When working with real estate investors in today’s market, implementing alternate default remedies will save both you and your borrower money and time.

As mortgage delinquency and rental vacancy rates in the U.S. continue to rise year over year, the effects are being felt across the private lending industry—impacting originators, servicers, asset managers, secondary marketers, and borrowers alike. Coupled with a slight uptick in unemployment and the rising cost of living, investment property owners may face greater challenges in rent collection, potentially leading to missed mortgage payments.

For lenders and investors in business-purpose loans, understanding the various loss mitigation options and their respective advantages and disadvantages is crucial. Depending on your borrower’s situation (i.e., facing a short-term or long-term hardship), you may evaluate various strategies to help them cure the delinquency, including modifications, forbearances, and deferments.

In instances where the borrower cannot afford any modification or repayment plan, you have three primary options: foreclosure, deed in lieu, or short sale.

Foreclosures

There are two basic types of foreclosure: (1) judicial, where the foreclosure proceeds through the court system and (2) nonjudicial, foreclosures outside the court system. These processes are determined by state law (which can vary from state to state) and by the terms of the mortgage itself.

For business-purpose loans, you typically initiate the foreclosure process once a loan reaches more than 60 days delinquency. Initiating foreclosure typically entails filing a formal complaint against the borrower (if judicial) or notice of intent to foreclose (if nonjudicial). On the one hand, the foreclosure process produces removal of subordinate liens from title while continuing to seek deficiency judgment against the borrower. On the other hand, the costs associated with the process combined with the unpredictable timeline to foreclose are significant disadvantages.

According to a year-end 2024 foreclosure report from ATTOM Data Solutions, the average number of days for a foreclosure in the United States was 762 days in the fourth quarter of 2024. The same report also showed that the following states took considerably longer to complete:

Louisiana: 3,015 days

Hawaii: 2,505 days

New York: 2,099 days

Wisconsin: 1,989 days

Nevada: 1,750 days

During the time required to complete a foreclosure, the subject property remains exposed to deterioration, vandalism, and damage that could severely impact the property’s value and recoverability. Additionally, you are burdened with the costs associated with maintaining property taxes and potentially force placing insurance coverage on the asset.

Work closely with your servicer and/or property preservation team to ensure occupancy is verified before initiating the foreclosure process. If the property is found vacant, work quickly to secure it to prevent damage from occurring. Regular, monthly inspections (even if exterior only) are critical during foreclosure. You should also obtain updated valuations every six months to better estimate potential loss, foreclosure bids, or negotiations with the defaulted borrower through a deed in lieu or short sale.

Deed In Lieu

A deed in lieu of foreclosure (DIL) is an agreement between a defaulted borrower and the lender to voluntarily transfer property ownership back to the lender. Through a DIL, the borrower is ultimately surrendering their rights to the subject property to avoid foreclosure, which could simultaneously discharge them from any further loan obligations. Like other loss mitigation options, a DIL application would need to be reviewed and approved by the borrower and lender.

For you, the lender, the review process is rather straightforward: (1) evaluating the borrower’s hardship or inability to reinstate/maintain payments by verifying current liquidity (financial statements), (2) obtaining an updated valuation of the subject property, and (3) obtaining an updated title search to ensure there is no material title defect(s) or subordinate lien(s). The main advantage is that both you and the borrower will not only avoid the incremental legal cost of foreclosure but also significantly reduce the amount of time spent on the foreclosure process.

That said, DIL agreements have potential drawbacks. You are still tasked with securing or preserving the property, ongoing costs associated with property taxes and insurance, and the eventual marketing and liquidation of the property as REO.

Mid-construction fix-and-flip properties are even more problematic. Costs to complete the remaining repairs to bring the property to marketable condition, for example, could be significant. Having a reliable resource to accurately estimate and complete construction as well as an appraiser versed in construction and estimating future after-repair value is helpful.

Short Sale

A short sale occurs when a defaulted borrower sells the subject property to another party for less than the total mortgage debt owed. In these situations, you agree to accept the sales proceeds in exchange for releasing your lien on the property as well as any deficiency balance that results following the sale.

Although you are accepting less than the owed amount to settle the debt, you are more likely to agree to the short sale to avoid larger losses by continuing with foreclosure, eventually maintaining and preserving the property just to ultimately resell it for a statistically 20-40% lower price than the typical short sale offer.

Like the DIL process, you should obtain necessary hardship information from the borrower to prove their current inability to reinstate or maintain payments. To better estimate the total amount of the shortfall/loss, you would typically want to review a preliminary settlement statement to determine the current purchase price and what the net payoff amount would be after closing costs and commissions. Updated property valuations would also be obtained during this review process to ensure the current purchase offer is within an acceptable range of the property’s current market value. You would likely complete due diligence on the prospective buyer to prove they are qualified by obtaining proof of funds and that the agreement between seller-buyer is a true, arms-length transaction (if the buyer is an entity, obtain articles of incorporation, operating agreement, bylaws, etc.). 

Although more complex and comprehensive compared to a DIL, a short sale could be a more favorable loss mitigation option since it immediately liquidates the property into cash proceeds, circumventing the ongoing carrying costs of maintaining and preserving the property while REO, and having to still market and negotiate the eventual sale of the property themselves.

For borrowers, benefits include a less significant impact on their credit report, avoiding a costly foreclosure process, and potentially releasing them from any further financial obligation for the mortgage. However, since you could forgive the deficiency balance with a short sale, a borrower’s taxes could be affected when reported as a debt cancellation on a 1099-C form. Debt cancellation can be treated as taxable income.

The Investor Perspective

The investor perspective is not much different from yours as a lender. Investors that purchase business-purpose loans typically show higher preference for short sales over DILs when comparing non-retention options. Foreclosure is the absolute last option, especially if the property lies in a judicial state due to the higher cost and prolonged timelines to complete the process.

An investor’s decision making is dependent primarily on the amount of the principal owed, the state in which the property is located and the results obtained from completing a cost-estimate (while considering timeline) associated with each loss mitigation option. The investor then proceeds with the option that leads to the best overall recovery.

Many cost-comparison tools and calculators exist online, so you can project loss if you have an estimated value of the subject property, total debt owed, estimated legal costs, and timeline (months).

Understanding mortgage-loss mitigation options is crucial for you to appropriately manage risk and minimize losses when faced with borrower default. Although a borrower’s hardship may be temporary, for those with long-term issues, a DIL or short sale may be potential non-retention options that avoid foreclosure.