Foreclosure Demystified

Commercial real estate foreclosure is a legal process that grants lenders the ability to sell or take ownership of the collateral property (the asset the borrower pledges to the lender should the borrower default on the loan) underlying a mortgage, to recover the remaining debt on the loan, when default occurs.

There are two different forms of default known as non-monetary and monetary default.

Non-monetary defaults occur when the borrower violates the terms of a loan. For example, if the debt service coverage ratio (the net operating income of the property divided by the debt service payments) or the loan to value ratio (the mortgage amount divided by the value of the property) fall below a predetermined threshold, these are each violations. Any violation of terms not related to the payment of the loan constitutes non-monetary defaults. Typically, a good debt service coverage ratio is around 1.25 and above, meaning the borrower is generating 1.25 times the amount needed to cover the mortgage payments. For loan to value, a ratio of about 80% or lower is ideal, meaning the value of the property is worth 20% more than the loan amount. A monetary default occurs when the borrower is unable to make payments on their debt to the lender.

The COVID-19 pandemic has hit many industries hard, but the impact on commercial real estate has been particularly severe, especially in the retail and lodging sectors. Since the second half of 2020, lenders have faced a growing number of monetary defaults of CRE mortgage loans. Based on CMBS loan data provided by Intex, the CoStar Group estimates that 5.1% of CRE loans are 30 days or more delinquent as of August 2020, among which 3.5% are in default, compared to 1.3% and 1.1% respectively as of January of 2020, prior to the onset of the pandemic.

The foreclosed amount has not roared yet for three reasons: first, lenders are usually apt to work with borrowers to reinstate the loan or resolve the financial hardship through workout strategies, which are known as a “Workout” in the foreclosure process and described later in the article. Second, the mortgage forbearance provisions imposed by The Coronavirus Aid, Relief, and Economic Security Act (CARES Act) along with novel loan modifications created by individual banks could resolve the financial difficulty for some loans and further delay it for others. Third, it can take years for a foreclosure to run its course before the final recoveries and losses are settled.

While frequently discussed, property foreclosure is not an overnight occurrence, and lenders will often work with borrowers to avoid foreclosure, which is typically a last resort. The foreclosure process is lengthy and costly for the lender, and much of the time the lender would rather work with the borrower to assist them in getting the loan to reperform or alter the mortgage terms to make them more favorable for the borrower. On average, the foreclosure process from default to the sale of the property can take anywhere from four to 18 months or even longer depending on the state in which the foreclosed property is located, and whether it is a judicial or nonjudicial foreclosure process.

However, it is expected that a wave of foreclosures will occur when the forbearance period ends, and economic stimulus runs out. Distressed transactions, often associated with foreclosed properties sold in public auctions or REO (Real Estate Owned) properties sold in private sales, could create an opportunity for investors to acquire property at a steep discount from the market price.

The general process for a commercial property foreclosure follows the steps outlined below.

Notice of Default: The process begins when the borrower defaults on the loan. The definition of default can vary depending on the lender, but typically default is standardized by regulatory definitions as well as research studies as loan payments that are 90 days past due. After default, the lender will send a written “notice of default” to the borrower, stating the amount that is due on the loan and when the amount is due. If the payment is not made by the time stated on the notice of default, the lender may proceed with the formal foreclosure process.

Workout: While not an official step in the foreclosure process, in many circumstances the borrower and lender will resolve their differences without going through a formal foreclosure process. Examples of some of the typical modifications are below:

• The lender modifies the loan structure to an interest-only loan, thus reducing the payment due. An interest-only loan allows the borrower to make payments just on the interest of the loan, with the full principal amount due at the maturity of the loan. At maturity, the borrower can choose to refinance, or pay off the remaining balance.

• The lender reduces the interest rate or principal of the loan.

• The lender extends the terms of the loan.

• The lender works with the borrower to help get the loan to reperform (i.e. once again make payments to the lender).

