Five Things Banks Should Consider When Foreclosing on Real Estate Collateral

With loan defaults on the rise, many banks are left with no choice but to pursue foreclosure actions against the real estate collateral pledged by borrowers. Unfortunately, there are usually no fast and easy solutions to bring defaulted loans current or to obtain title to the encumbered property. In light of the long, involved process of judicial foreclosure, there are many factors banks should consider prior to, during and after filing a foreclosure action. A number of these factors are discussed below; these are but a sampling of the many issues banks are likely to encounter when foreclosing on real estate collateral.

Hiring Legal Counsel

The first and most important action a bank should take when faced with a loan in default is to hire legal counsel. A team of experienced real estate lawyers will be invaluable in advising the bank on every aspect of the process, from considering possible alternatives to judicial foreclosure, to the actual court proceedings, to dealing with property-specific issues once possession of the real estate collateral is obtained.

Considering the Alternatives

After legal counsel has been retained, a bank and its counsel should consider alternatives to judicial foreclosure. For example, third-party investors may be willing to acquire the property from the borrower and assume the loan, or purchase the note from the bank. In some cases, the borrower may also be amenable to providing the bank a deed in lieu of foreclosure.

Due Diligence

Prior to taking any legal action, a bank must complete its due diligence regarding the encumbered property. It is important to review, along with legal counsel, the loan documents and understand what collateral is encumbered, as well as to determine the parties to which the bank must serve notice of default, when the notice must be served and by what means of delivery.

A bank and its legal counsel should think about the type of real estate collateral that is encumbered (e.g., single family, multifamily, condominium, commercial, industrial or new development under construction) and consider site-specific issues, such as whether the property is vacant or occupied and whether eviction of the borrower or any tenants will be necessary. Also, a bank should identify any available non-real estate collateral (e.g., machinery, equipment, inventory or receivables) and determine the best course of action to proceed against the non-real estate collateral, such as taking possession of the collateral or selling it pursuant to a UCC sale.

One of the first steps a bank should consider is to order minutes of foreclosure from a reputable title company in order to confirm the bank’s lien priority and to determine whether there are other liens or encumbrances of record against the property. Further, a bank—or professionals hired by the bank—should assess the condition of the property to identify building code violations or structural or environmental issues affecting the property. The bank should also discuss with its legal counsel potential liability that may result.

Regarding insurance, it is important for a bank to confirm that coverage on the property has not lapsed. If it has, the bank should consider force-placing the insurance coverage, as is generally permitted under a bank’s loan documents. Additionally, a bank should determine whether insurance policies covering the property require that the carrier be notified of anticipated or actual foreclosure or vacancy. A bank should also make certain it has complied with any obligations under the loan documents to pay the property insurance premiums from escrow.

Time and Expense

It is critical that a bank understand the time and expense involved in a judicial foreclosure action. Litigation costs will include, but are not limited to, court filing fees, costs for standard “service of process” on all of the borrowers and guarantors (and in some cases, a special process server where the borrowers and/or guarantors avoid service of process), costs of notice and publication, attorneys’ fees and possibly receiver costs. A bank should have a general idea of how long the foreclosure action will take, from filing the initial complaint through judgment and delivery of a sheriff’s deed. In some jurisdictions, such as Cook County, the high volume of foreclosure cases flooding the courts could easily result in a 12-month to 18-month judicial foreclosure process. The case management system recently implemented by Cook County’s Chancery Division could delay that process even further.

Taking Possession

After obtaining the legal right to take possession of the real estate collateral, either by agreement or by judgment, a bank should consult with legal counsel to confirm the proper steps to physically take possession of the property (e.g., enter the property, evict the borrower and/or tenants, change the locks, etc.). Problems are likely to arise if a bank utilizes self-help measures to enter the property, change locks or evict occupants prior to receiving the necessary authority from the court.

Once a bank has taken physical possession of the property, it should secure the property as necessary to maintain the value of the collateral and to prevent theft and vandalism. Also, a bank should check the municipal ordinances that may affect the property, such as the City of Chicago Vacant Building Registration Ordinance (Section 13-12-125 of the Municipal Code of Chicago). This ordinance requires owners of vacant buildings to file a Vacant Building Registration Form within 30 days after a building becomes vacant and every six months thereafter. Among other things, it also requires that owners pay an annual fee of $250, enclose and secure the building, post required signage on the building and maintain sufficient liability insurance for the property. Failure to comply with this ordinance may result in fines and other penalties. Additionally, a bank taking possession of real estate collateral should generally hire a property management company, construction manager and/or receiver to oversee the property or project.

A bank should also evaluate whether to appeal the taxes on foreclosed real estate collateral. Tax appeals should be filed as soon as possible after a bank receives title to the property (or earlier, if permitted). In some instances, real estate tax relief may be available due to building vacancy and/or a decrease in the value of the property. In addition, depending on the property type, its condition and the duration of any vacancy, the property may be eligible for certain real estate tax incentives, such as a Class 6b classification for industrial property.

The factors detailed above are just a sampling of the many issues a bank should consider prior to, during and after foreclosing on real estate collateral. The foreclosure process is complex and banks are not in the business of owning and managing real estate. Therefore, it is imperative that a bank consult legal counsel and other professionals throughout the foreclosure process in order to secure, maintain and manage the property; to preserve the value of the real estate collateral; and to realize the highest return on its eventual sale.

Steven L. DeGraff represents developers, owners, entrepreneurs, closely held businesses and institutional lenders in acquisitions, dispositions, financing, leasing transactions and other commercial real estate matters. He also has extensive experience in a broad range of financial distress issues, which include negotiating and facilitating favorable results in workouts of financially troubled loans. Steve can be reached at 312.521.2683 or sdegraff@muchshelist.com.