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Hard Money Foreclosure

Gavel Next to Small House

Want to learn about hard money foreclosure?  As a note investor, determining the bid price for a foreclosure sale is always a tricky proposition. This article will focus on decisions relating to taking a hard money, or private money note to a foreclosure sale from your perspective as the investor/note owner.

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 private money lenders in Maryland

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.

Current Value

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.

Liens

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.

Mechanics Liens

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.

Title Insurance

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.

SUNK COST

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.

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