This article discusses the risks of financial loss by a seller on a carryback sale, and the safeguards needed to cover those risks.
Protection is led by disclosures
An absentee owner is unable to effectively manage a small income-producing property he owns. Confronted with below market rents, unreliable tenants and deferred maintenance, he decides to sell the property. The condition of the property and its income will continue to deteriorate until it is sold to a local buyer who can provide hands-on management.
The owner contacts an agent for the purpose of marketing the property and locating a suitable buyer. The property has an existing fixed-rate, long-term loan which can be assumed by a qualified buyer. The owner and listing agent believe their asking price for the property is not set too high.
To pursue his asking price and pass on the cost of disrepair and the delinquent rent situation to the buyer, the seller lists the property with the agent’s broker to market the property for sale and locate a buyer. The listing terms include a low down payment and a carryback note and trust deed. The seller and his listing agent agree an acceptable offer must include a further-approval contingency calling for the owner to confirm the buyer is financially and personally qualified to purchase the property, and is prepared to cure the deferred maintenance and upgrade the tenancies on the property.
However, the listing agent quickly determines the owner is not familiar with real estate financing techniques and does not fully understand the risk-of-loss involved in carrying back a second trust deed note. The risks, if known and understood, might cause a (prudent) seller to take steps to cover the risks and protect his continuing investment represented by the carryback note. The listing agent knows he is duty bound to inform the owner of the risks of carrying back a second trust deed note, so appropriate decisions can be made regarding the terms for payment of the sale price and management of the carryback note and trust deed.
Agency duties and carryback risks
Sellers often do not know what risks of loss exist when carrying back paper, much less understand or even ask about them. Brokers and their agents who represent carryback sellers under a listing must be knowledgeable enough to provide essential risk-management information for the care and protection of their clients.
Listing agents who do not know or understand the risks of carrying back paper on a sale often brush them aside as minimal. However, sellers need to be advised that they must consider more risk reductions and remedies than just “taking back the property” if their buyer defaults. If a seller does not inquire about the risks, his listing agent has an affirmative duty to voluntarily advise the seller of the risks known to the broker and the agent, and recommend any due diligence investigation or analysis the agent believes they or the seller should undertake in a carryback sale.
Risks posed to a creditor involved in holding carryback paper differ dramatically from the risks of owning real estate. When the seller carries back paper on the sale of property, his ownership interest is exchanged for a creditor’s (lender’s) secured position in the property, called a security interest.
Covering the risks of junior financing
The risks of carrying paper are similar to the risks taken by an equity lender holding a comparable junior lien on the title to a property. The risks of a junior lender, and thus a carryback seller, are covered or compensated by employing several techniques and variables, including:
1. The amount of the down payment which sets the size of both the equity the buyer feels compelled to protect and the amount of cash sales proceeds the seller will net to cover the risk of future advances he may have to make should the buyer default;
2. Further collateral in addition to the seller’s equity in the property sold, be it personal property or other real estate, a situation sometimes called cross collateralization which converts the carryback note to recourse paper and avoids anti-deficiency laws;
3. A personal guarantee from someone other than the buyer, which may be secured by real estate owned by the guarantor, to assure the seller the carryback note will be paid off by the guarantor on the buyer’s default on the note (in essence, the guarantor agrees to buy the note on a default and the seller agrees to assign it to the guarantor who will then deal with the default foreclosure proceedings);
4. A premium interest rate on the note to cover the risks created by a small down payment which is inadequate to provide the seller with sufficient cash sales proceeds to pay all the carrying costs and trustee charges on a foreclosure and resale of the property should the buyer default (the interest rate for this minimal down payment situation would be comparable to sub-prime mortgage rates and junk bonds which are generally 3% to 6% above prime mortgage rates);
5. Monthly payments based on a short amortization schedule to quickly reduce the principal balance remaining on the note and increase the seller’s cash reserves before a default (which usually does not occur for three to five years);
6. Private mortgage insurance (PMI), available from insurance companies if the buyer qualifies, to cover any loss of principal and interest due to a default by the buyer;
7. Assignment of rents as additional security (in the form of cash) if the property sold is income property which generates rents. Rents can be readily collected by the use of pre-printed notices sent to both the buyer and the tenants which informs them to pay the carryback seller or be personally liable to the carryback seller for nonpayment;
8. A credit application and a net worth statement (balance sheet) from the buyer which the seller uses to order out a credit report to confirm the buyer’s propensity to timely pay his debts and by a review of the buyer’s networth to confirm he has assets with sufficient equity to bolster the buyer’s ability to pay the carryback note (and possibly provide additional security for the carryback note); and
9. Inspect and investigate the care and management of real estate already owned by the buyer to determine if he maintains and operates property without deferring maintenance.
