Although foreclosure laws vary by state, the thought process and analysis for liquidating your investment is essentially the same. In many circumstances the hard money lender (or private money lender as they are commonly referred to) who originated your note, will guide you through the process in conjunction with your loan servicer, attorney, trustee, or other professionals. But having as much knowledge about the foreclosure process and upcoming decisions will assist you in achieving your objective at the foreclosure sale.
DETERMINE IF YOU WANT THE PROPERTY
Whether or not you want the underlying collateral of your note will drive your foreclosure decisions. Things to consider include rental income, potential future value, the estimated rate of return, the ease of maintaining the property, the location of the property, your personal financial situation, and other liens on the property.
Consider two diverse examples: Foreclosing on 10 acres of vacant land 400 miles from where you live vs. foreclosing on a single family home which was in the process of being rehabbed. If you are a developer looking for land in that particular location, then foreclosing and owning the land may be the best option for you. However, if you are not experienced with land but have many personal rentals, then taking cash at the foreclosure sale for the land, but keeping the rental property may be the best choice. Or, you may be a passive investor with no interest in property ownership, in which case in both examples, liquidating the investment at a foreclosure sale is the best decision.
The point is that there is no “right” decision when it comes to retaining a property upon which you’ve foreclosed. Often, maintaining ownership is a choice based on the individual objectives and specialties of the investor.
DETERMINE WHO WILL MAKE DECISIONS AFTER A FORECLOSURE
If you are the only investor in a note, then you of course will be the sole decision maker on the collateral. If you invested in a fractionalized note, perhaps several additional investors will be on title with you. Determining whether or not you and the other investors (if any) want the property may revolve around how complicated the decision processes will be after the foreclosure. If the property reverts back to the fractionalized investment group, there will be many decisions the investment group will have to make about either maintaining the property as a rental, managing a rehab of the property, choosing a broker to sell the property, etc. One significant consideration will involve advancing additional cash, both during the foreclosure process and after it. Not all investors may have the same level of liquidity and may not be able to participate in the additional cash requirement.
One strategy employed by investment groups is to form an LLC (Limited Liability Company) and transfer the property into the LLC prior to the foreclosure. The advantage of this strategy is multi-fold. First the group can appoint a Manager who is responsible for all foreclosure and/or ownership related decisions. Second, the group’s liability is limited by the legal nature of the entity. Third, the sale of the property is simpler because only one grant deed must be signed by the Manager instead of multiple deeds by multiple investors. Whether or not the group is willing to form an LLC will of course depend upon the investors’ ability to come together and agree on the decision to form the LLC and to appoint a manager.
DUE DILIGENCE BEFORE THE FORECLOSURE SALE
It is important to know as much as you can about the property before foreclosing including the current value of the collateral, lien assessments, condition, environmental issues, and anything else that may materially affect the value or the ability to liquidate it.
The extent of your due diligence before the foreclosure may depend on whether or not you originated the loan. If you did originate the loan, you may have a title policy insuring your lien position. If it was a commercial property, you likely have a Phase I or II environmental study and other relevant documents to review. If you have access to these documents, you will have to make an assessment as to how current they are and whether or not it is worthwhile to update them. If you purchased the note from another party, documents may or may not be available to review and may or may not be current.
Always assess the current market value of the property. Even if the foreclosure is relatively close in time to the loan origination, values and circumstances can change. Value is best determined with multiple points of input. Consider an outside appraisal from an expert in the collateral property type, your own drive by assessment and perhaps a broker price opinion (BPO). Once of the best sources of value is to call brokers with unsold listings of similar properties to find out the current list price and the interest level from prospective purchasers. Although list price does not equate to market value, it does give you a sense of the competition (if you list your property, you will likely be competing with other listed properties) and how well the competing properties prices are being received by the marketplace.
Have your title company prepare an updated report of liens on the property. Pay special attention to delinquent property taxes, state tax liens, IRS liens and mechanics liens.
Delinquent Property Taxes
Rules vary by state, but make sure that the state or municipality does not take a tax lien to sale and wipe out your lien position. Tax liens often have a super-priority and are always senior to recorded mortgages.
