Our goal, whether we’re working for ourselves or for others, is to analyze how possible mortgage purchases are situated on the risk-reward spectrum. There’s nothing magic about that. Consciously or not, every investor does the same.
When investing in mortgage notes, the upside reward side of the equation is easy to estimate.
In this case of mortgage investments, reward is expressed in terms of yield. Like most investments, yield means the amount of profit, expressed as a percent of original investment on an annual basis.
In an ideal situation, investors realize their yield when borrowers pay exactly as promised.
While estimating rewards is enjoyable, analyzing risk is greatly more important. Once a mortgage note has been purchased and placed with a servicer, there is not much an investor needs to do except track payments and make sure that the servicer is paying insurance and taxes as promised. In that respect, investors’ behaviors and actions cannot measurably affect rewards.
Therefore, investment tasks revolve around understanding and mitigating possible risks. When it comes to investing in mortgage notes, it is crucial to understand that
notes are promissory notes with unconditional promises to repay.
If borrowers stop paying, no matter the reason, lenders have the absolute right to foreclose their loans. Through foreclosure, investors can recover their money by having sheriffs sell borrowers’ properties.*
Therefore, managing downside risk depends heavily on confirming values of underlying properties, the strength of mortgage terms, the extent of property insurance and properly listing the note holder as loss payee.
During the loan origination process, borrowers’ abilities to pay are usually vetted by checking credit scores, job histories, tax returns etc.
We invest in loans that are already in existence and have two or more years of payment history. Consequently, credit scores are usually somewhat moot. Moreover, until investors actually own loans, they are unable to check borrowers’ credit scores anyway. However, it is entirely legal (and prudent) to search for evidence of bankruptcy filings and view documents through the United States Courts’ PACER system.
For the most part, borrowers’ longevity and pay histories are stand-ins for credit worthiness. If borrowers have been actively paying their mortgages for one or more years, we have good evidence they intend to keep their properties. The longer the seasoning of mortgages, the better. Obviously, borrowers who have built up significant equity are less likely to default on mortgage payments.
Ideally, we want collateralized properties to be worth at least 33% more than the value of our investment. In order to acquire valuation estimates, we depend upon brokers’ price opinions (BPOs), automated value models,** recent sales of comparable properties and asking prices of similar properties currently on the market.
We further evaluate qualities of neighborhoods surrounding collateral properties for concerns such as crime, noise, traffic, cleanliness, schools and so forth. (We want to be sure our properties will fetch the highest possible prices if we ever need to take any back through foreclosure or deeds in lieu of foreclosure.)
Even though they may otherwise appear to have excellent yields and investment potential, we personally avoid buying loans on properties in blighted and high-crime urban areas. Our philosophy is that there are simply too many other opportunities with lower risk. Our “bread and butter” opportunities are found in working class, blue collar neighborhoods across middle and southern America.
Having explained how we analyze investment opportunities, we nonetheless warn that we are not going to suffer paralysis by analysis. We are confident in our analytical abilities and we tend to filter opportunities quickly. We are in the business of buying discounted mortgages that commonly carry elevated interest rates and commensurately higher yields. We are not in the business of buying low-interest loans on perfect properties in perfect neighborhoods guaranteed by perfect borrowers. (The yields are simply too low!)
Obviously, some investors are more risk-averse. That is okay. Obviously, those kinds of passive investors are willing to trade yield for measurably lower risk. In those cases, we look for highly seasoned loans that might have only a few years to run. In general, we prefer a little more uncertainty in return for higher yields with longer terms. In all cases, though, we discard opportunities that lack acceptable collateral or other exit strategies.
* Many mortgage investors try to avoid the expense and time of foreclosure by negotiating for deeds to properties in lieu of foreclosures.
** We check eighteen different automated valuation models (e.g. Zillow, Trulia, Bank of America, RealtyTrac, etc.) although target properties are rarely listed by more than six or eight companies.