Buying a Non-Performing Commercial Real Estate Note

Lenders sell non-performing notes for reasons that often have little to do with the collateral's underlying quality: portfolio cleanup ahead of a regulatory review, capital constraints, or a simple preference to exit a workout situation rather than manage it through resolution. A buyer stepping in gets the same rights the original lender had, including the ability to pursue any of the resolution paths available under the loan documents.

This creates an opportunity for a buyer willing to do the work of diligencing a distressed situation: notes typically trade at a discount to the underlying collateral value precisely because the seller is prioritizing a clean exit over maximizing price, and the buyer is compensated for taking on the resolution process the seller wanted to avoid.

Non-performing notes are sourced through direct relationships with banks and special servicers, loan sale advisors who run structured bid processes, and, less commonly, direct outreach to a lender known to be carrying a troubled asset. Smaller, single-asset note sales are often negotiated directly, while larger portfolios typically move through a formal bid process with a defined timeline.

Pricing a non-performing note starts with an independent view of the underlying collateral value, typically discounted from any stale appraisal in the loan file to reflect current market conditions and the property's actual physical and leasing status. The buyer then models the likely resolution path, whether a reinstatement, a discounted payoff negotiated with the borrower, or a foreclosure, and prices the note to produce an acceptable return under a realistic timeline for whichever path is most likely.

A note secured by a property with clear, easily transferable value and a cooperative borrower generally prices closer to collateral value, while a note tied up in litigation, environmental issues, or an uncooperative borrower prices at a steeper discount to compensate for the added time and cost of resolution.

Diligence on a non-performing note is as much about the loan file as the property: confirming the note and mortgage were properly executed and recorded, that the chain of assignments is complete and unbroken, and that there is no defect that could complicate foreclosure or otherwise slow the resolution process. A gap in the assignment chain or a defective acknowledgment can delay a foreclosure by months.

A note purchase can be financed with its own capital stack, similar to a property acquisition, using senior debt sized against the underlying collateral value and the buyer's own equity or subordinate capital for the remainder. Lenders financing note purchases generally underwrite conservatively given the added uncertainty of the resolution timeline compared to financing a stabilized, performing asset.

A buyer should also budget for the resolution costs themselves, including legal fees, carrying costs, and any capital needed to stabilize the property after foreclosure or a deed in lieu, as part of the total capital plan rather than treating the note purchase price as the full cost of the transaction.

A note purchase closes through an assignment of mortgage and an allonge to the note transferring the debt from seller to buyer, typically accompanied by a loan sale agreement that specifies representations about the loan file, servicing history, and any known defects. The buyer's counsel should review this agreement closely, since it usually limits the seller's liability for the accuracy of the loan file after closing.

Beyond the seller and buyer, a note purchase often involves a loan sale advisor if the deal was sourced through a bid process, a servicer transferring the loan file and payment history, and, once the buyer moves toward resolution, local counsel in the property's jurisdiction to advise on foreclosure or workout procedure specific to that state.

As an illustration, a note with an unpaid principal balance of $3,000,000 is secured by a property with a current estimated value of $2,600,000. A buyer models a likely resolution through a negotiated deed in lieu or foreclosure over an estimated twelve months, with carrying costs and legal fees of roughly $150,000, and offers to purchase the note at $2,000,000, pricing in a discount to collateral value that compensates for both the resolution timeline and the carrying costs along the way.

Once a note purchase closes, the buyer typically pursues one of several resolution paths depending on the borrower's cooperation and the property's condition: reinstating the loan if the borrower can cure the default and resume payments, negotiating a discounted payoff, accepting a deed in lieu of foreclosure, or pursuing foreclosure through the courts or a non-judicial process where available.

Foreclosure timelines vary considerably by state and by whether the jurisdiction uses a judicial or non-judicial process, with non-judicial states generally resolving faster than states requiring a full court proceeding. A buyer should build jurisdiction-specific timeline assumptions into the pricing model rather than using a single generic estimate across every deal, since the difference between jurisdictions can be substantial and should be confirmed with local counsel for the specific property.

Buyers sometimes price a note against a stale appraisal without confirming current collateral value or property condition, leading to an unpleasant surprise during the resolution process. Another common mistake is underestimating the timeline and legal cost of foreclosure in a judicial state, which erodes the return the discount was supposed to protect.

H Equities evaluates first mortgage bridge loans from $5,000,000 to $50,000,000, which can apply to financing a note purchase or the eventual re-financing of the underlying property once resolution is complete.