Federal Tax Liens (IRS Lien)
An IRS lien has a special privilege called 120-day right of redemption. If the IRS’ recorded lien position is junior to the lien being foreclosed upon, the IRS has 120 days to redeem the property. This means if the lender takes the property back at a foreclosure sale, the IRS could approach the lender within their 120 day allotted time frame and elect to purchase the property from the lender. To do this, the IRS need only provide the lender with a check for the full payoff amount. The IRS does not buy the property for market value. The IRS also will not reimburse the lender for improvements made to the property unless they were made to prevent “waste” on the property. So remodeling the interior of an office building to rent it is not a reimbursable repair, but repairing the roof during a heavy rain may be reimbursable.
State tax liens do not have the same 120-day right of redemption that IRS liens have.
Be aware that the face value printed on the recorded lien documents is rarely the amount of the actually payoff. The IRS and state taxing authorities often file one lien but when asked for the payoff will roll up other back tax years or new delinquencies that have occurred since the lien recording.
Pay special attention to mechanics liens that may be recorded on the property after your lien was recorded. Mechanics liens have special considerations because if the contractor follows certain procedures, the lien can be enforceable when the work began instead of when the lien recorded which means it is possible that the mechanics lien could be superior to a 1st mortgage even though it was recorded afterwards.
Most title policies insure lenders against this event as long as everything was properly disclosed when the insurance offer was made and the proper endorsements are obtained at the time the policy is issued.
For example, consider a first lien made for $500,000 on February 1, 2009 to a developer for a commercial construction project. Just prior to your lien, the developer contracted with a window manufacturer to purchase $250,000 of windows. If later the developer defaults on the $250,000 obligation to the window vendor, the vendor may be within their rights to record a mechanic’s lien. That lien will show on record after the February 1, 2009 senior lien, but because the work began prior to the senior lien, and the vendor followed the rules of his state, the lien is enforceable in front of the junior lien position. Whether or not the lien is enforceable in senior position to the note depends on what state law requires contractors to record and notice throughout the contracting process and whether or not the contractor followed the procedures.
Immediately report in writing to your title company, any lien discovered during due diligence, that is senior to your lien. Consult your attorney, and do not foreclose until you notify your title company, and receive a written response giving you the authority to proceed with your foreclosure.
Title insurance is not like homeowner’s insurance where you submit a claim and can expect a check. The title policy is an indemnity policy which will indemnify you against loss if the loss actually occurs.
Even if the title company missed a lien, you will only be reimbursed if that error results in a loss. Proceeding without title company approval may void your policy coverage.
Do not let decisions of the past drive your decisions in the future. A sunk cost is one that has been incurred in the past and cannot be recovered.
Consider an example where an investor loaned $300,000 on a property worth $400,000. The borrower defaulted, and in the time it took to foreclose, property values substantially declined and the $400,000 home is now worth $275,000. The investor must contemplate the instructions to give for the foreclosure. In this decision process, it is common for an investor to think, “I will rent the property so I do not lose the $125,000 or so in deteriorated property value ($400K original value less current market value of $275K). I’ll wait for the market to come back and then resell so I don’t lose money.” While any investor can empathize with this line of thinking it will lead to sub-optimal financial results because it ignores the fact that the $300,000 original investment in the loan is a sunk cost. The $300K investment occurred in the past and no decision in the future will change that past decision.
To further illustrate the dangers of ignoring sunk costs, assume the investor in the previous example will recoup $240,000 of their $300,000 at a foreclosure sale. The optimal thought process is for the investor to decide if it is better to take the $240,000 today (cash proceeds at the foreclosure sale), or take the property today (reverts back to the investor at the foreclosure sale). If the $240,000 is taken today, what alternative investment can be made with the $240,000 and at what yield? If the property is taken today with the objective to keep it as a rental; what will the rental yield as an investment?
