This article presents the various options a foreclosing lender has when he becomes the landlord of property occupied by tenants.
A cyclically familiar scenario for mortgage lenders brought about by a recessionary market is the need to foreclose on income property secured by a loan they own.
On completing the foreclosure sale, the leasehold interest of tenants under rental and lease agreements with the prior owner are eliminated from title by the foreclosure sale, unless the agreements were entered into before a the lender’s trust deed was recorded or the loan was otherwise subordinated giving the tenant’s leasehold interest priority. However, any tenant with a subordinated lease who remains on the property is classified as a tenant-at-sufferance, an unlawful holdover in possession of the property. His holdover situation places the lender or the high bidder at the foreclosure sale in the role of an involuntary landlord, a foreseeable event which a lender foreclosing on income property must plan for.
The lender acquiring income property on foreclosure does not want an empty, non-productive income property on his hands. As the owner-by-foreclosure of income property, also known as real estate owned (REO), the lender has several options to choose from when confronted with the existence of tenants whose leases were not eliminated by the foreclosure due to the leases’ priority to the loan, subordination of the loan, or by a non-disturbance agreement:
- enter into a lease or rental agreement with those tenants whose leasehold interest in the property is junior to the loan and eliminated by the foreclosure sale;
- elect to retain tenants under lease agreements which contain attornment provisions;
- evict the wiped-out tenants andmarket the property for sale; or
- accept a deed in lieu of foreclosure to preserve the lease agreements which are subordinate to the loan and do not contain attornment provisions.
Many variations on these basic “rent or don’t rent” activities are discussed below.Included in the lender’s decision-making process are:
- the effects of the strength or weakness of the local rental market on the level of rents the property can command [See first tuesday Form 318-1]; and
- the lender’s degree of prior planning during their management of the trust deed investment by:
- using the due-on clause to require all leases entered into after loan origination to include provisions for pre-foreclosure subordination of the lease by the lender of its trust deed; [See first tuesday Form 552-2] and
- requiring the tenant to attorn to the lender on the lender’s post-foreclosure election to enforce the lease despite the lease’s elimination from title and unenforceability by the tenant.
Editor’s note — While this article casts lenders in the role of the involuntary landlord, the rules discussed also apply to any third party who bids and obtains ownership of property at aforeclosure sale.
Negotiate rental and lease agreements or evict
To prevent vandalism, lack of maintenance, and loss of income while holding an REO asset and attempting to locate a buyer, the lender taking title at the foreclosure sale decides to keep the tenant who remains in the property. As the owner-by-foreclosure, the lender is entitled to collect rent from the tenant at current market rates. One way to accomplish this collection is to enter into a rental or lease agreement. (The other method is through a money judgment in an unlawful detainer (UD) action to evict the tenant.)An agreement with the hold-over tenant further benefits the lender by removing any uncertainty about the occupant’s right to possess the property on a resale of the property, a concern which might deter a buyer. [See first tuesday Forms 550, 551, 552, or 552-1]
Since the occupant’s right to remain in possession of the property has been eliminated by the foreclosure, the lender taking title at the foreclosure sale is free to set rent at market rates – except in rent control areas or under Section 8 arrangements. To determine the proper rent to be charged, the lender prepares a Comparable Market Analysis (CMA) spreadsheet to summarize the rental data gathered on properties similar to the REO he now owns. [See first tuesday Form 318-1]
However, on entering into a rental or lease agreement with the tenant, the lender is now responsible for living up to his duty owed to a tenant as a landlord. Some of these duties include:
- paying property insurance and real estate taxes;
- collecting, accounting for, and refunding security deposits he collects;
- contracting for services, repairs, maintenance, and security on the property;
- serving notices on tenants and filing UD actions as needed;
- performing regular periodic property inspections of the unoccupied areas; and
- complying with any local rent control ordinances or Section 8 occupancies. [See first tuesday Forms 559-591]
Foreclosed condominiums will add the responsibilities of paying:
- association assessments incurred during the lender’s ownership of the unit; and
- ground lease rent, if applicable.
