$25k into a note on a park where I never had a lien

This is the beginner version of a loss because I was a beginner.

Someone I met through a real estate group was selling participations in a loan he'd made to an operator buying a 140-lot park. The loan was $900k at 11 percent interest only, 18 months, and he said it was secured by the park at a 65 percent loan to value. Participations were $25k minimum. I took one.

I got a one page participation agreement and a copy of the promissory note. Interest showed up monthly for seven months, $229 a month, and then it didn't.

What I learned afterward. The mortgage was recorded in the name of the lender's own entity, which is normal for a participation, and my agreement gave me a share of what he collected. It did not give me a lien, a right to enforce, or a right to direct anything. When the borrower stopped paying, the decision about whether to foreclose or work it out was entirely his, and he chose to work it out, twice, over almost two years.

It also turned out the 65 percent LTV came from an appraisal that assumed the operator's rent increase plan was already done. Actual value on in-place income was closer to $1.1M, so the loan was more like 82 percent. And there was a seller carryback of $180k behind us that I didn't know about, which mattered less than I feared but nobody told me.

The park did eventually change hands. I got $9,400 back across two years plus the $1,603 of interest I'd already received. Call it $14k out of $25k.

What I'd do differently. I'd ask to see the recorded mortgage and the title policy, not just the note. I'd ask in writing who decides what happens on default and whether I have any say. And I'd ask what income the appraisal used, because in-place versus pro forma was the whole difference between an 65 and an 82.

Answer

2sonia_alvarez Get yoursPRO6

Everything you named is right, and the piece I'd put at the top is the servicing and enforcement question, because it decides all the others.

In a participation you are buying a contractual share of somebody else's loan. The lead lender holds the note and the recorded lien, services the loan, and makes the decisions. A well-drafted participation agreement spells out what the lead can do alone and what needs your consent, usually listing things like extending maturity, reducing the interest rate, releasing collateral, or accepting a discounted payoff. A one page agreement almost certainly said the lead can do whatever he wants. That's the document that cost you the money, more than the LTV did.

The alternatives, so you know they exist. You can be a direct co-lender named on the mortgage as a fractional interest holder, which gets recorded and gives you standing, and recording practice for fractional interests varies by state. Or you can invest in a fund that makes loans, where you accept that you're an equity holder in the lender and you price it accordingly. What you don't want is the shape you had, which reads like a lien position and behaves like an unsecured claim on one person's collection efforts.

On the appraisal, get the report itself rather than the summary number. On park loans specifically, ask whether the income approach used trailing twelve actuals or the borrower's pro forma lot rent, and ask what expense ratio the appraiser used, because 35 percent versus 45 on a 140-lot park moves value by a lot.

Whether your participation agreement gave you any remedy you didn't pursue is a question for a lawyer looking at the actual paper, and it may be worth the hour.

3 replies

1Rena Expert

Two mechanisms in @vellum's story are worth separating, because they fail differently.

The first is the participation structure. A participant's rights come from the participation agreement and nothing else. The lien sits with the lead lender, and if the agreement grants no consent rights, the lead can extend, modify, or settle without asking. That is the standard structure, and it is workable when the agreement lists the decisions requiring participant approval and when the lead has real capital behind it. Whether a given agreement also creates a securities offering depends on how it is structured and marketed, which is a question for a securities attorney, and it comes up more often than people expect.

The second is the collateral valuation. Manufactured housing communities are valued by capitalizing net operating income, and the sector's low operating expense ratios, roughly 35 to 45 percent against 50 to 65 for apartments, mean a small change in the assumed ratio moves value noticeably. An appraisal built on post-improvement lot rent and a thin expense ratio produces a loan to value number that describes a park that does not exist yet. The lender's protection at closing is the in-place figure. Ask for the trailing twelve on which the income approach rests and check what expense ratio the appraiser used.

The original deal rested on the expectation that an 18 month loan would be repaid by a refinance that itself depended on the borrower completing a rent increase program. When the program slipped, there was no takeout, and the loan became a workout. Short bridge paper on a value-add plan carries that risk regardless of how the participation is papered.

1stephen_ok9CO2CPRO6

@vellum the number that would have told you most, cheaply, is the borrower's debt service coverage at closing on in-place income.

140 lots, and if lot rent was somewhere around $300 with a 40 percent expense ratio, that's roughly $300k of NOI. A $900k loan at 11 percent interest only is $99k a year, so coverage looks fine on paper, which is probably how it got sold. But there was a $180k carryback behind you with its own payment, and if the operator was also buying homes to fill vacant lots, the actual cash out the door was much higher than $99k.

So ask for the borrower's full sources and uses and their full debt schedule, not just the loan you're participating in. A borrower who is current on your note and drowning on everything else is going to be late on yours eventually. Getting $14k back on $25k over two years is a bad outcome that could have been much worse, and you learned the enforcement lesson at a fraction of what most people pay for it.

$25k into a note on a park where I never had a lien

3 replies