Another way to think about this decision is for an investor to ask themselves, “If I could use the $240,000 in any investment, would I choose to buy this particular property for $240,000 and rent it for x number of years? Or, would I invest the $240,000 in something else? The investor’s decision may very well be that taking the property back at the foreclosure and renting it is the best decision. The key to this example, however, is not the end result. The key is to understand the methodology used to arrive at the result which acknowledges sunk costs in order to make the best decision for the future.
ATTEND OTHER FORECLOSURE SALES
Become familiar with the foreclosure process in your state. Each state has different foreclosure processes, different timelines and different players involved in the transaction. It’s one thing to read about the sale, but you will have better firsthand knowledge of what transpires and information to help you formulate strategies if you attend a sale well in advance of the one for which you are preparing your note.
Be sure to have your insurance ducks in a row. If the collateral underlying the note sells to a third party, you no longer need insurance on the property. But if you take the property back at the sale, you are now the owner and need to bind coverage on the property immediately. If you had a forced place insurance policy prior to the sale, that policy will no longer cover you as the owner of the property.
DOING THE MATH
One of the calculations you will need to decide whether to pursue taking back this property or choosing to let the property sell at the foreclosure sale will be a realistic foreclosure sale price. The best approach is to put on the hat of the bidder and determine what they will pay for the property at a foreclosure sale.
Assume the successful bidder at the sale will purchase the property to resell for a profit. To anticipate what a bidder may bid, you will need to make assumptions about what it will cost the bidder to take possession of the property and eventually resell it.
Below is a simple spreadsheet to help you make that determination. There are many considerations that will change based on property type and the state in which you operate, but the idea is to give you a framework to set up your own spreadsheet to calculate a probable opening bid.
Consider an example of a small mixed use commercial property being foreclosed upon by the senior lien holder. Assume the full payoff of the note is $600,000 and the current estimated value of the property is $750,000. Let’s also assume the investor decided they do not want the property for an investment and they wish to set the bid so that the property sells at the foreclosure sale.
The spreadsheet example is set up from the bidder’s perspective so that the investor can think like a bidder to determine the price to sell the property at the foreclosure. For simplicity, we’ll assume the bidder agrees the market value of the property is $750,000. Putting on the bidder hat, the bidder will factor in the following items when considering whether or not to bid at a sale, and how much to bid:
Fix Up / Rehab / TI (Tenant Improvements) – Any cost the bidder will incur to bring the property to the $750,000 value estimate.
Cost of Money – The bidder must factor in his own cost of funds, even if paying cash. This is sometimes referred to as the bidder’s discount rate, or the opportunity cost of the bidder’s funds.
Termite / Environmental – Factor in any reports or repairs required as the result of termite damage, or factors from a Phase I or Phase II environmental report.
Wire, Courier, Certs – Various escrow costs involved in closing the transaction. Remember, we have the bidder’s hat on and using the costs from the bidder’s perspective.
Hazard / Liability Insurance – Consider this cost only during the term of ownership for the bidder. If the bidder has the property only 4 months; calculate 4 months worth of insurance fees.
Title Insurance – Consider insurance for acquiring the property and disposing of it. Many bidders obtain a binder policy on the property since they intend to resell the property relatively soon after acquiring title. Binder policies are typically only 10% more than a single title policy.
Transfer Tax – Be sure to consider the transfer tax upon the bidder acquiring the property at the foreclosure sale and selling it. Transfer taxes vary substantially by city, county and state so be sure to investigate the full amount the bidder will be charged for acquisition and resale.
Miscellaneous – Various costs such as maintenance, repairs, administrative, and legal should be factored in to the bidder’s profit picture.
Utilities – Factor in the utilities the bidder will have during the term of ownership.
In this example, the total costs are $96,806. In addition to these, factor in the customary real estate commission for selling the property. Bidders will rarely pay a commission for the acquisition at the foreclosure sale, but will often incur a commission when selling the property. Many times bidders are licensed brokers and may not incur the full commission. For example, if 5% is a customary commission, a bidder with a broker’s license may actually pay out-of-pocket costs of 2.5% and not the full 5%.
The gross margin in this example is $615,694 which can be interpreted as the net cash proceeds the bidder will receive if he bought the property at the foreclosure sale, sold it for $750,000 and incurred each of the itemized expenses assumed in the above example.