The foreseeability of a default
Lender rights and obligations are especially prevalent when a buyer defaults, a foreseeable occurrence against which the trust deed lien is the first line of defense.
When the buyer defaults on a trust deed, the carryback seller may proceed with a foreclosure and recover the value of the property if the delinquent amounts are not paid in full. Defaults on a trust deed include the buyer’s failure to:
· pay installments on the carryback note;
· pay property taxes, assessments and hazard insurance premiums;
· pay senior lenders; or
· maintain the property.
During the foreclosure period, the carryback seller may need to use cash reserves to keep the senior trust deed note current and avoid the initiation of foreclosure proceedings by a senior lender. Commencement of foreclosure by the senior lender will add to the carryback seller’s costs of recovering the property.
If the downpayment amount is a small percentage of the price, which results in a high loan-to-value (LTV) ratio for the carryback seller, the seller who begins foreclosure and makes a full credit bid stands a good chance of taking the property back at the trustee’s sale.
Most importantly, the seller’s source of recovery on a carryback note which is secured only by the property sold is limited to the value of his security interest held under the second trust deed lien. The dollar value of a junior trust deed holder’s secured position on the property’s title is the property’s fair market value, minus:
· the balance remaining due on the senior loan;
· the dollar amount of foreclosure;
· resale costs; and
· carrying costs (taxes, insurance, operating expenses) until the property is resold.
Any rents collected from tenants by the seller due to the seller’s enforcement of his assignment of rents lien (in the trust deed) will be applied to offset the costs of “carrying” the property and deducted from the amounts due the seller to set the amount of an underbid at a trustee’s sale. Also, interest on the carryback will be unpaid and uncollected unless paid on a bid by a cash buyer at the trustee’s sale, or recovered in the resale price should the seller recover the property at the trustee’s sale and resell it.
For the seller to limit his risks of lost equity and interest on non-income producing property, the cash proceeds from the buyer’s down payment on the initial sale of the property must equal or exceed the total of eight to twelve months of senior trust deed payments, other carrying costs incurred during this period, and foreclosure and resale costs. If the buyer’s down payment is large enough, the value of the seller’s security interest in the property should be sufficient to recoup the principal balance and interest on the carryback note, the property’s carrying costs and the costs to foreclose and resell the property.
The listing agent representing the broker must prepare and review a Foreclosure Cost Sheet with the carryback seller to impress upon him the need for an adequate down payment (or additional security or a guarantee). The information in the disclosure will aid everyone in an analysis of the risks a second trust deed holder is exposed to and the steps to be taken to cover those risks.
The Foreclosure Cost Sheet is useful as a visual aid to make disclosures. The worksheet documents the potential expenditures, and the cash reserves required to cover the risk of default and protect the carryback paper from loss.
Foreclosure cost calculations are made by the agent and reviewed with the seller on each of two occasions:
· once when accepting the listing; and
· a second time when presenting an offer.
Lastly, a major hidden cost of foreclosure is the time and energy spent by the carryback seller to keep track of any foreclosure and resale process he may have to undertake. The recovery of this opportunity cost is built into the increased sales price for the property, the increased interest yield and the increased monthly payment amount on the carryback note.