The duties of a landlord are owed to one individual, the tenant, to care for one property over a long period of time. This duty is a far different concern than the short-term needs of lenders to locate new borrowers and make new loans in their everyday business.By nature, lenders are averse to taking on the burden of landlording since it is an expertise outside their field of knowledge and inconsistent with their culture. If they are burdened with an income-producing REO property which cannot be quickly sold, the lender may hire a real estate broker who operates a property management company to perform the everyday management duties and account to the lender.
If lenders are looking to make a profit from the REO property, out-sourcing everyday management duties becomes something of a double-edged sword. The lender must ensure the REO is managed efficiently to maximize the property’s profitability for a later resale. At the same time, he must understand that fees paid a property manager will lower the net operating income from the property and thus lower the price buyers might be willing to pay for the property.
Also, the broker acting as a property manager may have issues with the length of time he will be operating the property since the first months of managing a property requires an investment of time and effort that will not pay off for months to come. A cancellation fee due the broker on the lender’s election to prematurely terminate the property management contract would be an appropriate solution.
Master lease as equivalent to a loan
Alternatively, the lender acquiring an income property on foreclosure might look to a property management broker, syndicator, orinvestor who is willing to enter into a master lease of the property if given the incentive ofan option to buy for a period of a two or three years. A master lease of the property would shift all landlord responsibilities entirely to the master tenant. Thus, the lender would be back in his traditional (and preferred) role of collecting monthly payments on an enforceable contract secured by the property (by reversion.) [See first tuesday Forms 552 and 161]
If the master tenant under a lease with option chooses not to exercise his purchase option, possession of the property reverts back to the lender when the lease expires. This is no worse a financial relationship than had the lender taken an insured deed-in-lieu from a borrower under a trust deed loan. [See first tuesday Form 406]
The master lease arrangement on a larger income property is a more palatable alternative for a lender than hiring a property manager to oversee the property. A lender is best served by considering a master lease during the recovery phase of a real estate cycle when retaining ownership of an REO property would likely maximize the net proceeds on a later sale due to the re-entry of buyers during periods of stable or rising prices. The lender granting a master lease and option not only recovers his investment in the property on exercise of the option, but will have received monthly rent, the economic equivalent of interest.
Subordination clauses in lease agreements
Rental market data plays a pivotal role in how the savvy lender will behave when confronted with the need to foreclose on an income property. While a strong rental market may suggest the lender after a foreclosure can negotiate better rent amounts than the tenants have been paying, a weak rental market will likely motivate the lender to preserve existing leases which contain rental terms which are more advantageous than those available in the current rental market.Lenders who can subordinate their trust deed to the tenant’s leasehold interest in the property prior to the foreclosure sale should consider doing so to preserve an advantageous lease from being renegotiated with the owner before the foreclosure sale. [CC §2897; see first tuesday Form 552-2]
Consider a lender who holds a first trust deed on investment-quality income-producing real estate. After the trust deed is recorded, the owner leases the property to a creditworthy tenant.
The lease agreement contains a lender-required subordination clause to satisfy the lender’s conditions for waiver of the due-on clause in his trust deed when the owners lease the property for a period greater than three years.
During the term of the lease, the owner defaults on the lender’s trust deed. The lender records a notice of default (NOD), initiating a trustee’s foreclosure sale. The lender has the property appraised and discovers the rent due over the remaining term of the tenant’s lease significantly exceeds current prevailing rental rates.
For the same economic reasons that cause the lender to preserve the lease agreement, the tenant wants out of the lease agreement.
The lender hears of negotiations between the owner and the tenant to modify the lease agreement. The lender does not want the landlord to alter the agreement prior to foreclosure since the lenders election under the attornment provision in the lease would bind the tenant to the lease after the foreclosure. The lender serves written notice on the tenant of his election to subordinate his trust deed to the tenant’s lease, altering their priorities prior to foreclosure as provided in the lease agreement.
After receipt of the notice of subordination of the lender’s trust deed, the tenant and the landlord modify the lease agreement, granting the tenant the right to terminate the lease agreement at any time on 30 days’ written notice. In exchange, the tenant pays the landlord a modification fee to make the agreement binding.
