The One in Which Due Diligence Was Not

As the home sales market has tightened and it becomes more and more difficult to sell a house, we’ve seen our investor clients shift their exit strategies to adapt to the current real estate climate. Investors who have been used to buying property on the cheap, holding short-term, and then selling at a reasonable profit are finding that investment model flawed as prices drop, overall sales decrease, and foreclosures skyrocket.

Instead, more and more of these investors are looking long-term, and we’ve seen a marked increase in investors who are waiting out the current problems in the housing market by becoming landlords and renting their properties. Others are looking at longer-term lease/options. Still more are turning to owner-financed sales through wraparound mortgages. Regardless of the shift in strategy, the effect is the same: to push back the investor’s payday until we see a better housing environment.

For those actively landlording, the investor won’t profit until they market and sell the house at some point in the future. In a lease/option, cashing out doesn’t happen until the tenant exercises their option and purchases the property. With wraps, because title transfers to the new purchaser, the investor, to get paid, is counting on that buyer refinancing the property as quickly as possible.

Most investors recognize the importance of due diligence in landlord and lease/option transactions. In fact, most investors would never think of entering into a lease/option agreement with someone before running a credit check on them, and evaluating their ability to get a mortgage.

However, it seems not all investors recognize that due-diligence is equally as important in wrap mortgage transactions.

Case in point: one of our clients recently contracted to sell a house with short-term wrap mortgage financing. With little equity in the property, the investor essentially was selling it at face value. Happy to find someone to take on the payments, the contract was signed. The buyer’s credit wasn’t run, and no due diligence was performed.

When we ran title, we uncovered almost $22,000.00 of liens and judgments against the proposed purchaser.

Needless to say, the amount of liens would have significantly affected the buyer’s ability to refinance the property; in order to qualify for a new loan, they would have to be paid off in full.

Even though the liens would have attached to the property junior to the wrap mortgage, the sale ultimately did not close. It is true that the investor could foreclose on the wrap at its maturity and knock the liens off title, but that would not achieve the investor’s ultimate goal: to get rid of the house, not to take the house back in two years, repair it, remarket it, and sell it again.

The moral of the story: Investors should always perform adequate due diligence when entering into a sales contract. A simple credit check on the buyer would have revealed that there was no chance he could qualify for a mortgage anytime in the foreseeable future. Knowing that, the investor would have passed on the deal altogether.