mortgage as a lien on the property. In other words, say there’s a first, second and third note on the property. You are interested in buying the second. Be sure modification of the note won’t cause the mortgage to lose its second position and move to third position. Loss of priority can occur if the modification of interest, payments or due date is so substantial as to put the third mortgage holder at a greater risk of loss than already existed.

In many cases, you will be turning a bad note situation into a good one by modifications that make it easier for the payor, so we will not be increasing the risk for any junior lien holders. Even so, the title insurer may be so cautious that they will ask any junior lien holders to sign subordination agreements, (assuring that the note’s position will be maintained) before issuing insurance. You may want to make a small cash payment to the junior lien holder to win his or her quick cooperation. Figure this payment into the cost of buying the note.

OPTION THE NOTE

The best purchase strategy involving note modification is to option the note from the seller, supervise the modification and then purchase the newly modified note from the seller.

Laws vary state by state, so be sure you seek the guidance of your attorney in note modification situations. Many states treat a note modification as an act separate from the original agreement. Even though the note and its debt remain the same, the terms have changed. Usury laws may control the modification. There may be tax considerations for the note seller, but they are beyond the scope of this article.

Best of Luck.

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