The trustee’s sale is held and the lender acquires the property. The tenant is notified by the lender that he is now the owner of the property and all rent payments under the lease are to be made to the lender. The tenant serves the lender with written notice of his election to terminate the lease agreement by cancellation under the provisions in the lease modification agreement.
The lender claims the tenant cannot cancel the lease agreement since the modification agreement which contained the cancellation provision, but not the original lease agreement, was eliminated by the foreclosure sale.
Can the tenant terminate the lease by canceling the lease agreement under the conditions stated in the lease modification entered into prior to the owner’s loss of the property?
No! The original terms of the lease agreement remain unaffected by the modification agreement and the foreclosure sale since the lender elected to subordinate his trust deed to the lease prior to the tenant entering into the lease modification agreement. Thus, the agreement modifying the lease was at all times unenforceable against the lender. The tenant’s entry into the modification agreement was junior in time to the lender’s subordination of the trust deed. Thus, the lease became a senior (unrecorded) encumbrance on title to the property with priority over the lender’s trust deed and could not be altered without the lender’s consent as a junior lienholder.
Thus, the modification of the lease agreement, but not the pre-existing lease agreement, was eliminated by the lender’s foreclosure. [In re 240 North Brand Partners, Ltd. (9th Cir. BAP 1996) 200 BR 653]
By subordination of the lender’s trust deed to the lease, the lender acted to maintain the property’s value based on rents under the lease. Subordination allows the lender to avoid the effect of any later modification of the lease prior to foreclosing and acquiring ownership at the trustee’s sale (and election to enforce the lease agreement under its attornment clause.
Further, the risk of loss due to a deficiency in the value of the property at the time of the foreclosure sale is reduced for both the lender and the wiped-out landlord, but the tenant must pay.
The new owner-by-foreclosure of income-producing property may also rely on an attornment clause to enforce a lease agreement the prior owner entered into with a tenant prior to foreclosure.
Attornment is the tenant’s agreement to acknowledge the purchaser at a foreclosure sale under a trust deed senior to his lease as a substitute landlord who may elect to enforce the tenant’s lease agreement rather than treat it as wiped out by the foreclosure sale.
To enforce a wiped-out lease agreement under an attornment provision, the owner-by-foreclosure notifies the tenant he has elected to be the substitute landlord on the tenant’s lease agreement with the wiped-out prior owner. However, the new owner need not do so; he can simply leave the wiped-out tenant with no interest in the property and no right to continued possession.
A nonresidential landlord has financial justification to include an attornment clause in a lease agreement. Should a senior trust deed lender foreclose, it is essential to the landlord that the property’s value be maintained if he is to reduce the potential of a deficiency judgment.
A financially advantageous lease agreement, enforceable by the high bidder at a foreclosure sale, will help maintain the value of the property on an appraisal. On the other hand, if a financially advantageous lease agreement does not contain an attornment clause, the property’s market value will be lower than it would have been had the high bidderbeen able to enforce the lease. Here, the lender’s alternative is to consider negotiating a deed in lieu of foreclosure and have the owner deed the property to the lender in exchange for the lender canceling the mortgage debt. This step would leave all the lease agreements and tenants in place to be enforced both by and against the lender as the new owner of the property by grant deed.Of course the deed-in-lieu would need to be insured by a title insurance policy.
If the high bidder elects to enforce a lease agreement containing an attornment clause, the lease agreement remains in full effect for the remainder of its term. Thus, the high bidder who makes the attornment election becomes the substitute landlord and must perform the obligations of the landlord under the lease. [Miscione v. Barton Development Company (1997) 52 CA4th 1320; Form 552-2]
The other side of the coin: non-disturbance agreements
While subordination and attornment provisions in lease agreements provide protection for the lender and protect his security interest in the property, a non-disturbance agreement entered into between a tenant and the lender automatically subordinates the lender’s trust deed to the lease so that the lease is not wiped-out should the lender need to foreclose under the trust deed. With a non-disturbance agreement, the lender surrenders his independent ability to change any terms of the lease to align the rent with inflation or current market rates after the foreclosure sale.
