How to Minimize Risks in Distressed Real Estate Loan Acquisitions

Originally published on November 19, 2020 and updated on September 28, 2022. 

Given the economic downturn and financial challenges many businesses are facing, acquisitions of distressed real estate loans are likely to be far more common. Often these transactions involve a quick turnaround, sometimes with just a few days to complete the due diligence and review and finalize the necessary documents. Such scenarios will likely become increasingly common with the current economic conditions.

Buyers of distressed real estate loans are typically motivated by one of the following goals: (i) to renegotiate the terms with the borrower and attempt a workout of the loan, or (ii) to foreclose on the loan and obtain title to and possession of the property. This situation has created an opportunity for investors with sufficient cash to purchase such loans at large discounts. If the borrower is in default but still making mortgage payments, such a loan would usually include a default rate of interest, in which case the buyer stands to potentially make a very good return.

These transactions are inherently risky, however, so you need a framework for thorough due diligence. With careful planning, however, you can minimize these risks.

Typically, the deal documents in these transactions have little room (or time) for negotiation or modification. In addition, the representations and warranties given by the seller in such transactions are often very limited and do not offer much comfort to the buyer. The following are some legal considerations to keep in mind in distressed real estate loan acquisitions to minimize the potential risks:

1. Due diligence. Due diligence for such deals is different than a typical real estate transaction because it must be done in a very short period of time and, oftentimes, with limited or dated information. Unfortunately, because of time constraints, there often is no opportunity to do a thorough analysis of the property, including an environmental and title review. One must also assume that if the borrower is in trouble on their loan—beyond just missing a couple of loan payments—it is often likely that one of the following situations is also involved: taxes and/or insurance payments may not be current; there may be mechanic’s (or judgment) liens on the property; and the property is likely in need of repairs and maintenance. It is very important to get this information before closing, since your client may end up being responsible for paying for these items.
2. Obtain title coverage. Depending on the circumstances, there are typically two options to obtain title coverage: (i) have the title company that issued the original lender’s title policy issue an assignment endorsement, or (ii) have the title company date down the existing lender’s title policy.
3. Representations and warranties. Since the reps and warranties are usually limited to those made in the loan sale agreement, one should always include a reference to the representations and warranties from the loan sale agreement in the assignment documentation.

If you have any questions, please don’t hesitate to reach out to our Real Estate Group.