Neither commercial mortgage lenders nor borrowers sign a loan agreement with the expectation of failure. Ideally, the borrower satisfies their end of the bargain. In the event they do not perform, however, a lender has options up to and including foreclosure. This process has a unique set of pitfalls that need to be addressed, particularly with the potential of an economic recession looming.
Understanding the foreclosure process can be crucial for mortgage brokers to salvage what is often a contentious and difficult situation. Timing is everything and this is certainly true when deals fail. Brokers and their clients should be aware of the steps and the variables involved in foreclosures, which lenders must always keep in mind as they maneuver through the process.
The two primary types of foreclosure (and the procedures required) are dependent on the state in which the loan was made, as well as whether the lien interest is a mortgage or a deed of trust. Although there are differences, both legal agreements are designed to be first-priority liens against the property that provide for a power of sale.
Nonjudicial foreclosure, sometimes called foreclosure by advertisement, means going through the statutory process without the involvement of a court. In simple terms, it requires publishing notice of the sale for a period of time before bringing the property to auction.
As the name implies, judicial foreclosure requires going in front of a judge who will make a decision on the validity of the debt, as well as whether a lender has complied with the applicable state laws. In states where there is a deed of trust, the procedure involves a trustee bringing the property to sale rather than the creditor or the servicer of the loan.
Knowing the risks
Specifically in relation to private lending, the foreclosure process has a certain number of inherent risks. Borrowers using hard money are most often doing so because they’re having difficulty securing a loan from a traditional brick-and-mortar bank. This may be for reasons such as self-employment, a prior bankruptcy or too much other debt.
On the other end of the spectrum, a borrower may be in desperate straits, needing to fund a struggling business or a fix-and-flip project on a decrepit commercial property. The more financially challenged the borrower, the higher the likelihood of nonperformance and the need to foreclose.
Because private lending is more likely to involve a distressed borrower, it can increase the odds that a foreclosure will become contested. Why is this the case? Consider the example of someone who is seeking to take out a loan on the only real estate their company owns. The borrower also has a Uniform Commercial Code filing, which allows the creditor recourse to seize personal property, and they own shares in the business entity itself.
This is a high-stakes situation. For a borrower who is already in distress, a foreclosure would likely put him or her out of business. Fighting it out in court might seem like the best or only option.
Depending on the type of loan product being utilized, some borrowers may have a balloon payment. In other cases, an interest-only loan may have made sense as it allows the borrower to buy some time and get another loan. If the borrower isn’t creditworthy, however, a balloon payment functions like a ticking time bomb.
In this situation, a high-risk borrower may need funds to start a business or keep a struggling one alive. But when the loan comes due, unless something has changed significantly for the better, they’re likely to be in the same position — or even worse in the event of an economic downturn, such as the one caused by the COVID-19 pandemic. In addition, given the circumstances, it will be difficult or impossible to find another lender to extend funds and pay off the balance of the balloon.
In rare cases, a deed of trust or a mortgage might fail to include the power to foreclose — which could happen if a private lender tried to save a few bucks by having an attorney buddy draw up the documents. This is far less common than a decade ago due to readily available standard mortgage forms, but it still warrants mention.
Also unlikely but possible are issues with origination, such as the way the note was signed, the purpose of the loan or the interest rate. In a contested proceeding, a desperate borrower might be willing to challenge these issues, even if only to delay foreclosure.
In the event of a successful foreclosure, a lender has the financial and operational burden of managing and preparing the asset for disposal. Moreover, this risk is increased by the nature of a distressed borrower. It’s not unusual for these people to be behind on their property taxes or have an outstanding utility lien that a municipality will aggressively pursue. These costs eat into the lender’s security interests and can be magnified further in the event of a contested and drawn-out foreclosure.
Foreclosures in action
Unlike the residential real estate market, where mortgage lenders are bound to follow specific and stringent underwriting and servicing requirements, private commercial real estate lending is less structured when it comes to regulations. So, while distressed borrowers may have a higher likelihood of challenging the right to foreclose, they have fewer arguments available to them. For lenders, that’s their side of the double-edged sword.
The situation plays out differently for the two types of foreclosure. In a judicial foreclosure case, the borrower receives a formal notice that a lawsuit is being filed against them and the creditor is taking action. Whether or not the borrower has the predisposition to fight the foreclosure, there are lower transactional costs for them in a judicial proceeding. After all, they’re already part of a lawsuit. Since they’re already spending money, many choose to appear in court and assert counterclaims to challenge the foreclosure.
Conversely, a debtor who wants to challenge a nonjudicial foreclosure needs to commence their own proceeding, commonly called an injunctive order, which is basically a temporary restraining order that would stop the foreclosure from moving forward. In terms of time, the expense of an attorney and the slim likelihood of success, that is a big lift for someone who is already in financial distress.
Their motivation could be an attempt to delay the inevitable or they may believe they have a legitimate claim to prevent a sale. Depending on the state, a borrower might attempt such action prior to the sale or after the sale but before eviction. In addition, many states have a redemption period, which allows a borrower to come forward and pay off the loan.
Forewarned and forearmed
The overarching foreclosure pitfalls for a private lender are time and money. In a best-case scenario, an uncontested, nonjudicial foreclosure that goes smoothly might take four to six months. A contested judicial foreclosure will cost far more and take longer, possibly six to nine months, even if the foreclosure claim is rock solid. Judicial processes are not built for speed and litigation is inherently unpredictable.
Having a valid debt and security interest against the property — including the power of sale — are the private lender’s first line of defense. Ultimately, however, there are usually solutions outside of foreclosure that can help to avoid contentious circumstances.
If they are relying only on asset values, with no consideration to credit or income, a private lender needs to be a keen observer of behavior. A contentious borrower may self-identify early in the process by missing payments and making excuses. In the event of a foreclosure, that’s a debtor who will put up a fight, so the lender needs to be prepared for that eventuality.
Other borrowers fall into a gray area and may be worth negotiating with to avoid foreclosure. Running a cost-benefit analysis may indicate that the wise financial move is to offer a loan extension with an appropriate fee, or to accept a payoff that is less than the full amount due but is more cost efficient than foreclosure proceedings. Commercial mortgage lenders, including private lenders, should be in the business of making loans rather than owning real estate. These options can remove the hassles of property disposition. ●