Economic recovery data in Colorado, almost universally positive, is resulting in a contraction of available inventory for purchasers and developers of distressed assets. According to the Colorado Division of Housing, from 2010 through 2011 new foreclosure filings fell 25.3 percent to a total of 31,914 filings. The number of completed foreclosure sales fell 17.7 percent during 2011, dropping to a total of 19,622 sales. The number of new filings and foreclosure sales in 2011 are the lowest since 2006. While foreclosure sales for the last four years have remained relatively constant at between 4,000 and 6,000 sales each quarter from 2007 through 2011, the decrease in number of foreclosure filings could result in tightened inventory of properties available to purchase at foreclosure sales throughout the remainder of 2012 and into the first half of 2013.1 As a result, the already stringent requirements of caveat emptor, or "buyer beware," demand additional examination.
This article focuses on considerations for developers purchasing distressed assets in order to renovate the property, take advantage of a budding economic recovery, and sell the investment at a profit.
What do fewer foreclosure sales mean for distressed asset investors?
The already tight requirements imposed on distressed asset investors in the form of few, if any, pre-sale property inspection rights and a short window to perform title checks are exacerbated by increased competition over a shrinking supply of foreclosed inventory. Therefore, identifying the risks in advance can help distressed asset investors avoid or mitigate circumstances that may reduce individual project returns.
Problems with Priority: Junior Redemption and Hidden Liens
From a distressed asset investor's perspective, a major purpose of purchasing property at a foreclosure sale is to gain title to the property free and clear of encumbrances that may prohibit a rapid sale of the asset. Unfortunately, junior lienholders do have the limited ability to potentially wreak havoc with the investment expectations of distressed asset investors. Furthermore, there may exist certain additional liens encumbering property title that do not appear on regular title examinations.
Redemption by Junior Lienholders ?
In Colorado, homeowners lose their right to cure or redeem unpaid debts at the foreclosure sale, but this is not true for junior lienholders. Under Colorado law, junior lienholders may, within eight business days of the sale, file a notice of "intent to redeem," which allows the junior lienholder a narrow time period in which to redeem the property by tendering the foreclosure sale price plus costs to the purchaser.
Even though the redeemer must reimburse both the sale price and the purchaser's costs, redemption by a junior lienholder nonetheless negatively impacts a purchaser at foreclosure by creating substantial work for the purchaser under a very tight deadline that does not account for or reimburse the purchaser's lost opportunity cost. Redemption by a junior lienholder is a very fast moving process requiring the purchaser to provide detailed accounting of the purchase price and all expenses incurred (with accompanying invoices) within a matter of days of receiving a notice of intent to redeem. The statutes do allow recovery for a marginal amount of interest during the time of redemption, but that interest may be negligible in terms of the time spent scouting the property and the rush required to respond to a notice of intent to redeem. The interest is typically the default rate as stated in the promissory note secured by the foreclosed deed of trust. In FNMA/FHLMC Notes, that rate is the same as the note rate, often below 5 percent.
Hidden Liens and Remedies: Tax Liens and Homeowner Association Superliens
Under C.R.S. § 39-1-107, tax liens have priority over all other liens on any parcel of real or personal property, which means that a distressed asset investor purchasing property at a foreclosure sale will take the property still subject to any tax liens on the property. A tax lien on the subject property may not yet be evidenced in the chain of title as of the date of the foreclosure sale because, though levied due to a previous owner's failure to remit tax payments, the actual assessment may not yet have taken place. (The statutory tax assessment date in Colorado is January 1, so any taxes levied for that tax year relate back to that date.)
The result is that the tax lien is an "inchoate lien" that relates back and attaches as of the statutory assessment date, encumbering the distressed asset investor's new purchase even though the title may have appeared clean before the foreclosure sale.
Another type of hidden lien is the homeowner association "superlien." Under the Colorado Common Interest Ownership Act, six month's of regularly budgeted homeowner association ("HOA") assessments automatically attach as liens to subject property, and have priority over all other liens — with the exception of tax liens — that are filed against the property later than the original HOA declaration. This means that these HOA liens usually have priority superior to any deed of trust currently being foreclosed upon, and since they do not need to be filed in order to attach, a search of title by a prospective investor will not disclose them.
Accordingly, any investor of foreclosed property should determine whether the property is subject to a homeowner's association prior to submitting its bid, and should factor a liability of up to six months of the HOA's budgeted assessments plus interest into its analysis of the property's value.
Conclusion: How can these costs be prevented or mitigated?
The sometimes narrow profit margins faced by distressed asset investors purchasing property from foreclosure sales may be protected by undertaking the following preventative measures.
First, be sure to check the title. Examining the property's title will alert distressed asset investors as to whether there exists any subordinate liens to the lien that is now being foreclosed. While this knowledge won't necessarily prevent any such junior lienholders from later attempting to redeem the property once the foreclosure sale has occurred, the knowledge will at least prepare the distressed asset investor for the possibility of having to respond quickly to any notice of intent to redeem so that all of the investor's costs may be quickly and easily accounted for.
Moreover, the foreclosure process frees the property only from the immediate lien and junior liens. Any earlier recorded lien will have priority to the foreclosure process, and thus, not be discharged. This means that a distressed asset investor who has not checked the property title could end up taking title to a property that is still subject to earlier mortgages or other liens, requiring the investor to make unexpected payments to discharge such encumbrances or lose its interest to the senior lienholder. Checking the title should alert the investor to all prior liens that will not be discharged in the foreclosure action, and accordingly prevent the investor from purchasing an interest in property that will require unexpected payments to another lienholder.
Second, inchoate tax liens may not yet be recorded, but there may be indications in the title that they exist. If possible, contact the foreclosing lender and ask whether the lender has any knowledge of existing or inchoate tax liens. If taxes have been assessed, but not paid by the mortgagor, it is possible that the lender will either know of them, or perhaps have even paid such taxes already in order to protect its investment.
Third, checking the title will also alert the distressed asset investor as to whether the property is subject to a homeowner's association declaration. If the property is part of an HOA, by contacting the HOA representative, the investor can determine the likely cost, if any, of any unrecorded liens attached to the property by the HOA, and include the cost of settling such liens in its calculation of the expected value of the asset.
Finally, due to the timeliness requirements imposed with meeting these hidden expenses, it is crucial that distressed asset investors secure professional representatives who understand the investor's business goals, as well as all of the investor's rights.