Originally posted on AAPLonline.com.
When used properly, a DIL can be a great option for lenders seeking to avert foreclosure.
Given the current economic uncertainty, unprecedented unemployment and number of loans in default, lenders should properly review, evaluate and take appropriate action with borrowers who are in default or have talked with them about payment concerns.
One alternative to foreclosure is a deed-in-lieu of foreclosure or, as it is colloquially known, a deed-in-lieu (DIL).
At the outset of most discussions concerning DILs, two questions are typically asked:
01 What does a DIL do?
02 Should we use it?
The first question is answered much more directly than the second. A DIL is, in its most basic terms, an instrument that transfers title to the lender from the borrower/property owner, the acceptance of which typically satisfies any obligation the borrower has to the lender. The two-word answer as to whether it should be used sounds deceptively simple: It depends. There is no one right answer. Each situation must be thoroughly analyzed.
Items that a lender should consider when determining which course of action to take include, among other things, the property location, the type of foreclosure process, the type of loan (recourse or nonrecourse), existing liens on the property, operational costs, status of construction, availability of title insurance, loan to value equity and the borrower’s financial position.
One of the misconceptions about accepting a DIL is thinking it means the lender cannot foreclose. In most states, that is inaccurate. In some states, statutory and case law have held that the acceptance of a DIL will not create what is called a merger of title (discussed below). Otherwise, if the DIL has been properly drafted, the lender will be able to foreclose.
General Advantages to Lenders
In most cases, a lender’s curiosity will be piqued by the offer of a DIL from a borrower. The DIL may very well be the least expensive and most expeditious way to deal with a delinquent borrower, especially in judicial foreclosure states where that process can take several years to complete. However, in other states, the DIL negotiation and closing process can take significantly longer to complete than a nonjudicial foreclosure.
Additionally, having a borrower to work with proactively can give the lender much more information about the property’s condition than going through the foreclosure process. During a foreclosure and absent a court order, the borrower does not have to let the lender have access to the property for an inspection, so the interior of the property may very well be a mystery to the lender. With the borrower’s cooperation, the lender can condition any consideration or acceptance of the DIL so that an inspection or appraisal can be completed to determine property value and viability. This also can result in a cleaner turnover of the property because the borrower will have less incentive to damage the property before vacating and handing over the keys as part of the negotiated agreement.
The lender can also get quicker access to make repairs or keep the property from wasting. Similarly, the lender can easily obtain from the borrower information on operating the building rather than acting blindly, saving the lender considerable time and money. Rent and maintenance records should be readily available for the lender to review so that rents can be collected and any necessary action to get the property ready for market can be taken.
The agreement for the DIL should also include provisions that the borrower will not pursue litigation against the lender and possibly a general release (or waiver) of all claims. A carve-out should be made to allow the lender to (continue to) foreclose on the property to wipe out junior liens, if necessary, to preserve the lender’s priority in the property.
General Disadvantages to Lenders
In a DIL situation (unlike a properly completed foreclosure), the lender assumes, without personal obligation, any junior liens on the property. This means that while the lender does not have to pay the liens personally, those liens continue on the property and would have to be paid off in the case of a sale or refinance of the property. In some cases, the junior lienholders could take enforcement action and possibly endanger the lender’s title to the property if the DIL is not drafted properly. Therefore, a title search (or preliminary title report) is an absolute necessity so that the lender can determine the liens that currently exist on the property.
The DIL must be drafted properly to ensure it meets the statutory scheme required to protect both the lender and the borrower. In some states, and absent any agreement to the contrary, the DIL may satisfy the borrower’s obligations in full, negating any ability to collect additional monies from the borrower.
Improper drafting of the DIL can put the lender on the wrong end of a legal doctrine called merger of title (MOT). MOT can occur when the lender has two different interests in the property that differ with each other.
For instance, MOT might occur when the lender also becomes the owner of the property. Once MOT happens, the lesser interest in the property gets swallowed up by the greater interest in the property. In real world terms, you cannot owe yourself money. Once the owner of the property and the lienholder (mortgagee/beneficiary) become the same, the lien disappears since the ownership interest is the greater interest. As such, if MOT were to transpire, the ability to foreclose on that property to wipe out junior liens would be gone, and the lender would have to arrange to have those liens satisfied.
As stated, getting the property appraised and determining the LTV equity in the property along with the financial situation of the borrower is paramount. Following a DIL closing, it is not unusual for the borrower to sometimes file for bankruptcy protection. Under the bankruptcy code, the bankruptcy court can order the undoing of the DIL as a preferential transfer if the bankruptcy is filed within 90 days after the DIL closing happened. One of the court’s main functions is to ensure that all creditors get treated fairly. So, if there is little to no equity in the property after the lender’s lien, there is a practically nil chance the court will order the DIL transaction undone since there will not be any real benefit to the borrower’s other secured and unsecured creditors.
