For example, John Paulson, who runs the $36 billion hedge fund firm Paulson & Co, is looking to buy distressed mortgages and distressed debt, despite being bearish on the overall economy, Bloomberg reported. Paulson wrote in a 2009 outlook to investors that he is interested in investing in debt restructurings, bankruptcies, strategic mergers and financial recoveries. Paulson's opinion is entitled to great weight as he made billions betting the subprime market would crash and was one of the few to get it right.

Economic Outlook Favors Distressed Debt

Distressed investments are good values during bad business times and bad periods in the credit cycle where there is a bad economy, a bear market in stocks and increasing defaults. As we can easily see, distressed assets are now in favor. Conventional knowledge rightly suggests that in a period of economic contraction, debt, rather than equity, is a good investment strategy.

Risks of Distressed Debt

Distressed debt requires considerable expertise. Such debt is subject to serious legal issues, including possible bankruptcy proceedings, that require experience and expertise to successfully navigate.

Traps for the Unwary in Buying Distressed Mortgages

There are also several traps for the unwary in buying distressed mortgages. First, the buyer of a distressed mortgage may want to bring a foreclosure proceeding to take over the house. This inevitably will cost time and money. Depending on the local courts, and the willingness of the homeowner to contest the foreclosure, such proceedings can take as much as a year. During this time, there may be no income on the mortgage while taxes and insurance costs have to be paid. Legal issues, such as the inability to find the mortgage note in mortgages that have been sold into pools, may stall foreclosures. Some mortgage pools were improperly assembled and documented, making foreclosure difficult.

Further, during the foreclosure proceedings, a disgruntled homeowner may actually damage the home to spite the lender. In our market, we have reports of even homeowners of very expensive homes vandalizing homes by doing such things as painting "Screw First National Bank" on the walls and punching holes in them. At the least, the homeowner's efforts at maintenance and repair will be minimal or nonexistent. The worst-case scenario is when the home is vacant, leaving it open to decay and vandalism. This scenario can give you nightmares.

Adding to the nightmare is the fact that in many communities, the zoning and building code game is designed to help the local established contractors keep market share. Thus, in some areas, if the property has to have large repairs, it has to be rebuilt entirely up to code standards, just as though you only owned the lot. Thus, the lender or distressed debt owner has to act as though the property consists of only a piece of land.

Some communities with impact fees may require the lender to pay an impact fee. Many older properties had not paid a fee and the local communities are looking for revenue. They may demand an impact fee be paid before allowing this "substantial rehab" to occur.

Also, many communities have six-month grandfather clauses that provide that if they can show that a non-conforming use has ceased to operate for six months, the community can deny a certificate of occupancy and demand the property be rebuilt up to current standards.

Bulk REO

We see many people chasing bulk REO properties where a bank is selling a pool of single-family homes they have foreclosed on. We believe that banks will tend to sell the worst properties they own in these pools, especially those that may have EPA problems, zoning problems, repair problems, impact fee problems or other problems. The buyer has a limited time to review these properties and may not be aware of the problems he is buying. While real estate is a business where knowledge of the local market is essential, some bulk REO pools contain properties that are spread out over dozens of states, making local market knowledge impossible and management of the property a daunting task.

Better than Distressed Debt

We believe that there is a better strategy than buying distressed real estate debt. Looking at buying the entire distressed home, not just the mortgage, can cause you to see the superiority of this strategy.

Such a strategy of buying distressed homes consists of advertising for distressed real estate sellers, negotiating deep discounts, and reselling these homes to buyers with less than perfect credit using lease options that allow lease-option buyers to lease the home while they are repairing their credit to qualify for a mortgage.

We can buy single-family homes at deep discounts that are comparable to the discounts offered by buying distressed mortgages. These large discounts are possible for a number of reasons. In this real estate market, home sellers face a huge imbalance in supply and demand. Home sellers listing their homes could wait as much as a year to sell, during which time the outlook for prices is a decline. Further, with the decline in the availability of mortgage credit, few buyers can get mortgages. In our market, banks are overloaded with residential real estate loans and do not want to make any more. Further, the seller has to compete with real estate that is being dumped on the market in foreclosures proceedings and in sales of real estate owned by the mortgage lenders.

When a distressed seller enters this market, the distressed seller needs cash and he needs it fast. Few if any buyers are out there for him. To more his home fast, he needs to sell at a very low price. This is how one can buy the entire home at prices equivalent to the prices being paid for only the debt on the home.

A smart investor who buys the entire home, the equity and the loan, has total control and all of the upside potential, whereas the poor distressed debt buyer has to hang on while the property is in the hands of the owner. The distressed homebuyer has all the equity and can improve the property easily and immediately re-sell or lease it.

Summary

In sum, in terms of return on investment, obtaining an asset that has to be foreclosed at 30% of its face value and praying that the asset is salvageable and serviceable at the end of the perfection/foreclosure cycle may not be cheap enough if the cost of bringing it back up to habitable status is 70% of the value. We believe that the more you study the matter, the more buying distressed homes offers better returns with less risk.