Recall that the mortgage being foreclosed upon is only $600,000 so initially you may think the opening bid at the sale can be set for the full $600,000. This does not, however, include the profit the bidder expects to earn for buying the property at the foreclosure sale. It is true that not all property purchased at a foreclosure sale is bought with a profit objective. But in states where 100% cash is required to purchase, there is likely a profit motive.
How much profit does an bidder expect to earn? It depends on many factors including the amount of cash advanced to purchase at the foreclosure sale, whether or not the property is vacant, the condition of the property, and the desirability of the location.
For this example, we have assumed a $50,000 profit. How can you determine the profit for the property you are taking to sale? Go to a foreclosure auction several weeks or months in advance of yours and talk with the bidders. Discuss general details of your property and get a sense of what they are looking to earn for that type of risk.
Using the $50,000 profit expectation, this will mean that in order for a bidder to bid on your property at the foreclosure sale, the opening bid would have to be approximately $565,000. Thinking of this from another perspective, a bidder paying $565,000, and reselling the property for $750,000 and incurring all the costs and commissions in the above example, can expect to earn a $50,000 profit.
The calculated bid amount of $565,000 is less than the full amount of the debt of $600,000. This means if the foreclosure sale is set at $565,000 it is likely that the private money lender will lose $35,000 ($600,000 less $565,000 bid price). Setting the opening bid less than the full payoff is referred to as a deficit bid.
Junior Lien Math
All of the above calculations apply when the lien offered at the foreclosure sale is a junior lien, but add the following considerations:
If the lien holder foreclosing is a junior lien holder, add as one of the costs, the full payoff of the senior lien. Be sure to get the full payoff and not just the unpaid principal balance. The full payoff may contain advances for delinquent taxes, insurance, or other legitimate advances. Using the same example, let’s assume the first is $450,000 and you have a second position junior lien of $150,000.
The gross margin is the same $615,694, but in this case the investor is bidding for a second lien and will take the property at the foreclosure sale “subject to” the first lien of $450,000. In order words, if the investor pays $115,000 at the sale, their true acquisition cost is the $115,000 plus the $450,000 senior lien or $565,000.
Danger Zone: The biggest risk to a junior lien holder is that the property reverts back to the junior lien holder and the junior lien holder cannot sell the property for more than what is owed on the first mortgage (plus costs to resell).
For example, in this case let’s assume the second lien holder took back the property at the foreclosure sale and now owned the property subject to the first. If the property value was not the $750,000 assumed, or the property value dropped, or the expenses to repair the property increased, the junior lien holder could find himself in a position where the net proceeds from the sale would not be enough to pay off the senior lien holder. This is a common trap for junior lien holders.
Consider just a slight change to the assumptions where the property value is $600,000 instead of $750,000 and repairs go up to $125,000. In this example, the net proceeds are negative $31,870 which means the bidder would have to come out of pocket that amount just to pay off the senior lien.
The bidder could decide to keep the property as a long-term investment property, but the bidder needs to consider whether or not the property cash flows warrant retaining it. If the property cash flows positive, the bidder will likely have little to lose by maintaining the property and looking for future appreciation.
If the property cash flows negative, the bidder should decide if the negative cash flow is worth keeping the property. A bidder, after acquiring the property, does not want to be in the position where the best decision is to stop paying the first lien and let the first lien holder foreclose to eliminate the burden of ownership. Junior lien holders often underestimate the amount of risk junior position can lead to when things do not go according to plan.
Foreclosure Bid Setting Strategies
Cash Out – Receiving cash at the foreclosure sale instead of the property. At the conclusion of the sale, the investor receives the final bid amount less expenses charged at the sale. In most states the funds are handled by a third party and once the sale is declared final, the cash is given to the investor.
