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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   March 2005

The Basics to Foreclosure and Negotiating a Loan Restructure

Foreclosure is the legal process in which your right to a property is terminated through a forced public-auction sale, usually because of a default of monthly mortgage payments. This article addresses nonjudicial and judicial foreclosure processes in California. The section on loan restructuring applies to all states.

Nonjudicial foreclosures

In California, nonjudicial foreclosure is a foreclosure not brought before a court. A promise of payment or other tasks can be secured with a mortgage and deed of trust, which contains foreclosure conditions and conveys the property’s power of sale to a trustee in case of default. In the deed, the borrower — the individual creating the trust — is called a trustor, and the lender — who is making a loan — is called a beneficiary. Upon default, the beneficiary may deposit with the trustee the deed of trust, the note and evidence of expenditures that are secured by the deed of trust, plus instructions to initiate the nonjudicial foreclosure process.

In this kind of foreclosure, a notice of default is recorded, and three months later (not counted as 90 days) a notice of sale may be recorded. Twenty-one days after sale notice, the property can be sold at a public auction. As many as five days before the sale date, the borrower may cure the default by paying the delinquent amount plus costs. If the property is not sold to a third party at an auction, the lender may acquire the property title.

For lenders, the advantage of non-judicial foreclosure is that it can be completed in less than four months, under ideal conditions. The disadvantage is that there is no further remedy or personal recourse to the borrower, unless borrower fraud, waste or malicious property destruction occurs.

Judicial foreclosures

In a judicial foreclosure, a lender may use court action to sell a property and pay a mortgage in default. Not only can lenders sell the property to recover their money, but they also can seek court judgment against the trustor for balance of their claims. However, under California law, deficiency judgments are not permitted when the seller has carried back a loan on the purchaser’s property.

A special note to homeowners: Loans obtained to purchase one to four units that are owner-occupied are protected from a deficiency judgment. When home- owners refinance the purchase-money loan on their homes, their liability changes. California code does not protect the property owner from personal recourse when this loan is refinanced. Be aware that lenders can and have judicially foreclosed refinanced home loans and obtained a deficiency judgment against the property owner.

Sometimes a lender also can file a complaint for judicial foreclosure and concurrently record a default notice. An irrevocable election of remedy only occurs after a nonjudicial-trustee foreclosure sale or a foreclosure judgment. It may be necessary to wait for a nonjudicial- trustee sale to determine if any personal exposure exists.

A caveat: When a senior lien forecloses and the successful bidder at the foreclosure sale is a third person other than the borrower, the junior secured lender may be able to file suit against the borrower to collect on the unsecured promissory note and avoid limits afforded to a borrower at a foreclosure sale. This situation is known as a “sold-out junior-lien holder.” If the junior lien is not secured by a purchase-money trust deed, the junior-lien holder can sue the borrower after the foreclosure of the senior lien and obtain a judgment against all people who executed the note.

Loan restructuring

One remedy available to a property owner facing delinquency and foreclosure is negotiating a loan restructuring, also called a workout. Each negotiation has special objectives, which for most people can include a:

  • Discounted loan payoff (debt cancellation might be a taxable event). 
  • Partial loan write-down with enhanced terms, such as extending a term to reduce the debt service, reducing the interest rate, placing a moratorium until property-performance improvement, capitalizing the accrued interest, restructuring the debt so net operating income is acceptable payment and negotiating for an advance.
  • Full debt restructure of payment, rate and terms without a partial write-down.
  • Deed-in-lieu with perhaps a discounted final settlement against a potential future deficiency judgment.

The five steps to planning a workout strategy are:

  1. Complete a financial analysis and evaluation of the expected recovery value that the lender would realize in a foreclosure. Acquisition dates and asset dispositions are projected. The analysis reviews property data such as loan-agreement copies, the promissory note, the deed of trust, the security agreement and all other liens secured by the property or borrower’s property operations, including real estate taxes and assessments. Also up for review are current rent rolls, copies of all current leases, a schedule of all rent concessions and current tenant improvements, copies of any current listing agreements and/or purchase offers from the past 12 months. Operating statements for the income and expenses face analysis for the previous three years to establish trends and calculate the current net operating income. 
  2. All appropriate expenses are analyzed and compared to expense models that lenders use to present a fair position on the owner’s behalf. Required capital expenses, leasing expenses for buyouts or brokerage commissions, the total debt service of senior debt and asset-management expenses then reduce the net-operating income. The results are the net proceeds from operations a lender may realize after acquiring title. 
  3. Establish market value. The operations proceeds are then added to the net-sale proceeds to create the expected recovery value available from the collateral.
  4. Thoroughly review the borrower’s exposure to a deficiency judgment. Facing analysis are all borrowers’ federal tax returns for the three most current tax years — including all K1s, if partnership interests are owned — along with a current financial statement, including cash-flow statements showing income sources and expenditure categories. The purpose is to develop strategies that protect personal assets and establish that it is not in the lender’s best interest to pursue a judicial foreclosure. Once the personal exposure is analyzed, asset values that may be exposed are reduced by liquidation and litigation costs, as well as risk factors in losing a judgment. This reduced value is the expected recovery value from personal assets. 
  5. Combine and discount the future expected-recovery value from the collateral and personal assets to create a present value. The discount rate considers the cost of funds, administration and risk. It takes great work and thought to develop the present value of the expected combined recovery. Negotiations begin with this discounted value. 
  6. Negotiate with the lender. Documentation is prepared and reviewed in this final phase. Upon approval, escrow and title are opened, and the transaction is closed.

Proper preparation of the financial analysis, which can be placed on a spreadsheet, is 70 percent of the work in a successful negotiation. Although comprehensive packaging for the lender is essential, negotiations must be directed to the present value of maximum recovery. The cost of a lender’s asset-management burden can reduce the maximum recovery to less than what a property owner can provide. In addition to closing the lender’s economic risk, adjusting the capital structure of a property allows the owner to maintain ownership and operation or the possibility for sale at a much higher price than if the lender sells it as real estate-owned.

When structuring strategies and implementation, it is vital to understand forbearance, loan restructuring, debt cancellation, short sales, deeds in lieu of foreclosure with release from any personal responsibility, land trusts and bankruptcy. Knowing how such devices and actions can be used independently, sequentially and or concurrently is essential in structuring strategies and their implementation. It also is vital to coordinate relationship strategies with other professionals who implement other aspects of assimilating and analyzing data or processing actions. 


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