Because foreclosures are often complex and lengthy, and the process varies depending on the location and property type, understanding the basics is critical for lenders. For example, some states require lenders to file a lawsuit and obtain a court order in order to foreclose (a “judicial” foreclosure), while others permit lenders to foreclose with the assistance of a trustee outside the court process (a “nonjudicial” foreclosure).
Nonjudicial foreclosures are generally faster and easier for lenders than judicial foreclosures, which go through the court system and are often subject to considerable delays. Additionally, foreclosures on commercial and non-residential loans and properties usually have fewer and less stringent requirements than those involving “consumer” and residential loans, as there are stringent federal and state consumer protection laws and notice requirements intended to protect individual consumers and residential borrowers.
Thus, where available, a nonjudicial foreclosure is generally the most efficient and cost-effective choice for lenders faced with a defaulted commercial loan. Here are the basics lenders should know about the process and requirements.
Mortgage vs. Deed of Trust
Mortgages and deeds of trust have many similarities, and both serve the same function – to secure repayment of a loan. The main differences between the two are the parties involved, and the remedies upon default. With a mortgage, the borrower takes title to the property but grants an interest in the property directly to the lender, which the lender records as a lien against the property. A deed of trust, which is used instead of a mortgage in certain states (and sometimes where the lender is not a traditional “bank”) also has the lender and borrower as parties, but it adds a third party – the trustee – who holds legal title to the property until the loan is paid off.
How a loan is secured, and the state where the property is located, also determines whether it will be foreclosed via judicial or nonjudicial foreclosure. In judicial foreclosure states, when a borrower defaults on a loan, the lender must file an action with the court and obtain a judgment of foreclosure in order to proceed with a sale of the property. In nonjudicial states, which generally use deeds of trust in place of mortgages, the “power of sale” clause in the deed of trust permits the trustee to foreclose and sell the property for the benefit of the lender without filing a lawsuit. While either a mortgage or a deed of trust can contain a power of sale clause, it is typically seen in a deed of trust.
Keep in mind that some states have both judicial and nonjudicial foreclosures, which means commercial loans in those states may be secured by either a traditional mortgage or a deed of trust, and that will dictate how the lender can foreclose.
What is the Foreclosure Process?
After a borrower misses a payment, they’re considered to be in default. The time period between the initial default and the start of the foreclosure process is called “pre-foreclosure.” Borrowers usually have time during the pre-foreclosure phase to cure the default and avoid the foreclosure process starting. In most cases, there is a defined waiting period lenders need to observe after the initial default before proceeding with foreclosure.
Once the lender decides to proceed with foreclosure, while there are some similarities in the judicial and nonjudicial process, there are also notable differences lenders should be aware of.
The judicial foreclosure process varies from state to state and even from court to court, but the general outline is usually as follows:
To foreclose on a commercial property in a judicial foreclosure state, a lender must first serve any default or pre-foreclosure notices required by the loan documents and/or statute, and wait for any applicable waiting period to expire. Note that in most cases, commercial loans don’t have special pre-foreclosure notice requirements, which can help to expedite the foreclosure process in states requiring judicial foreclosure.
Commence a foreclosure action in the court with jurisdiction over the mortgaged property by filing a summons and complaint and serving copies on the borrower. Once served with the summons and complaint, the borrower has a certain amount of time to contest the lawsuit and file an answer – typically between 20-30 days after service.
If the borrower fails to answer the complaint, a lender can apply for a default judgment from the court. In the alternative, if the borrower challenges the lawsuit, the lender may need to file and respond to multiple motions, or even go to trial, before it secures a judgment. Once the court issues a foreclosure judgment, the property goes to sheriff’s sale and is sold to the highest bidder. If no bidder reaches the minimum threshold for the property, the property is then sold to the lender, who is generally permitted to credit bid up to the amount of the foreclosure judgment.
With a deed of trust containing a “power of sale” clause in a nonjudicial state, a lender has the ability to foreclose on a commercial property in an expedited manner, and without court intervention. This process is guided by the third-party trustee, who handles the foreclosure process and eventual property sale, rather than a judge.
Like judicial foreclosures, nonjudicial foreclosure procedures differ from state to state, but the general steps are as follows:
Depending on the type of loan and the terms of loan documents, a lender may need to send the borrower a notice of default and give the borrower an opportunity to cure prior to commencing the foreclosure process. While most commercial loans expressly waive this requirement, “consumer” and residential loans generally have both contractual and statutory notice requirements that must be met before a lender can foreclose. Every state has different requirements for the content and delivery of any required statutory notice, and lenders should also be mindful of any separate contractual notice requirements contained in the terms of the loan documents. If a notice of default is required, it will typically contain pertinent details about the loan, default, amount owed, and options to cure the default.
Assuming a borrower fails to cure the default during any applicable notice or waiting period, the lender may then proceed with publishing a notice of sale. The publication requirements differ from state to state, including how, where, and how many times the notice must be published before the sale can take place. Copies of the notice of sale must generally also be sent to the borrower as set forth in the terms of the loan documents and/or per state statute. In most cases, the notice of sale will advise of a prescheduled sale date that will take place after a given waiting period, if the borrower does not cure the default or contest the sale.
After the notice of sale is published and any applicable waiting period expires, the trustee proceeds with auctioning the property at a trustee sale. These sales are scheduled for a set date and time as reflected in the notice of sale, and are either open to the public at large, or sometimes to a private group of buyers or bidders. At the sale, the lender is permitted to credit bid up to the amount owed on the loan, and the property is sold to the highest bidder. If there is no bid higher than the lender’s credit bid, the property is sold to the lender, and it becomes “real estate owned” (REO). If there are excess proceeds from the sale after all liens on the property are fully satisfied, the borrower is reimbursed any “surplus funds”.
In some states, like California, there is a redemption stage, in which the buyer is given a certain period of time to buy back the home from the successful bidder.
Now that you’ve got a basic understanding of how commercial judicial and nonjudicial foreclosures work, stay tuned for Part 2, where we’ll cover in-depth how rules and regulations for the nonjudicial foreclosure option differ from state to state.
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This article does not constitute an offer to sell, or the solicitation of an offer to buy, any security interest in any jurisdiction. This material is distributed for informational purposes only and should not be construed as investment, legal, tax, regulatory, financial, or other advice. No assurance can be given that any investment objective will be achieved, or that an investor will avoid losses or obtain a return on an investment. While the information contained in this article is believed to be reliable, its accuracy is not guaranteed. Individuals should consult with their own professional advisors with respect to the legal, tax, regulatory, financial, and accounting consequences of any potential investment.