The foreclosure risk of having to sell the property again is often shared by the brokers and agents through various deferred fee arrangements to reduce any moral hazards present in the agent’s optimistic encouragement of a carryback sale.
When the amount of an underlying senior loan is more than 75% of the property’s current market value and a buyer defaults on the seller’s carryback note, the seller should first negotiate with the buyer for a deed-in-lieu of foreclosure and possession to the property before initiating foreclosure. Negotiations for a deed-in-lien of foreclosure should be considered at the time of the default, but must be considered before commencing foreclosure.
A deed-in-lieu is a grant deed containing special language to assure title insurers the debt has been canceled, and no lease-option or other lender/debtor relationships has been created to cause the deed-in-lieu to be recharacterized as a mortgage-in-fact.
A deed-in-lieu, as a preforeclosure workout, eliminates many of the risks of foreclosing. The deed-in-lieu saves the carryback seller the high cost of foreclosure, while possibly providing the buyer with some “walking money”, consideration for immediately conveying title and transferring possession to the seller under the deed-in-lieu.
Also, the deed-in-lieu must be insured by a title company before the seller accepts it. Without title insurance on the deed- in-lieu to confirm the condition of the title, liens may have attached to the property or a change in vesting may have occurred which renders the deed unacceptable.
If a deed-in-lieu remedy or other pre-foreclosure workout (short payoff sale or modification of the note) is not available to resolve a default, a trustee’s foreclosure sale is the next most expedient procedure for recovery on a defaulted note.
However, the carrying costs and trustee’s charges incurred during a trustee’s foreclosure may reduce some or all of the financial benefits of a carryback note if the down payment is inadequate (less than 15% to 20% of the price), the value of the property has not risen or the seller procrastinates in commencing foreclosure.
For example, suppose a buyer pays $100,000 down and assumes $800,000 in existing loans on a $1,000,000 sales price. The seller carries back the $100,000 balance remaining to be paid on the purchase price in a note and trust deed secured by the property sold.
The brokerage fees and other costs, credits and adjustments associated with the sale amount to $50,000. Thus, the seller’s net proceeds on the sale are $50,000 cash and the $100,000 in paper. [See first tuesday Form 310]
However, foreclosure and resale costs can run from 15% to 20% of the property’s resale value, in this case, $150,000 or more. More than half of this amount would be met from the seller’s cash reserves to pay foreclosure and other carrying costs until the property is resold. Foreclosure on income producing property can be less demanding on a seller’s cash reserves since the carrying costs may be offset by rent received under the trust deed’s assignment of rents provision.
The carryback seller is also subject to the risk the buyer may file a bankruptcy petition to preserve any equity he may have in the property. The carryback seller’s foreclosure sale is automatically halted by filing the petition, called a stay, and remains in effect until the bankruptcy court releases the stay.
Any delay in the foreclosure process results in further expenditures to pay the property’s carrying costs — at the hands of an insolvent and distraught buyer. Further, a buyer who realizes he will lose the property often fails to continue to properly maintain the property, called impairment of the security or waste.
If only deferred maintenance occurs, the carryback lender will incur the expense for fixing up the property to resell it (or to keep it and rent it).
These conditions are common risks any mortgage lender is exposed to. As with all mortgage risks, the risks are manageable and capable of being covered by a mix of a sufficient down payment, a premium interest rate, assignment of rents on income property, a short amortization period, additional security and guarantees. A real estate market of rising values is always a cure for a failure to adequately cover the risks of loss.
Eviction by the involuntary landlord
A buyer wiped out by a foreclosure sale must vacate and deliver possession of the property to the carryback seller who acquires it at a foreclosure sale. If the buyer does not vacate, the seller must serve the buyer with a written Three-Day Notice to Quit Due to Foreclosure. [Calif. Code of Civil Procedure §1161a(b); see first tuesday Form 578]
However, a wiped-out buyer might refuse to vacate the property on expiration of the three-day notice. If this occurs, the carryback seller will need to proceed with an unlawful detainer (UD) action, as would any landlord dealing with any tenant who unlawfully detains the property.
