Real estate ownership, both residential and commercial, frequently involves financing some portion of the purchase price with a mortgage loan. Should an owner stop making payments to a lender, the lender can attempt to recover the balance of the loan through foreclosure: the forced sale of the property at auction, often at a below-market price. This presents opportunities, but also risks, for real estate investors. Understanding the foreclosure process and the potential liabilities involved is essential for California real estate investors who are interested in “distressed” properties.
What Is a Foreclosure?
To understand the foreclosure process, one must understand the parties involved in real estate purchasing and financing. The sale of real estate begins with a seller and a buyer. Since few people have enough liquidity to afford to pay a purchase price in cash, a buyer must obtain a loan. The lender effectively becomes the third party to the transaction.
The buyer, also known as the borrower, arranges for a mortgage loan prior to the closing of the sale. At the time of closing, the seller executes a deed conveying the property to the seller. The buyer/borrower typically executes two documents, both involving the lender:
– A promissory note, which sets the terms for repayment of the mortgage loan; and
– A deed of trust, which places a lien on the property in the lender’s name.
The lender now has the legal right to foreclose if the borrower fails to make timely payments. California allows two types of foreclosure: judicial and non-judicial.
Non-Judicial Foreclosure
The most common type of foreclosure in California is known as “non-judicial” foreclosure because it does not require direct court involvement. A lender may use non-judicial foreclosure if the deed of trust contains a “power-of-sale clause,” which gives the lender the right to force a sale of the property.
The lender, through a trustee identified in the deed of trust, must follow a series of steps established in the deed of trust and by state law. This includes a notice of default to the borrower, followed by a notice of foreclosure if the borrower fails to cure the default. The trustee then publishes a notice indicating the time and place of the foreclosure auction.
Once a non-judicial foreclosure is complete, the borrower has no further rights to the property, unless they can prove that the foreclosure was unlawful or wrongful in some way. This might include fraud or false statements by a trustee or a continuance of the foreclosure after the borrower successfully cured the default. The burden is on the borrower to file suit and prove these allegations by a preponderance of evidence. A buyer at a foreclosure sale therefore risks the possibility of involvement in litigation by an allegedly aggrieved borrower.
Judicial Foreclosure
Judicial foreclosure is rare in California, and typically it only occurs when a deed of trust lacks a power-of-sale clause. The lender must file a lawsuit and obtain a court order allowing a foreclosure sale. The auction process is largely the same in both types of foreclosures, except for one critical difference: A borrower who loses their property in a judicial foreclosure has a one-year “right of redemption,” meaning that they can buy the property back from whoever purchased it at auction within one year.
