Time is money, so speed is key.
As private investment in real estate becomes more widespread, the problem of loan defaults and the costs associated with foreclosed properties are bubbling to the surface. For many lenders, particularly those new to the industry, this is a problem they didn’t thoroughly anticipate. Now, they must figure out how to deal with it.
The first three articles in this series discussed how to minimize foreclosures and mitigate their impact on your loan portfolio. Up to this point, we’ve focused mostly on loan default prevention through underwriting and collateral monitoring, as well as asset preservation and the pre-foreclosure process. But, the occasional foreclosure is inevitable, and eventually those REOs end up in your portfolio—and on your books.
Try to Get Back on Track
The quicker you can dispose of those distressed assets, the less capital you will burn. The best-case scenario for a lender facing potential defaults is to get those loans back on track. As soon as a troubled loan shows up on your radar, you need to work closely with the borrower to help navigate whatever
challenges they’re facing.
In many cases, the borrower may be struggling to make interest payments or to pay off the loan, but if they are already marketing the property or have it under contract, it might make sense to extend the loan until the property is sold. It might even be beneficial to offer the borrower the option of a discounted payoff to avoid foreclosure. Breaking even or taking a slight haircut may be preferable to the losses you could incur by holding on to the property.
When a borrower has been unable to make timely interest payments or has struggled to keep construction progressing, it’s an indication they ran into unanticipated costs or delays that they didn’t have the experience or the capacity to overcome. These issues can result in insufficient cash flow or a protracted timeline, both of which put the project in jeopardy. As the lender, it’s now your job to decide if you should enter into a workout with the borrower or take control by foreclosure.
Once a loan is posted for foreclosure, you need to act quickly. Again, time is money, so speed is key when it comes to the disposition of distressed assets.
If you’re a lender and you don’t have a loss-mitigation protocol, you may be setting yourself up for months or even years of carrying costs like property taxes and insurance, which can cannibalize any potential profits.
First, make sure all taxes and insurance on the property are up-to-date. Immediately following foreclosure, you should conduct some due diligence to estimate the value of the property. This evaluation includes reassessing the current market value of the property by reviewing the old appraisals and analyzing current market conditions.
You also need to determine the phase and quality of construction, so you know what else needs to be done to complete the project. If the borrower didn’t stick to the construction budget agreed upon during the underwriting phase, or their work is otherwise not up to par, you may have to devise a new budget for completion. This evaluation process should provide you with all the information you need to figure out what will be the best exit strategy for any given investment property.
Assess Your Options
Based on your assessment of the property, there are a few options available to you.
First, you can sell the property “as is” to an investor outright. There’s no shortage of real estate investors who already have capital at their disposal and just need to find the deals. Selling it “as is” typically is the quickest and often the most favorable option for a lender.
Second, if you can’t find an immediate buyer, take advantage of your borrower network and consider reoriginating a new loan on the property to another (more qualified) borrower. If you decide to do this, you can incentivize borrowers with better terms as compared to a typical loan, and you might agree to split profits or work out a profit waterfall with the borrower based on the final sale of the property. Whichever loss-mitigation strategy you decide to follow, it’s crucial to minimize the amount of money you spend on the property.
Sometimes, a foreclosed property might actually present an opportunity to make a profit instead of just mitigating losses. So, a third option is to have an experienced asset management team come in, complete construction and sell the finished property. This is when it’s beneficial to have asset management capabilities at your disposal.
In some cases, if the previous borrower adhered to the construction budget and scope of work but just couldn’t meet the timeline, you may be able to pick up where they left off and complete construction on the property according to the original plan while still achieving a profitable market value for the home. If the original plan doesn’t build the necessary value into the home, then you need to change course to ensure you can optimize what the home is worth. This strategy will usually involve rebudgeting the project or completely revising the scope of work and redeveloping the property appropriately.
Finally, if the project has gone completely off a cliff and the initial investment can’t be recovered by completing construction and selling the home, you might be able to still make a profit off the investment by completing the project and renting it.
Renting the property allows you to generate the regular interest payments you would expect and recover principal over time. And in the event of a housing market downturn, it is wise for investors to keep a portfolio of rental properties to generate income until home sales and property values pick up again. Then once the property is right-side-up, you can sell it and cash out whenever it makes sense to do so.