Assuming risk when foreclosing on a note

12 Replies

Hi all - I am new to Bigger Pockets, and I am exploring several investment options.  One option is to buy first position, performing notes.  I want the monthly cash flow more than I want to get the property.

However, I am unclear on what happens if I have to foreclose.  I understand that it would involve a legal foreclosure, and I would end up with the property.  But would I also inherit other liens against the property?  If the owner took out a second position note, would I be responsible to pay for that? Would I be responsible for unpaid taxes and/ or tax liens that came after I got the original note?  

@Ann Howell , welcome to BP. Take some time to fill out your profile and add a photo. It is much easier to share information relevant to you when people know something about you. I am not an attorney and Texas has real estate laws that are unique to Texas so it would be wise to get a local legal opinion. Generally, tax liens are senior to private liens and must be paid if you were to foreclose. Junior liens (a lien in second or lower position if yours is in first position) will usually be wiped out in a foreclosure. I am reluctant to say this will always happen because it is possible to have a rare exception.

thanks for the info. I'll work on my profile!

Originally posted by @Ann Howell :

Hi all - I am new to Bigger Pockets, and I am exploring several investment options.  One option is to buy first position, performing notes.  I want the monthly cash flow more than I want to get the property.

However, I am unclear on what happens if I have to foreclose.  I understand that it would involve a legal foreclosure, and I would end up with the property.  But would I also inherit other liens against the property?  If the owner took out a second position note, would I be responsible to pay for that? Would I be responsible for unpaid taxes and/ or tax liens that came after I got the original note?  

 From your questions you sound new to notes.  Welcome but be careful there is a lot to learn before buying to make e sure you get a good deal.  

If you FC you don't necessarily get the property, it is possible that the somebody will pay more then you are owed on the note and you just get your money back. When a 1st position lien does a FC it wipes out most other liens s a second lien would get cleared out. Tax and city liens will stay. HOA liens depend on what state.

Even if there is enough equity in the property to cover tax liens and the 1st lien and the 2nd, the 2nd will still get wiped? 

@Arthur Mayer  Yes, in general, all junior liens get extinguished in a foreclosure action. Those liens are no longer attached to the property and the lienholders lose their ability to foreclose on the property.

If there is enough equity to cover the 1st and 2nd positions, they will both get paid. With so many people underwater on their houses, typically, the 1st isn't made whole in a FC so the 2nd gets nothing.

When a 1st (or a 2nd or 3rd, etc) forecloses, all junior liens get wiped out. The trustee will pay out all of the proceeds to the foreclosing lienholder up to the maximum amount they are legally entitled to (typically UPB, arrears, fees). Anything leftover is applied to the next junior lienholder up to the maximum amount they are entitled to. So on down the line until there are no lienholders left. If there's still something left over, it goes to the previous owner. 

If a 2nd forecloses, the senior lien stays in place and the senior lienholder gets nothing from the proceeds of the trustee sale. His position is still protected since any winning bidder takes title subject to the senior lien and the senior lienholder retains his right to FC in case the new owner fails to fulfill the obligations of the senior lien.

(To the smarter guys out there, please correct me if I'm wrong.)

A performing loan always carry a risk of default.  An investor can offset that default risk with equity. Either through the loan it self, like limiting the loan to value to a level which will accommodate recovery of the advances required to enforce the security instrument, or through limiting the capital invested in the loan through discounting.  Fundamentally they are the same but have different mechanics.  

Borrower gives an interest in the property as collateral.  The interest given is limited and defined through the security instrument.  That interest does not include possession.  As Bob mentioned you are not entitled to own the property.  You are entitled to use the property to recover what is owed under the note.  As such, a Mortgagee does not "inherit" anything.  A Mortgagee defends their interest in the property from liens which 'may' have priority.  An example would be property taxes.  A property tax lien has super status meaning it always has the highest priority regardless of time of recording.  The security instrument will define what types of defenses a Mortgagee can take and to what extent the Borrower will owe or Mortgagee be entitle to recover.  Preserving the property condition (with restrictions/limitations) is another example of that idea.  

The key to those ideas is they are not necessarily things that require immediate and direct action.  For instance, property taxes may go delinquent in a default event.  That does not mean that the Mortgagee must advance payment for those taxes immediately.   A Mortgagee would advance that tax payment 'IF' the tax lien stands to encumber their lien priority.  If taxes are simply delinquent the property can still be foreclosed and provided the delinquent taxes do not give way to a tax lien foreclosure then the taxes will be recovered through any foreclosure auction sale.  If the property reverts back to the Mortgage due to a lack of a proper buyer at auction then the taxes may need to be paid post [failed] sale.  In other words the tax payment can be advanced, especially when it stands to jeopardize the priority of the Mortgagee.  It does not always have to be advanced because the taxes due are not an immediate danger to lien priority in every instance.  Rest assured, property taxes always get paid somehow or the other.

