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Commercial Magazine

Is This Deal For Real?

Beware of the risks when purchasing distressed property

By Suzanne Hollander

With interest rates rising and inflation stubbornly high, there may be more distressed real estate opportunities on the market. Clients of commercial mortgage brokers may wonder if now is the time to make a great deal for real estate at a low price. But sometimes the question becomes, how do you know if a deal is for real?

Distressed property purchases may create business opportunities for nearly everyone involved in a deal, including the buyer, seller, real estate agent and mortgage broker. Buyers often purchase distressed properties with cash and refinance shortly thereafter.
To be able to advise a client on whether a distressed deal is the real thing, commercial mortgage brokers need to understand the risks and rewards of the following types of distressed-property transactions. Without the right knowledge, a client could have a good deal turn into a disaster.

Short sales

The first scenario is a short sale, which occurs when the property owner attempts to sell for less than the amount owed to the lender or mortgage note holder. Short sales often happen in economic environments where real estate values drop below the amount of the mortgage or the purchase price. Short sales were rampant during the 2008-2010 housing crisis.
There are benefits to buying property via short sale. Prospective buyers may inspect the property before purchase, and the property title normally transfers through a warranty deed, which includes a full set of legally enforceable seller promises. Also, it is usually the seller’s obligation to clear liens and provide clear title to the buyer.
There also are risks to this type of deal. The lender’s consent is required, although the sale is between the buyer and seller. But there is no legal requirement for the lender to provide consent, meaning that a buyer may submit an offer and never hear back from the seller. Also, the negotiation of a short sale can take anywhere from three months to more than a year.
Originators who have clients who do not have the capacity to pay their mortgages may consider telling the clients about selling via an arm’s length transaction (a deal between two enterprises in which the parties act independently and the price is fairly agreed upon without undue influence). For the seller, the deal may be more advantageous than a short-sale situation, since a short sale will hurt a client’s credit and the ability to purchase property in the future.

Foreclosure auctions

The third quarter of last year saw a major jump in real estate foreclosures. Attom Data Solutions reported that nearly 93,000 U.S. residential properties had foreclosure filings as of Q3 2022, which includes any type of default notice, scheduled auction or bank repossession. This figure was up 104% from Q3 2021, which was during the federal government’s foreclosure moratorium period.
The foreclosure process varies around the country, but typically, buyers purchase property directly from a county courthouse. This is the final step of a foreclosure process that may be judicial, quasi-judicial or nonjudicial. Depending on the state in which the property is located, the foreclosure auction may take place on the actual steps of the courthouse or via an online auction.
The main potential benefit of buying a foreclosure property is the chance to purchase the property for less than market value. A benefit to a commercial mortgage lender is that a buyer who purchased a property with cash may seek refinancing options.
There are risks to the foreclosure process as well. Generally, the winning bidder must pay in full with cash on the date of the purchase. They are often responsible for paying all outstanding property taxes and the fees related to any existing liens, as well as any environmental problems, upon taking title.

Additional foreclosure risks

Normally, there is no opportunity to inspect a property being sold through foreclosure, meaning that prospective buyers don’t know its physical condition. After the purchase, the buyer may find the property has significant damage or tenants who must be evicted. Buyers also are usually responsible for outstanding condominium or homeowners association fees, property taxes and liens on the property.
They may obtain a type of title, such as a certificate of title, that is difficult for title companies to insure. Unlike a warranty deed, a certificate of title does not include any seller promises. When obtaining a foreclosed property, a buyer may need to spend additional funds to initiate a quiet title action through the courts. A quiet title settles who has ownership and other legally
recognized interests of a property.
Many states now hold foreclosure auctions online, providing a case number and a limited time period to bid on each property. Online bidding places the burden on the buyer to conduct due diligence on the property, such as a title and lien search.
Often, prospective buyers will spend time and money to research a property only to find there is too much competition and the price is too high. In other situations, the owner may resolve any financial issues and the property never progresses to foreclosure. Some states have a right of redemption period, which allows an owner who has been foreclosed upon to redeem the property even after it’s been sold at auction.
Again, for originators working with real estate owners who are having trouble making their monthly payments, it might be wise to encourage them to sell distressed property while values are relatively high, instead of going through the foreclosure process, which will hurt their credit and ability to purchase property in the future.

Bank-owned properties

Bank-owned properties, also known as real estate-owned (REO) properties, are those that have been returned to a lender. In these scenarios, the lender took possession of the property because it wasn’t sold at the foreclosure auction and is now listing it for sale. Lenders normally want to get REOs off their books quickly and look for a fast cash sale because they are in the business of lending money, not owning and managing property.
Typically, there is less risk when buying a bank-owned property. These assets are often sold at below-market prices, meaning that any associated mortgage can include a lower downpayment or a lower interest rate. Also, the lender (current seller) will commonly cover outstanding taxes and liens while making it easier for the buyer to obtain title insurance.
The buyer can usually inspect the property. The seller, however, often stipulates that the title only passes via special warranty deed, where the seller limits its promises about the condition of the title to the period of time that it owned the property. This is normally a short period of time for a lender that took back the property and is trying to sell it rapidly.
Be aware that an REO transaction may require an all-cash purchase along with the use of a lender’s form contracts, which may limit due-diligence periods or require selling the property “as is,” despite any damage. The competition also can be fierce for such properties.

Promissory notes

Another option is to purchase a promissory note. When a buyer purchases a note, they “step into the shoes” of the lender that holds the note but do not purchase the property itself.
The note purchaser hopes to buy the note at such a discount that they may negotiate with the property owner (borrower) to lower their payments and still make a return on the investment. Alternatively, if the owner cannot repay the loan, the note holder may be able to convince the property owner to deliver a deed in lieu of foreclosure.
A promissory note is only as valuable as the borrower’s ability to repay. The borrower may continue to default and force the note holder to go through the foreclosure process, which is often a lengthy and expensive judicial process. Also, the note buyer only holds the lien right (not the right to possess the property) and they don’t have the right to inspect the property. In this situation, the note purchaser needs to learn about the borrower’s capacity to repay and to be able to negotiate a discount on the purchase of the note.

Tax certificates

Often, real estate owners in distress will not pay their property taxes. To collect these funds, many states sell tax certificates. The process varies by state, but in general, an investor will pay off the delinquent property taxes in return for a tax certificate.
In these situations, the investor is guaranteed a certain rate of return if the owner or lender repays the taxes. Purchasing a tax certificate and paying off the delinquent taxes, however, is not a purchase of the real property. In Florida, for example, the maximum interest rate is 18%, while other states offer lower rates.
In many states, an investor who owns a tax certificate may petition a municipality to sell the property via tax deed for the value of the outstanding taxes plus interest. For this reason, lenders often pay off the taxes because they do not want to lose the property. Purchasers of property through tax deeds buy the property itself, not the tax certificate, and face certain risks such as the inability to inspect the property and title irregularities.

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In today’s difficult economy, there is renewed investor interest in making a great deal by purchasing distressed property (or interest in property). By knowing the differences, risks and rewards of distressed-property purchases, brokers can help their clients make the best decisions regarding buying, selling or financing these types of real estate assets. ●

Author

  • Suzanne Hollander

    Suzanne Hollander is an attorney and professor teaching real estate law, property rights and commercial leasing at Florida International University, and previously taught at New York University. She is the broker of Hollander Realty LLC, representing Florida buyers and sellers. Hollander offers real estate education, speaking and consulting services to lenders, owners, buyers and government entities through her company, Professor Real Estate LLC. She authors the blog at professorrealestate.com. Reach Hollander at suzanne@professorrealestate.com or (786) 202-0587

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