Distressed note acquisitions seem to have emerged as a new opportunity area in the multifamily arena. It's an opportunity that investors believe will continue for the next 12 to 18 months, especially as more banks return to health and are able to take more losses.

But with any opportunity comes challenges, and distressed note purchases are no exception. In fact, there are many variables to consider when underwriting a potential note acquisition.

The problem is, buyers often don’t have much time. While it varies from lender to lender, the due diligence window usually isn’t very large on a distressed note acquisition. “The guys selling the notes don’t want you to think too much about it. The more you look under the hood of this stuff, the more ugliness you’ll find,” says Derek Kahn, CFO of Atlanta-based Brand Properties. “But you’ve got to gobble up everything you can, talk to everybody you know, get as much information as possible.”

Specifically, investors advise to get as much information as you can about the original borrower to help determine their financial status and business strategy. The key is figuring out whether the original borrower is inclined to file bankruptcy if you threaten to take the asset back.

Bankruptcy Influences  
The end game of a distressed note purchase is to own the asset. But an investor can also turn a pretty profit by buying a discounted note and just collecting the remaining balance.

An important step is determining how long the borrower might continue to service the debt, and how much in arbitrage you can get while you’re just “clipping the coupons.” Arbitrage basically is the difference between what you’re paying to finance the note and what you’re collecting on the note.

Investors say that the higher the likelihood of bankruptcy, the lower the price on the note, given the large amount of risk involved.  “If you’re relying on a bankruptcy court judge to make decisions for you, you’ve got to get a much bigger discount to handle that kind of risk,” says Michael Dance, CFO of Palo Alto, Calif.-based REIT Essex Property Trust. “You could get a judge that says you’ve got to extend the loan at the same terms for two years.”

Many of the construction loans that Essex has looked at acquiring were made at the peak of the last cycle, priced at 150 basis points (bps) to 200 bps over LIBOR. Since LIBOR rates are at historic lows—30-day LIBOR rates were around 30 bps in late July, and 90-day rates were only 47 bps—many newly constructed properties are still cash-flowing, albeit at a low level.

“So there’s a lot in it for the borrower to try and tie it up in bankruptcy for a year or two,” Dance says. “They can cash flow and make the loan payment, but they don’t have enough equity to pay off the principal of the loan.”

Judicial vs. Non-judicial Foreclosures
Another important consideration is local foreclosure laws, a process that could differ greatly depending on the market. These considerations will go a long way in determining how much the foreclosure process will cost an investor.

Specifically, the first thing to sort out is whether you’re dealing with a state that has judicial or non-judicial foreclosure laws. Non-judicial foreclosure laws are much more orderly and pose less risk. “In non-judicial foreclosure states, we estimate that the process takes about a month,” Kahn says. “In judicial foreclosure states, we have been advised that the process could take up to a year, or more in extremely contentious cases.”

In a judicial foreclosure state, the acquirer has to assume that the original borrower will stop making payments from the time the foreclosure process begins until a resolution is reached. “A year of getting zero return on your capital has a huge impact on your returns,” Kahn says.