Similar ideas go with almost all the other allowable (customary) advances under the security instrument.  For instance, property insurance may elapse due to Borrower lack of payment.  As a Mortgagee you have a right to insure the property if the Borrower fails to do so.  That does not mean you are mandated to make an advance for property insurance.  Obviously if some damage happens to the property while it is not insured then there would be no insurance money to file a claim to repair the property.  So if it burns down it will likely be pretty tough to recover the amounts due under the note since the property value will have diminished due to the fire.  

It is probably worth a mention that a performing loan will go through a delinquent stage before being in default.  Delinquent loans along with defaulted loans do have some mandated actions as a foreclosure alternative.  State requirements vary a bit.  Mixed in there are ideas such as Deed in Lieu or Short Sale/Short Pay as methods to resolve the default or delinquency and avoid foreclosure.  The point is to make sure we understand that a missed payment does not immediately mean foreclosure and the path to foreclosure may involve additional steps to see if it can be avoided.

Understand that foreclosure is actually the termination of junior interest's (to those of the Mortgagee foreclosing) right or equity of redemption.  So through the process a junior interest can redeem a senior interest, by paying the total due or they forfeit their right and their interest is removed from the Subject Property.  Those interests can be lien holders or title holders.  A lien can not foreclose interests senior in priority.  A foreclosure extinguishes 'all' junior priority interests regardless of payment distribution from an auction sale. Proceeds distributed to lien holders also means collect-ability of that debt can no longer take place and the lien is extinguished and the debt owed is satisfied.  So "Yes" Arthur, the second's lien is extinguished and the debt (since they received proceeds) is satisfied.  Two different ideas there.  Sometimes a lien can be extinguished but the debt can survive.  In that event the property can no longer be used to recover what is owed.  (Lien extinguished & Debt 'not' satisfied)   Other collections methods would have to be deployed to collect then.  A tale for a different thread.

From the thread title, the OP seems to believe that "assuming risks" happens "when foreclosing on a note". The reality is that the risks are all taken on as soon as one becomes a note holder, because any note can go into default and eventual foreclosure. 

Well, all close enough, you can read your state statutes as to foreclosure.

It also depends on the type of note, was the loan funded by cash or equity based on an agreed sale price, if it was an equity funded note the sale is terminated and the property goes back to the seller. If that note is sold, it gets more complicated as to the note holder's basis in cash and equity.

Things are further complicated by bankruptcy, if your borrower leased the property or sold the property subject to your loan.

State laws may also govern insured losses, a total loss may pay you off or, the borrower may have the right to insurance proceeds to rebuild, payments may be deferred after an insured loss.

I always suggest that if someone has the funds to buy a note, they should have enough to spend for an hour of an attorney's time. All real estate is local, an attorney who does foreclosures can tell you what the process is, how long they usually take and the costs associated.

If you purchase a note, you can always change the Trustee of a deed of trust to your attorney. You may also inquire as to these matters with the named Trustee of a mortgage you might be looking at.

And, I didn't see mention of the requirement or a borrower's option of taking a judicial foreclosure route, which can add time and expense over a non-judicial sale agreed to under the security agreement.

The more you learn before you leap the better you can manage your risks of loss. You should also have a mortgage servicer to collect payments for you, screw that up in notices and collection practices and you can lose your investment! Let the pros do it, they are insured. 

I'd also suggest you begin your note buying ventures in your own backyard. Good luck :)  

Thanks to all.  This has been really helpful.  I would definately use an attorney before venturing into the notes world.  However, I will only invest in opportunities that I understand, so I am trying to educate myself enough to know what questions to ask an attorney.  It is challenging to find credible information, books or educational materials about buying notes.  Any recommendations?

I'm working on it Ann. Until then, just ask Dion or I. :)

Originally posted by @Ann Howell :

Thanks to all.  This has been really helpful.  I would definately use an attorney before venturing into the notes world.  However, I will only invest in opportunities that I understand, so I am trying to educate myself enough to know what questions to ask an attorney.  It is challenging to find credible information, books or educational materials about buying notes.  Any recommendations?

 Yes, I've just reviewed both the 1st and 2nd position NPL courses from Keyhole Academy and they are quite thorough & well written. Contact me privately if you would like additional info or the syllabus for each. Their link is http://www.keyholeacademy.com/

Bob

I had not come across the Keyhole Academy.  I will check it out!  I watched some of the video at realestateandnoteinvesting.com, but it focuses on collecting from non-performing second position liens.  That site and the comments here have been very helpful in clarifying my question.  Every piece of information I get is making the puzzle more understandable.

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