Calculating Your Upset Price Before You Buy: The Costs Every Investor Should Identify Before Purchasing Mortgage Notes in Foreclosure

July 2010Newsletters In the Zone

As an investor, if you are purchasing a defaulted mortgage note, you generally intend to make a return on your investment in one of two ways: either by receiving a payoff from the borrower in an amount that exceeds the purchase price of the note, or by foreclosing on and selling or operating the mortgaged real estate at a profit. When your goal is the latter, it is particularly important to identify upfront some of the often overlooked costs that may accumulate as you move through the foreclosure process.

Before a sheriff's sale, a lender will carefully calculate its "upset price" – the amount that the lender is owed by the borrower. Usually, the "upset price" is the sum of the outstanding mortgage and any interest and fees and other costs accumulated since the start of the foreclosure process. If only an investor could know what its "upset price" would ultimately be before it purchased the defaulted mortgage note, the investor could know whether the investment would be profitable. Unfortunately, we cannot see the future. But, by knowing the types of costs that can arise during the foreclosure process, an investor can make an informed decision as to whether to purchase a defaulted mortgage note and at what price.

Prior Liens and Municipal Water and Gas Charges

Before making an offer to purchase a defaulted mortgage note, one of the first things an investor should do is determine the amount of the liens that have priority over the mortgage by obtaining a title search of the property. These items include real estate taxes (current and delinquent), municipal claims (such as some licensing violations), and gas and water and sewer charges (current and delinquent). It is important to know what these amounts are since they will be paid by you if you purchase the property back at the sheriff's sale or, if the property is sold to a third-party bidder, they will be paid before any distributions are paid on account of your judgment against the borrower.

Realty Transfer Tax

Generally, sheriff's deeds to the foreclosing lender are exempt from realty transfer taxes. In Philadelphia, however, if you are not the original lender and you purchase the property back at a sheriff's sale, the sale will be subject to the realty transfer tax. The Philadelphia realty transfer tax is three percent of the computed value of the property. Considering the potential transfer tax when you formulate the purchase price for the defaulted mortgage note is important as it can mean tens of thousands of dollars you did not otherwise plan to spend.

Sheriff's Poundage

In most counties, the sheriff's poundage (or the sheriff's commission) is equal to two percent of the bid price up to $100,000 and .05 percent of any amount above $100,000. In Philadelphia, the sheriff's poundage is eight percent of the bid price up to $5,000 and then two percent on the remainder. The sheriff's poundage is paid before any distributions are made to the lender. And, when the mortgaged property is purchased back by the lender, the lender must pay a sheriff's poundage based on the other costs of the sale (i.e., realty transfer tax, liens, judgments, recording fees, etc.).

Costs of Delays

Time is money. This old cliché proves true with respect to purchasing defaulted mortgage notes if the foreclosure process is delayed. Delays can mean increased attorneys' fees and, if you as the lender have control of the property, delays can also mean additional months of maintenance fees, insurance payments and other costs of operating the property. A borrower can delay the foreclosure process by, among other things, petitioning to open the judgment, petitioning to postpone the sheriff's sale or by filing for bankruptcy. As a result, it is important to consider at the outset whether the borrower will delay the process. During your due diligence, you may be able to get an idea of whether the borrower is likely to delay the foreclosure process. For instance, a borrower that has greater equity in the mortgaged property may be more likely to delay the foreclosure process than a borrower that has no equity and is willing to walk away from the property without a fight.

Delays may also necessitate the court filing of a Petition to Reassess Damages, which is filed when the judgment entered against the borrower no longer includes all of the costs the lender has incurred to date, such as accrued interest. Petitions to Reassess Damages are particularly important where the property has an appraised value that is greater than the judgment amount and is likely to be bid on by third parties at the sheriff's sale. This is because if the property is sold to a third party at the sheriff's sale, the winning bid amount will be distributed first to pay the sheriff's costs (including prior liens, poundage, municipal charges, transfer tax, etc.) then to pay the lender in the amount of the judgment, and then any balance will be paid to other creditors or the borrower. If you as the lender have not filed, and been granted, a Petition to Reassess Damages to update your judgment before the sheriff's sale and the property is sold to a third party, you may not recover all of your costs.

When added together, these often over looked costs can be significant and can affect an investor's bottom line returns. But by considering these costs before you commit to purchasing defaulted mortgage notes, the better off you will be down the road.

For more information, please contact Lauren W. Taylor at 215.918.3625 or [email protected].