At the unlawful detainer hearing, the carryback seller must show the property was acquired at a trustee’s sale and all statutory notice requirements for the sale and the UD action have been satisfied to evict the buyer.
After foreclosure and recovery of possession, the carryback seller who reacquires the property is back to square one — he owns the property again, minus his out-of-pocket expenses to foreclose.
Other security devices
Land sales contracts, reverse trust deeds, unexecuted purchase agreements with occupancy (lease-purchase sale) and lease-option sales, are sales which typically present the additional risk and cost of a judicial foreclosure should the buyer default and challenge an eviction action. The completion of a foreclosure of the lien created by any security device is a requisite to recovering possession, since the buyer’s right of redemption (to pay off the debt) must be eliminated to clear title of the buyer’s ownership interests. These alternative security devices do not usually contain a power-of-sale clause to authorize the more efficient, less expensive trustee’s foreclosure sale.
The exposure to the repossession risk of a judicial foreclosure outweighs any purported benefit these alternative security devices might offer in a small- downpayment carryback sale.
Judicial foreclosure, regardless of the security device used, is a lengthy, emotionally troublesome and costly procedure. A trust deed foreclosure by a trustee’s sale is the maximum risk for recovering title any seller should accept when extending credit to help finance the sale of real estate.
Analyzing the Foreclosure Cost Sheet
The Foreclosure Cost Sheet, first tuesday Form 303, is used by a broker or his agent to inform a carryback seller or lender about the estimated cost to foreclose on the secured property and resell the property in the event the buyer or borrower defaults on the trust deed. As a disclosure, the seller or lender is informed of the out-of-pocket expenditures needed to foreclosure and resell the property, and of the net proceeds resulting from a foreclosure and resale, all foreseeable events
Preparing the carryback foreclosure cost sheet
The following instructions are for the preparation and use of Form 303, the Foreclosure Cost Sheet. Form 303 is designed for a broker or his agent as a disclosure of the cost of a foreclosure of the trust deed and resale of the secured property, for the purpose of anticipating the cash reserve requirements of a foreclosure and resale, as well as the projected net proceeds recoverable by the combined events.
The numbers on the worksheet correspond to the numbers given provisions in the form.
Editor’s note — Check and enter items throughout the worksheet in the boxes and blanks for each provision, unless the provision is not intended to be included as part of the worksheet, in which case it is left unchecked or blank.
1. Referenced document: Check the appropriate box to indicate the document for which the form is prepared as a disclosure.
1.1 Date of document: Enter the date and location which identifies the referenced document.
1.2 Parties to the document: Enter the names of the principal parties to the referenced document.
1.3 Real estate involved: Enter the common address or other identification of the real estate which is the subject of the referenced document.
2. Resale value: Enter the property’s present value. If the seller has to foreclose within the first few years, the foreclosure will likely be due to a lack of sufficient value in the property he sold. Thus, the present value might be an overstatement.
3. Senior loans:
3.1 Underlying first trust deed: Enter the dollar amount of the principal balance remaining on any existing first trust deed loan.
3.2 Underlying second trust deed: Enter the dollar amount of the principal balance remaining on any existing second trust deed loans.
4. Future cash advances: Provides for the future advances the carryback seller or junior trust deed lender will make until the foreclosure is completed and the property is resold to keep current those obligations which have priority to the junior trust deed lien, or would otherwise impair the junior trust deed holder’s interest in the property if not paid.
Editor’s note — The agent estimates delinquencies and carrying costs for several months of payments up to the trustee’s sale and thereafter for several months until a resale escrow can be closed, a total of 8 to 12 months without considering the receipt of rental income if the property is occupied by the buyer.