Take back to resell or for Investment – If an investor decides the loss in a “cash out” strategy is too high, the investor may wish to set the opening bid at the full debt which would likely lead to the property reverting to the investor at the sale. But before choosing this strategy the many risks associated with it have to be considered:
Gaining Possession – The property may or may not be vacant. Even though you have title via the foreclosure sale, you must gain legal possession of the premises. Investigate the situation before you foreclosure and take back a property. Having a cooperative occupant (perhaps a long term tenant(s) willing to lease back from you while the property is resold) vs. a combative tenant (a former borrower intent on prolonging their possession at your expense) is a big consideration on whether or not to take back a property.
Ownership Risk – There is a substantial amount of risk in owning property which you may not have possession of. The occupant may create situations beyond your control which could lead to city, county, state or other types of fines.
Environmental – Be sure you understand the environmental risks, if any, on the property you foreclose upon.
Resale Risk – The property may not sell for the amount of your estimated value by the time you get possession. You may think the property is worth $750,000, but if it takes you 6 months to gain possession of the property, or make repairs, the property value may drop.
Liability – During your term of ownership, you have liability for fire, hazard and general liability of the premises.
Remodel / Structural – It could cost you substantially more than your estimate to make repairs or improvements to the property. You are not always able to conduct as thorough of an investigation when foreclosing because the occupant may not be cooperative.
Insurance Considerations When Bidding
Many investors set the opening bid at a low amount and then credit bid themselves up to the amount they desire. For example, in our previous example, the investor could set the opening bid at $200,000 and then credit bid if there are any bidders, up to the $565,000 or $600,000.
If no bidders attended the foreclosure sale, the property would revert back to the investor at a reflected sale price of $200,000.
If there are bidders, the investor can set instructions to bid against the bidders in any increments. For example, “Bid in $10,000 increments against any third party bidder up to $565,000.”
The reason for the low initial bid is to preserve insurance rights and reduce transfer taxes. If the investor opens their bid with the full amount of the debt and no investor bid, the investor is deemed to have purchased the property for $600,000. The $600,000 is full consideration which would extinguish any ability to file an insurance claim if the investor obtained possession and discovered damage covered by insurance.
Different states have different ways of communicating bidding instructions. Surprisingly, most states have a relatively informal process whereby you communicate the information either in an email, a fax, or often verbally. Be sure to get a signed acknowledgement of the instructions you provide and do not rely on informal methods of communication. Even if you are submitting instructions to your attorney, ask your attorney to get a signed acknowledgement back of the exact instructions.
Foreclosure sales are often relatively unorganized and chaotic and if you want to be assured your instructions are followed accurately, get the signed acknowledgement. If your instructions get executed improperly, unwinding the sale is nearly impossible, time consuming, and costly, even if the error was not yours.
THINGS TO BE ALERT TO PRIOR TO A SALE
Last minute bankruptcy
Borrowers will frequently turn to bankruptcy to delay the process. Bankruptcy is a federal process and puts a “stay” on all state foreclosure actions until the bankruptcy court issues a “relief of stay”. It is not uncommon for borrowers to file bankruptcy the day before or hours before the foreclosure sale. Be alert and notify your attorney immediately if the borrower calls to provide bankruptcy information. It is more expensive to reverse a sale than to postpone it.
Reinstatement of your lien by an unauthorized party
Often borrowers will get a last minute loan to reinstate a foreclosing lien. Before you accept funds, or authorize your loan servicer to accept funds, determine if the funds are coming from a source authorized by your note and security instrument. For example, many commercial loans do not permit a second lien to be recorded without prior authorization from the senior lien holder. If you discover funds are coming from a second lender, you may choose not to accept those funds. Check with your counsel for applicable laws.
Deeding into other entities
Borrowers get very creative in trying to circumvent a foreclosure. Watch for deeds transferring ownership. One common tactic is for a borrower to deed a 1% interest to an entity already in bankruptcy in another state. The bankruptcy is likely not to come up in your title company / attorney / trustee title search, because the filing will have occurred in the past, and in a different district.
Check the public records frequently and alert your counsel to any unauthorized transfers.
Most carriers offer an insurance guarantee of sorts that means different things in different states. Most of these policies generally guarantee the foreclosing party (the sheriff, the trustee, the auction company) that they are foreclosing on the right parcel, or have sent notices to the correct address. The policies offer very little insurance, if any, to the investor.