By Michael Hanks, Esq.
Consider the following: Fred and Ethel are solid, hard-working citizens who have planned for their retirement. They were fortunate enough to be able to acquire three rental houses in 1979, just before the Sacramento real estate market took off during the 80’s. They paid $50,000 for each property in cash. During the 80’s the value of the properties tripled, until in 1987 they were appraised for $150,000 each. Feeling giddy by the increase in the value of their properties, they decided to refinance all three properties by taking out loans against each for $120,000, and acquired more rental units using the proceeds, for $100,000 each, in order to keep the ball rolling. They then put $25,000 of repairs into each new property for a total cost following improvements of $125,000 each.
The cash flow from the rentals made all the mortgage payments and provided a surplus for taxes, insurance, maintenance and other related costs of ownership. In some years Fred and Ethel even had a positive cash flow coming in after payment of all expenses. In addition, they were able to take depreciation. They felt good about the future.
Then the 90’s happened. When the California real estate market declined, the value of their properties went down. Each property now has an appraised value of only $70,000. The mortgages on the properties exceed their fair market value. Moreover, periods of vacancy and the general decline in rents have turned that positive cash flow negative. Fred and Ethel find themselves having to feed the properties each month, which exerts a considerable strain on their resources.
They seek counsel regarding turning the properties back to the lenders and walking away in order to stop the bleeding. Unfortunately, life is not so simple.
The Basic Problem. In order to understand the realities facing Fred and Ethel, it is necessary to have at least a passing familiarity with California law relating to “deficiencies” under a mortgage, or deed of trust.
A loan used to acquire a personal residence can only be satisfied by the value of the residence in the event of foreclosure. The lender has no right to recover an affirmative monetary sum from the borrower, even if the value of the property has declined significantly and is now less than the amount owed. For our purposes all other loans can result in a “deficiency,” meaning the lender will have a legal right to recover from the borrower the difference between the amount owed and the fair market value of the property following foreclosure.
In Fred and Ethel’s case, all loans against their rental properties are “recourse” or deficiency-type loans. If the lender proceeds in the proper manner, it will have a legal right to recover deficiencies on each loan from Fred and Ethel individually.
Assuming the fair market value of the properties is $70,000 each, and that the amount owed the lenders is $120,000 each, the amount of potential deficiency per unit is $50,000 and the combined deficiency over the six units ($720,000-$420,000) would be a whopping $300,000.
Accordingly, when Fred and Ethel go to the lender, ask it to accept title to the properties “in lieu of foreclosure” and forgive any remaining balances owed, the lender is being asked to walk away from a potential claim of $300,000.
Further, lenders are not wild about receiving additional inventory into an already over-burdened real estate portfolio.
Accordingly, in my experience, negotiating “deeds in lieu of foreclosure” on behalf of borrowers facing deficiency liabilities is difficult at best, and may be impossible under Fred and Ethel’s circumstances.
The Problem of Net Worth. Since Fred and Ethel are not fools, they wisely put a significant portion of their accumulating wealth in areas other than their real estate holdings. They placed a significant amount of money into their private pension plan. They have about $100,000 in stocks and bonds, which they hold outside their pension plan. In addition, they have about $200,000 of equity in their home.
A lender presented with this financial picture will conclude that, if properly pursued, Fred and Ethel may be worth all or a significant portion of the total deficiency claim. The equity in their house over $75,000 and the $100,000 of stocks and bonds are clearly available for collection of a deficiency judgment. In addition, Fred and Ethel both work, and a wage garnishment could be instituted.
Further, the lender realizes (or at least hopes) that, by simply refusing to accept a deed in lieu, Fred and Ethel, being responsible citizens, will probably come up with a way to service the debt and avoid default, such as by using their available cash and equity in their home. Accordingly, lenders under these circumstances can have a heart of stone.
The Title Problem. As if that were not enough, asking a lender to accept title to property by a deed in lieu of foreclosure creates potential title problems. A successful foreclosure of their deeds of trust will eliminate any junior liens on the property. Accepting a deed in lieu of foreclosure will not. The lender will thus be taking title subject to potential junior liens, abstracts of judgment and so forth. This can be a particular problem in the case of people who may be facing financial difficulties, such as Fred and Ethel. Accordingly, title considerations come into play to complicate the picture even more.
The Procedural Angle. The second leg of California foreclosure law which comes into play in these cases is the requirement that in order for the lender to obtain that deficiency judgment, it has to hire an attorney to sue Fred and Ethel in a civil action called a “judicial foreclosure” proceeding. Otherwise, it could simply foreclose its deed of trust under the power of sale through a title company, which is a quicker and cheaper procedure. A lender may thus be willing to accept a deed in lieu in cases where the potential deficiency is low or the borrower’s net worth is limited in order to avoid the cost of attorney’s fees and the delay inherent in a civil lawsuit in already crowded courts.
A lender looking at a request for a deed in lieu of foreclosure has to take into account each of these factors, including the net worth of the persons liable on the loan. Each transaction is therefore very specialized and handled in an individual way.
Differences Between Lenders. Different lenders also have different policies. All of them are tough, and all require a considerable amount of information regarding efforts to sell the property, current value, borrower’s current financial resources, and so forth, in order to even consider an application.
Out of state lenders tend to be somewhat more difficult than in-state lenders, in some instances because in-state lenders better understand California deficiency law.
Anyone considering approaching an institutional lender to propose a deed in lieu of foreclosure should contact the lender and request a “package” to complete. The next stop should be consultation with experienced real estate counsel for a review of your situation. You will need all the help you can get.
Next time: Additional Problems with Deeds in Lieu, and Some Solutions and Strategies.
To speak directly with Attorney Michael Hanks about a business, real estate, estate planning, elder law or prenuptial agreement matter, contact the Law Offices of Michael Hanks at (916) 635-0302.