• The lender accepts a “deed in lieu of foreclosure,” where the borrower signs the deed of the property over to the lender to satisfy the loan. This can prevent the lender from needing to go through many costly months in the courts, and the expenses of an auction.

• The lender sells the non-performing commercial note to another investor or entity who typically plans on either taking control of the property or working with the borrower to get the loan back to performing status.

Foreclosure: Assuming the borrower is unable to pay the lender, and the two sides are not able to make an arrangement that will keep the loan performing, the lender — in a judicial foreclosure — proceeds to file a lawsuit to obtain a court order, which forces the sale of the property. In a nonjudicial foreclosure, the lender must follow the terms set out in the mortgage documents, but no court order is needed. Those mortgage document terms typically include:

• A power of sale clause, providing the lender with the right to foreclose on the property without the need of a court.

• Requirement that the lender send the borrower one or more notices of default.

• Stipulation that when the borrower receives a notice of default, if they are unable to work with the lender or to make payments on their mortgage, the lender will proceed with the foreclosure process.

• Language saying that the lender is authorized to sell the property to recover the outstanding loan balance.

• Clarity that the property will be sold at auction in the same manner as a judicial foreclosure.

Management: In both a judicial and nonjudicial foreclosure, a lender may request a court appointed receiver to manage the property while the foreclosure process is taking place, through the final sale. There are typically no universal requirements for who can serve as receiver, but the court usually requires that the receiver have experience in a related area such as property management, brokerage or development. The receiver is responsible for maintaining the property and collecting rents from existing tenants and is expected to act in the best interest of both parties, while maintaining the value of the property and its related assets and income streams.

Sale: A sale notice is posted, providing notice that the property is entering a foreclosure sale. This notice is usually published in a local newspaper, or at the local courthouse in the jurisdiction of the property.

Public Auction: A public auction is held, where the property is sold to the highest bidder for a price that satisfies the outstanding loan amount.

REO: If none of the bids fulfill the amount left on the commercial mortgage, it is possible for the lender to purchase the property by submitting a credit bid, which is based on the outstanding balance of the mortgage. A credit bid is equal to the unpaid principal plus the interest of the mortgage debt, including the expenses, fees and other costs associated with foreclosure. The lender will then sell the property later via a private sale. When the lender holds the property following auction, it is known as being “REO,” meaning real estate owned.

While the foreclosure process differs from state to state depending on local guidelines and regulations, the general process remains consistent and can be divided into two primary categories: judicial and nonjudicial.

The judicial foreclosure process, as the name implies, involves the court system. In some states, it is the only option available, and requires the lender to take the property through a court order. This process can take anywhere from six to 18 months.

Additionally, many states include a “statutory redemption period” of six to 12 months where the borrower can pay back the loan after the property has been sold at auction and retain control of the asset. Depending on the state, a judicial foreclosure also provides the lender with the ability to pursue a deficiency judgement against the borrower. A deficiency judgment can be sought by the lender if the property sells for less than the loan amount that is due, and results in a lien on the borrower for the judgement amount.

A nonjudicial foreclosure, which is not permitted in all states, allows the lender to take possession of the property without the need for a court order. The nonjudicial process is a much faster alternative for lenders than the judicial process and can happen within four months. If permissible by state law, a nonjudicial foreclosure occurs when the terms of a commercial mortgage include a “power of sale” clause, granting the lender the right to foreclose on the property without requiring action from the court. The nonjudicial process may include a redemption period, but it is less likely, and the window for the debtor may be smaller. Additionally, in many states a deficiency judgement is not allowed during a nonjudicial foreclosure.

While state’s varying laws play perhaps the most significant role in how the foreclosure process will work for a distressed commercial property, the general processes and terminology are typically consistent. While a difficult time for borrowers, the foreclosure process does offer the borrower multiple opportunities to maintain their asset, and lenders may be willing to work out an agreeable solution. Moreover, the process creates opportunity for investors, who may come across a distressed asset at auction, at a significant discount from the market, as the lender is most interested in recovering their outstanding balance.

This article was edited by Margarita Foster, a senior editor with LoopNet.