How a borrower switching managers to save two points can push a second position note to 92 cents.
A case worth studying for anyone holding private paper on a small operating asset. Take $180,000 in a private note secured by an 18 unit built in the seventies in a soft secondary market, second position behind a small bank first, paying 10% interest only. The sponsor is competent, occupancy is 94%, delinquency is running about 3%. The one thing the note holder never papers is who operates the asset. Month seven the sponsor fires the manager, who is charging 9% plus a leasing fee, and hires a shop at 7% flat. That saves roughly $2,900 a year on a $1.6M asset. The new shop has 400 doors and no staff within 40 minutes of the property. What happens over the next six months. The rent roll handoff is partial, so five tenants get no payment instructions in month one and two of those never fully catch up. Delinquency goes from 3% to 14%. Three notices to vacate get filed late because nobody local is tracking the ledger, so those units sit an extra six weeks each. Occupancy hits 81%. The first mortgage stays current because the sponsor feeds it, and the note holder gets partial interest in four of six months. The exit in this illustration is 92 cents at month nineteen. Call it $14,400 of principal plus about $9,000 of interest never collected. The sponsor is still fine, incidentally, and the asset recovers a year later under a third manager. What to do differently. In a second position note on a small operating asset, the holder wants a covenant that a change of property manager requires notice with the new manager's name, door count and distance to the asset, and the right to review before it happens. Whether a consent right like that is enforceable and how it interacts with the first lien is a question for counsel in that state, so it should be drafted rather than copied. And ask for the monthly delinquency report rather than the occupancy number, because occupancy lags the problem by about four months.
