Foreclosures Explained
Commercial real estate foreclosure allows lenders to sell or take possession of the collateral property. This is the asset that the borrower pledges to the lender if the borrower defaults on a loan. It also helps to recover any remaining debts on loan.
There Are Two Types Of Defaults
There are two types of default: monetary and non-monetary:
Non-monetary defaults are when the borrower breaches the terms of a loan. These include violations of terms such as the debt service coverage ratio, which is the net operating income of the property divided with the debt service payments, or the loan-to-value ratio, which is the mortgage amount divided and the property's value. Non-monetary defaults are any violation of terms that are not related to the repayment of the loan. A good debt service ratio is usually around 1.25 or higher. This means that the borrower is producing 1.25 times the amount required to pay the mortgage. A ratio of approximately 80% is ideal for a loan to value. This means that the property's value is 20% higher than the loan amount. When a borrower cannot make their payments to their lender, it is called a monetary default.
Foreclosure Is The Last Resort
Although it is often discussed, property foreclosure does not happen overnight. Lenders will often work with borrowers to avoid foreclosure, which is usually a last resort. Lenders can be costly and take a long time to complete the foreclosure process. Most lenders will work with borrowers to help them modify or reperform their mortgage terms to be more favorable to them. From default to the sale, the foreclosure process can take between four and 18 months, depending on where the property is located and whether it's a judicial or unjudicial process.
There will likely be a flood of foreclosures after the forbearance period expires and the economic stimulus ends. However, investors may be able to purchase property at a significant discount if distressed transactions are associated with foreclosed properties and sold in public auctions.
The Foreclosure Process
These are the steps that will be used to foreclose the commercial property.
Notice Of Default:
This is when the borrower defaults. The definition of default can vary depending on the lender, but typically default is standardized by regulatory definitions and research studies. For example, lending payments 90 days late. The lender will send the borrower a "notice" of default in writing. It will state the amount due and the due date. The lender can foreclose if the payment is not received by the due date.
Workout:
Although it is not an official step in the foreclosure procedure, the lender and borrower often work out their differences without having to go through the formal foreclosure process. Below are some examples of common modifications:
The lender changes the loan structure to an interest-only loan. This reduces the monthly payment. An interest-only loan allows the borrower only to pay the interest on the loan. The principal amount is due at the loan's maturity. The borrower has the option to repay the loan or refinance the loan at maturity.
Lenders reduce the principal or interest rate of loans.
The lender extends the terms of the loan.
Lenders work with the borrower to get the loan to repay (i.e., Once again, make your payments to the lender.
A "deed in place of foreclosure" is where the borrower signs over the deed to the lender in order to pay the loan. This will save the lender the expense of going to court for many months and the hassles associated with an auction.
The lender will sell the non-performing commercial note to an investor or entity. Typically, the buyer plans to either take control of the property or work with the borrower in order to return the loan to its original status.
Foreclosure:
If the borrower cannot pay the lender and they are unable to agree on a payment plan that will keep the loan in force, the lender files a lawsuit to get a court order. This forces the seller to sell the property. The lender must adhere to the terms of the mortgage documents in a nonjudicial foreclosure. However, no court order is required. These terms are typically found in mortgage documents:
A power of sale clause gives the lender the right to foreclose the property without a court's approval.
The lender must send one or more notices to the borrower in default.
The lender can foreclose if the borrower fails to pay their mortgage or works with them.
The language indicates that the lender has the authority to sell the property to repay the loan balance.
Clarity: The property will be sold at an auction in the same way as a judicial foreclosure.
Management:
A lender can request that the court appoint a receiver to manage the property during judicial or nonjudicial foreclosure proceedings. This receiver will then sell the property. Although there are no set requirements regarding who can be the receiver, the court will usually require that the receiver has experience in the area of property management, brokerage, or development. The receiver is responsible for maintaining the property, collecting rents from tenants, and is expected to act in the best interests of both parties.
Foreclosure Sale:
A notice of sale is posted to inform the public that the property has been placed up for sale. This notice is typically published in a local newspaper or at the courthouse within the jurisdiction of the property.
Public Auction:
The property is sold at a public auction to satisfy the outstanding loan amount.
REO:
If no bids meet the amount on the commercial mortgage, the lender can submit a credit bid. This bid is based upon the remaining balance of the mortgage. The credit bid equals the principal unpaid plus the interest on the mortgage debt. This includes fees and expenses associated with the foreclosure. The lender will then make the property available for sale via private sale. The property is known as "REO" if it remains in the lender's possession after an auction. This means that the property is real estate owned.
Judicial And Nonjudicial Foreclosures
Although the foreclosure process can vary from one state to the next depending on local regulations and guidelines, it is generally consistent. It can be broken down into two main categories: judicial or nonjudicial.
As the name suggests, the Judicial Foreclosure procedure involves the court system. It is sometimes the only option in some states and requires that the lender obtain a court order to take possession of the property. This process can take up to six months.
Many states also have a "statutory redemption" period of six to twelve months in which the borrower can repay the loan and keep control of the asset. The state may also allow the lender to seek a deficiency judgment against the borrower. Lenders can seek a deficiency judgment if the property is sold for less than the amount due. This results in a lien against the borrower for that amount.
Nonjudicial Foreclosure is a way for the lender to take over the property without requiring a court order. Nonjudicial foreclosure is an alternative to the judicial process for lenders and can be completed in as little as four months. Nonjudicial foreclosure is allowed by state law if the terms of a commercial loan include a "power-of-sale" clause. This gives the lender the power to foreclose the property without the need for court action. While the nonjudicial process can include a redemption period and may offer a smaller window for the debtor, it is less likely. Nonjudicial foreclosure is also prohibited in many states due to the prohibition of a deficiency judgment.
Opportunities For Investors And Borrowers
Although the state laws that govern the foreclosure process for distressed commercial properties play the largest role, they are generally consistent in terms of the terminology and processes. Although it can be difficult for borrowers, the foreclosure process offers many options to preserve their assets, and lenders may be open to working out a solution. Investors may also be able to purchase distressed assets at an auction at a substantial discount. This is because the lender is most interested in recovering the outstanding balance.