However, if there is a significant amount of money left on the table, the court may very well undo the DIL and place the property under the protection of bankruptcy. This will delay any relief to the lender and subject the property to action by the bankruptcy trustee, U.S. Trustee, or a Debtor-in-Possession. The lender will now incur additional attorneys’ fees to monitor and possibly contest the court proceedings or to evaluate whether a lift stay motion is worthwhile for the lender.
Also to consider from a lender’s perspective: the liability that may be imposed on a lender if a property (especially a condominium or PUD) is under construction. A lender taking title under a DIL may be deemed a successor sponsor of the property, which can cause innumerable headaches. Additionally, there could be liability imposed on the lender for any environmental issues that have already occurred on the property.
The last possible disadvantage to the DIL transaction is the imposition of transfer taxes on recording the DIL. In most states, if the property reverts to the lender after the foreclosure is complete, there is no transfer tax due unless the sale price exceeded the amount owed to the lender. In Nevada, for instance, there is a transfer tax due on the amount bid at the sale. It is required to be paid even if the property reverts for less than what is owed. On a DIL transaction, it is looked at the same as any other transfer of title. If consideration is paid, even if no money actually changes hands, the locality’s transfer tax will be imposed.
When used properly, a DIL is a great tool (along with forbearance agreements, modifications and foreclosure) for a lender, provided it is used with great care to ensure the lender is able to see what they are getting. Remember, it costs a lot less for advice to set up a transaction than it does for litigation.
Pent-up distressed inventory eventually will hit the market once foreclosure moratoriums are lifted and mortgage forbearance programs are ended. In light of this, many investors are proceeding with caution on acquisition opportunities now, even as they prepare for an even bigger buying opportunity that has not yet materialized.
“It’s an artificial high right now. In the background, the next wave is coming,” said Lee Kearney, CEO of Spin Companies, a group of real estate investing businesses that has completed more than 6,000 real estate transactions since 2008. “I’m definitely in wait-and-see mode.
Kearney said that real estate is not the stock market.
“Real estate moves in quarters,” he said. “We may actually have another quarter where prices rise in certain markets … but at some point, it’s going to slip the other way.”
Kearney continues to acquire properties for his investing business, but with more conservative exit pricing, maximum rehab cost estimates and higher profit targets in order to convert to more conservative purchase prices.
“Those three variables give me an increased margin of error,” he said, noting that if he does start buying at higher volume, it will be outside the large institutional investor’s buy box.
“The biggest opportunity is going to be where the institutions won’t buy,” he said.
The spokesman for the New York-based institutional investor explained how the buying opportunity now is connected to the bigger future buying opportunity that will come when pent-up foreclosure inventory is released.
“I do think the banks are anticipating more foreclosures, and so they are going to make room on their balance sheets … they are going to be motivated to sell,” he said.
Although the average price per square foot for REO auction sales increased to a year-to-date high the week of May 3, those bank-owned properties are still selling at a significant discount to retail.
Year-to-date in 2020, REO auction properties sold on the Auction.com platform have an average price per square foot of $77, while nondistressed properties (those not in foreclosure or bank-owned) have sold at an average price per square foot of $219, according to public record data from ATTOM Data Solutions. That means REO auction properties are selling 65% below the retail market on a price-per-square-foot basis.
Similarly, the average sales price for REO auctions sold the week of May 3 was $144,208 compared to an average sales price of $379,012 for properties sold on the MLS that same week. That translates to a 62% discount for REO auctions versus retail sales.
Those types of discounts should help protect against any future market softening caused by an influx of foreclosures. Still, the spokesman for the New York-based institutional investor advised a cautious acquisition strategy in the short term.
“The foreclosures will catch up to us, and it will hurt the entire market everywhere—and you don’t want to be caught holding the bag when that does happen,” he said.
Others view any influx of deferred foreclosure inventory as providing welcome relief for a supply-constrained market.
“It will help with the tight supply in these markets … because the providers we work with are going to see more distressed inventory they can pick up at a discount, whether at auction or wherever, and turn into a turnkey product,” said Marco Santarelli, founder of Norada Real Estate Investments, a provider of turnkey investment properties to passive individual investors. “We’re still in a seller’s market. … The sustained demand for property, whether homes or rentals, has not waned a lot. It has paused a bit, but people are coming back.”
Written by Randy Newman
Originally posted on AAPLonline.com.