We are very pleased to have a post today from one of our colleagues here at Bean, Kinney & Korman that focuses his practice on real estate related matters, John Kelly . We are looking forward to John’s contributions here on the blog moving forward and believe John may become a regular mainstay here shortly!
Given the present economic climate, it is no surprise that many real estate developers are having difficulty paying back their lenders. The lender may agree to waive the existing defaults and restructure the loan by modifying the terms of the loan or adding additional collateral or the lender may instead proceed immediately to foreclosure. After conducting its distressed loan due diligence, however, the lender may determine that neither extreme is the right choice. Restructuring the loan may be impractical given that economic circumstances make foreclosure inevitable, but the lender may want to avoid the expense and time needed to foreclose. This post will discuss in detail the compromise position where the borrower averts foreclosure by agreeing to convey the property back to the lender via a deed-in-lieu-of-foreclosure, typically in exchange for the cancellation of the indebtedness. This will be a two part series, with the first part discussing the key aspects of a deed-in-lieu transaction, and the second part of this post will review in brief the related tax and bankruptcy issues.
The main advantage offered to both the borrower and lender is that a deed in lieu avoids the cost, time and negative stigma of a drawn-out and contested foreclosure action. For the lender, they can quickly and efficiently take over the operation of the project and preserve existing leases and contracts. For the borrower, they can obtain a release of their personal liability.
To preserve the validity of the transfer of the property to the lender, it is very important that the conveyance was made voluntarily and for adequate consideration. Lenders will want to protect themselves from the borrower later arguing that they were subject to duress, undue pressure or fraud in an effort to overturn the transaction. With regard to adequate consideration, the lender typically will not accept the conveyance unless the fair market value of the property is close to the amount of the indebtedness and the property can be obtained for less than the total cost of a foreclosure. To make clear that the transfer was voluntarily, the borrower should first submit a written offer to the lender offering to convey the property to the lender with outlining the terms and conditions of the offer. The lender should in turn reply to the borrower’s offer in writing, providing a list of conditions under which it will accept a deed in lieu. With respect to the adequacy of the consideration, the lender and borrower should self-servingly provide in an agreement that the current value of the property is equal to or less than the outstanding indebtedness. Lastly, as part of its due diligence, the lender should order an appraisal of the property, along with a title search and environmental study.
Usually, the agreement would also preserve the lender’s first lien on the property. This give the lender the right to later proceed with a regular foreclosure in order to wipe out any junior lienholders and clear title as needed. To preserve this right, the agreement should make clear the intent of the parties for the lien to remain separate even though the lender would then be the owner of the property as well as the holder of the mortgage lien. Another method of dealing with these anti-merger concerns is to have the lender take title to the property in a related entity.