4.1 Property taxes: Enter the dollar amount of property taxes to be paid (two installments).
4.2 Insurance premiums: Enter the dollar amount of the hazard insurance premiums (one year policy).
4.3 Improvement bond assessments: Enter the dollar amount of delinquent and future payments of any improvement/bond assessments (Mello-Roos).
4.4 Home owner’s association (HOA) assessments: Enter the dollar amount to be paid for any ownership association charges which are senior to the carryback or will be enforceable against the junior trust deed holder after he completes the foreclosure and becomes the owner of the property.
4.5 Loan installment: Enter the total dollar amount and number of monthly installments on the underlying senior encumbrance(s), for the period from default to resale and disposition of the property.
5. Foreclosure costs: Provides for the expenses the junior trust deed holder will advance on a default to commence foreclosure and pay for all the expenses for notices, fees and conveyancing.
Editor’s note — To obtain the foreclosure cost, the agent calls a foreclosure service and requests estimates of charges for all items typically incurred on foreclosure of the second trust deed.
5.1 Trustee’s guarantee policy: Enter the dollar amount of the charge for a trustee’s title guarantee policy. The charge is based on the unpaid principal on the second trust deed note.
5.2 Recording notices: Enter the dollar amount of the recording costs of foreclosure notices and the trustee’s deed.
5.3 Publishing notices: Enter the dollar amount of the charge estimated for publishing the trustee’s sale notice for three weeks. The estimate is based on the length of the legal description of the property, and the advertising rate at the newspaper.
5.4 Postage: Enter the dollar amount estimated for the cost of postage for mailing the notices to interested parties.
5.5 Trustee’s fees: Enter the dollar amount of the trustee’s fees based on the unpaid principal of the junior trust deed note.
5.6 Miscellaneous charges: Enter the dollar amount of any miscellaneous charges.
6. Resale costs: Enter the dollar amount of the expenditures it is estimated the seller will incur to market the property and close a sale.
Editor’s note — The broker estimates the price for interior painting and replacement of flooring and window coverings. The title insurance premium and escrow costs for a resale will be the same as for the carryback sale, and can be taken from the carryback seller’s net sheet. [See first tuesday Form 310]
6.1 Repairs and fixer-up costs: Enter the dollar amount of the fixer-up costs anticipated to be incurred before the property can be properly marketed.
6.2 Title insurance premiums: Enter the dollar amount of the title insurance premiums on resale, based on the property’s estimated resale value.
6.3 Escrow and charges: Enter the dollar amount of the escrow fees/charges for resale.
6.4 Broker fees: Enter the dollar amount of the brokerage fee the seller will incur on resale.
7. Total expenditures: Enter the total dollar amount of all loans, charges and carrying costs borne by the junior noteholder to foreclose and resell the property from lines 3 thorough 6.4.
8. Amount recovered: Enter the dollar amount of the seller’s net proceeds by deducting all charges and cost in §7 from the estimated resale price in §2.
Other important financial aspects of foreclosure/resale which may be discussed with the carryback client for a full understanding of his trust deed benefits and risks include:
a. any offsetting rental income collected from tenants under the trust deed’s assignment of rents provision [See first tuesday Forms 456, 457, 458];
b. eviction costs to remove holdover owners or tenants after the trustee’s foreclosure sale is complete;
c. delays in foreclosure or eviction due to the filing of a bankruptcy petition by the buyer, plus any attorney fees incurred by the seller due to bankruptcy proceedings;
d. expectancy of a change in the property’s value due to local housing demand for the property over the next three years;
e. income tax reporting triggered on completion of the foreclosure for any portion of the down payment (and principal payments on the carryback note) which have not been reported as profit on the carryback sale;
f. alternatives to foreclosure, such as a deed-in-lieu (after default), renegotiating the terms of the carryback note, or a pre-foreclosure workout or sale (short sale) of the property in cooperation with the buyer.