Before you fund a note, verify the documents, the payment record, the property, the title, the taxes and insurance, and the seller. Anything you cannot verify should change your price or end the deal.
Due diligence is the checking a buyer does between agreeing a price and paying it. What follows expands the due diligence section of the guide for note investors into a working list for a note secured by real estate. Treat it as a starting point and have an attorney review the documents on any purchase you intend to close, because a list cannot give legal advice.
How to use this list
Your purchase agreement should give you a review period and say what you may do if the file does not match what you were told. Read that clause first. Then work the list in order, because the cheap checks come first, and there is no reason to pay for a title search on a note whose paperwork fails on page one.
The list is shorter when the file arrives prepared. On a note that comes through us, we collect the documents and the payment record from the holder before buyers see it, and anyone who has chosen to join the buyer list is told which items we have verified and which we have not. That shortens your work without replacing it, so run your own checks on the title, the value and the originals before you fund.
The loan file
1. The documents
The set of loan documents is called the collateral file, and what is in a collateral file decides whether the loan can be enforced at all. Ask for copies at the start and the originals at closing.
- The original promissory note, signed by the payer. Read the rate, payment, start date, maturity date, late charge and any balloon, meaning a large final payment.
- Every endorsement or allonge. An allonge is a page attached to the note that carries an endorsement. Together they must form an unbroken chain from the first lender to the seller.
- The mortgage or deed of trust, with the county’s recording stamp.
- Every assignment of the mortgage or deed of trust, each one recorded, matching the chain on the note.
- Any modification, extension or forbearance agreement that changed the terms.
- The settlement statement from the sale that created the note.
- The title insurance policy from that sale, if one was issued.
Check that the names, the amount and the legal description of the property agree across every document, since a small mismatch found now is far cheaper than one found during enforcement.
2. The payment record
- A payment history showing the date and amount of every payment, or at least the last 12 to 24.
- Independent proof: a servicer’s ledger, or the seller’s bank statements showing deposits. A list the seller typed proves nothing until it is matched to one of those.
- A recalculated balance. Build the amortization schedule, the table of how the balance falls with each payment, from the note’s terms and the payment dates. Your figure should match the balance you are being sold.
- The pattern of late payments, if any. Three late payments spread over five years reads differently from three in the last six months.
- Whether anyone other than the payer has been making the payments.
Pulling the payer’s credit has legal conditions attached, so ask your attorney or servicer how to do it properly.
The collateral
3. The property
- A current opinion of value from someone independent. A broker price opinion, or BPO, is a local agent’s written estimate based on recent sales.
- Recent exterior photos, and interior photos if they can be had.
- Occupancy: the payer, a tenant or nobody.
- Condition, and anything visible that would cost real money to fix.
- The property type and how active the local market for it is.
- Flood zone and any known environmental issue, especially on commercial property or land.
From the value, work out your investment to value, or ITV: your purchase price divided by the property’s value. As an example, paying $60,000 for a note on a property worth $100,000 is an ITV of 60%. The lower the figure, the more room you have if you ever need to rely on the property.
4. Title and liens
- A title search or an ownership and encumbrance report, often shortened to O&E, which names the owner of record and what is recorded against the property.
- Confirmation that the payer is the owner of record.
- Your lien’s position. If the summary says first lien, the record should show nothing ahead of it except items such as current property taxes.
- Other mortgages, judgments, tax liens, mechanic’s liens and association liens.
- That the mortgage or deed of trust was recorded, and recorded against the right parcel.
- Whether you can get title insurance, or an endorsement to the existing policy, covering the assignment to you. Ask a title company what is available in that state.
5. Taxes, insurance and other claims
- Property tax status. Unpaid property taxes generally take priority over a mortgage, and a tax sale can threaten your lien.
- Hazard insurance in force, with the note holder named as mortgagee, meaning the lender entitled to be paid on a claim.
- Flood insurance, where the property needs it.
- Homeowner or condominium association dues, which can carry lien rights of their own.
- Any open bankruptcy involving the payer. A search of court records will show it.
The seller
Start with identity: the person or entity selling should be the one named as the current holder at the end of the chain. Then check authority. If the seller is an LLC, a trust or an estate, ask for the documents proving that the person signing has the power to sell.
Ask whether the note has been pledged as collateral for a loan or sold in part to someone else, and whether there is any dispute, lawsuit or complaint between the seller and the payer. Get the answers as written statements in the purchase agreement, where they are called representations and warranties. Buying through a broker does not remove this step: verifying the note seller still means checking the holder named at the end of the chain.
Questions for your attorney
Some checks need a lawyer because the answer depends on the state and on how the loan was made.
- Was the loan made in line with the lending rules that applied to it? Seller-financed loans to people buying a home can be subject to federal and state rules, and a loan that broke them may give the payer defenses.
- Does the interest rate or any fee raise an issue under that state’s law?
- What would enforcement involve in that state, and roughly what would it cost?
- Does owning or collecting on this note require any registration or license for you? This varies by state and by the type of loan.
What to do with what you find
| Finding | Response |
|---|---|
| A fixable gap, such as an unrecorded assignment or a lapsed insurance policy | Ask the seller to cure it before closing |
| A fact that changes the risk, such as a lower value or late payments not disclosed | Reprice, and show the seller why |
| A defect that puts enforcement in doubt, such as a missing original note with no clear remedy | Get legal advice, and be ready to walk away |
| A seller who will not provide documents | Walk away |
If you reprice, tie the change to a finding and put it in writing.
Keep a copy of this list with each file and date every item as you clear it. The dated list is what you hand your attorney, and it is your record of why you paid what you paid if the note is ever questioned or resold.
Related questions
Who pays for due diligence on a note?
The buyer, unless the purchase agreement says otherwise, since the checks protect the buyer's money. That covers items such as the title report, the valuation and the attorney's review. Allow for these costs when you set your price, because they come out of your return whether or not you close.
Can I skip the valuation if the payer has never missed a payment?
You can, but it removes your backstop. A perfect record tells you about the past. The property value tells you what you would have if the payments stopped. Buyers check both because either one alone can mislead.
What if the seller cannot find the original note?
Do not assume it can be fixed with a signed statement. Whether a lost note can be replaced or enforced, and what paperwork that takes, depends on state law. Get an attorney's opinion before you go further, and price the delay and the doubt if you continue.