Non-disturbance agreements are usually entered into when a loan is originated or a long-term lease is entered into, possibly haunting the lender when foreclosures occur.
Selling property subject to an existing lease
Ultimately, the lender wants to sell the REO in order to remove the management and financial onuses of owning the property. To best protect his interests in case a willing and able buyer is located, the lender and owner-by-foreclosure is best served during recessionary times by entering into a month-to-month rental agreement with the holdover tenants. [Form 551 or 552-1]
Additionally, in order to show the property to a prospective buyer, the lender needs to serve the tenant with written notice of his right as the new owner to enter the premises and display it to a buyer after giving 24-hour’s telephonic notice.[See first tuesday Form 116]
Eviction as a last resort
Instead of continuing a rental relationship with any holdover occupants in the foreclosed property, the lender may choose to evict the occupants since the occupants do not have enforceable lease agreements.This choice is most likely in single family residences since most buyers would either want possession of their principal residence or the ability to re-sell it to a buyer who will.
A holdover owner can always be evicted, as the owner’s interest in property is extinguished by foreclosure. Leases entered into and recorded after the foreclosed trust deed was recorded are extinguished by the foreclosure unless the lender subordinated the loan or elected to be the substitute landlord under an attornment provision. Leases entered into before the foreclosed trust deed was recorded remain in effect after foreclosure. [Fahrenbaker v. E. Clemens Horst Co. (1930) 209 C 7; Calif. Code of Civil Procedure §1161a]
Before the lender may evict holdover occupants, he must deliver the appropriate notices.
An evicted holdover owner is only entitled to a 3-day notice to quit due to foreclosure, whether the property is residential or nonresidential. Likewise, a nonresidential holdover tenant is only entitled to a 3-day notice to quit due to foreclosure. [CCP §1161(a)(b)(3); CCP §1161a(b)(4); see first tuesday Form 578]
A residential tenant, however, is entitled to a written notice to quit for a period of no less than the periodic tenancy under his wiped out rental or lease agreement, but no greater than 30 days. Thus, a 30-day notice will always suffice. [CCP §1161(a)(c); see first tuesday Form 573]
A lender must keep the proof of service on the holdover occupants should a UD action be necessary to remove the tenants. [See first tuesday Form 580]
A holdover tenant or holdover owner who refuses to vacate the unit within the noticed period owes retroactive rent based on the property’s rental value from the date of the trustee’s sale to the date he vacates the property. [MCA, Inc. v. Universal Diversified Enterprises Corp. (1972) 27 CA3d 170]
Rent control bars eviction
When residential income property subject to local rent control ordinances or a Section 8 contract is acquired by an owner-by-foreclosure, the lender must comply with the ordinances and Section 8 rules.
Consider a trust deed lender who forecloses on residential rental units by a trustee’s sale and acquires the property at the foreclosure sale. The lender wants to remove the occupants who are former tenants under wiped-out rental or lease agreements. The lender intends to renovate the property and resell it.
The lender, now the owner-by-foreclosure, serves each tenant with a statutory 30-day notice to quit due to foreclosure. However, the property is located in a rent control community.
The occupants claim they cannot be evicted by the lender since local rent control ordinances do not permit an eviction on a change of ownership. The rent control ordinances limit the circumstances which are cause for a tenant to be evicted. Change of ownership for any reason is not a permitted basis for the eviction of a residential tenant located within a rent control area.
The lender claims the tenants can be evicted due to foreclosure since the local ordinance is preempted by state law allowing the high bidder at a foreclosure sale to evict a tenant following a foreclosure sale.
Can the residential tenants be evicted by the lender since the lender is an owner-by-foreclosure?
No! Residential tenants protected under rent control ordinances cannot be evicted after a foreclosure, unless permitted by local ordinances. The statutory 30-day notice required before a residential tenant can be evicted in a UD action following a foreclosure sale does not preempt local rent control ordinances.
The UD notice-and-eviction process merely provides a legal remedy for a lender who has grounds to recover possession from the tenants, in lieu of using self-help to remove tenants. Under rent control, it is the ordinance which establishes the grounds for eviction of a residential tenant. [Gross v. Superior Court (1985) 171 CA3d 265]