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One example of where such an insurance policy might be worthwhile is on a high value house where you have a master lease option agreement, and any purchase might be several years away. If the property fell into foreclosure despite the best efforts of the owner, any option you would have on the property just evaporated, despite perhaps many years of taking care of that property. (Perhaps the owner was blindsided by losing a huge lawsuit, or by whopping medical expenses, or by devastation to his employer’s industry — things neither you nor s/he could foresee.)
The same issue might arise if you have a master lease option on a multi-family property. If after you’ve spent much effort bringing its value back up to its potential, you stand to lose a bundle of value if the same calamity takes place. There are probably tons of other such examples.
Does anyone have any experience with insuring the value (the appraisal value minus the option strike price, roughly, minus some small discount as a disincentive to promote such foreclosure) in such an option (properly drafted and registered), or know of some substantial reason why this might not be possible?
Yours,
Dee Graber
Frisco, TexasThank you, Don, for your interest in this puzzle. I have both of Jack Miller’s options courses, and the most relevant discussion I could find that addresses the foreclosure hazard to an option is in Course 2 (the Advanced package), on page 15 of the printed manual (which is part of his multi-page option agreement). His solution is a provision in his option contracts that in the event of foreclosure or bankruptcy, any rights of redemption the Optionor might have will transfer automatically to the Optionee. The problem with that in Texas (and who knows what other states) is that rights of redemption only exist for property tax foreclosures, but NOT for mortgage foreclosures.
So it appears that Jack’s solution is very state-specific to whichever states might have such rights of redemption in mortgage foreclosure cases.
That doesn’t mean that I might not have missed some other solution of Jack’s throughout the two courses, but so far it seems that my insurance approach, if feasible, is still on the discussion table.
First, about the right to make the mortgage payments — that might work on a residential property. But it’s not likely to work on a multi-family (5 units or up) commercial property. The banks are catching so much flack from the federal government (FASB rulings, OTS (Office of Thrift Supervision)pressure, and even some FDIC pressure that some of them are being forced to foreclose when the borrower is violating any of the loan covenants in even the slightest little way — or even if the bank suspects those loan covenants “might” be violated in the near future. I know of one commercial borrower in the DFW area with a $5M loan who has never ever been late, but his debt service coverage ratio (safety margin) is just on the razor-thin side of the “not quite enough” contractually required line. This is insane. The bigger the bank, the worse it gets. All the TBTF banks can suck on an FDIC subsidy that mandates foreclosing if the bank wants the full amount of the subsidy — and that subsidy can also apply to residential property as well. If anyone had an MLO on that property, the option would soon turn to toast. Simply making his payments wouldn’t kill the foreclosure.
Second, about the kind of insurance I was contemplating. I was hoping there might be some commercial insurance company (since an MLO deal is a commercial project regardless of whether the property is residential or commercial) with some experience in insuring the option (more likely from the totally commercial side since that’s where the expertise in master leasing originated, and the volume of options there over the decades would dwarf the historical volume of Tilney style MLO business transactions. But that’s just my hope and guessing.
Third, based on what I’ve learned about that deadly FDIC subsidy (called a “shared loss agreement” or SLA on the FDIC website, I would not even bother approaching a property owner whose lender had access to that SLA subsidy potential, and neither would any reasonable insurance company. But if one sticks to the smaller banks, the portfolio lenders, who don’t sell their loans into the secondary market where rules from the federales lurk (and that can include some slightly larger regional banks), an MLO deal could make a lot more sense with much less risk.
So the search for a commercial insurer who might consider covering the growing value of an option in an MLO deal continues….
—Dee Graber
I forgot to mention another type of loss that could apply to EITHER residential property or commercial. That’s the civil asset forfeiture racket, which netted several levels of government last year about $2.5 Billion, spread over some 15,000 cases. One of the personal episodes that brought this hazard to my attention was when I had to clean up the remains of a drug lab in my rent house on a quarter section of farm land. Had the federales gotten to my skippees first, I could have lost the whole thing. And this was in the late 1980s. Here are a lot more details from a news story this morning:
http://www.thefiscaltimes.com/Columns/2012/07/23/How-the-Feds-Can-Take-Your-Property.aspx#page1
And no provision in an option contract to take over making payments to a lender could stop this kind of loss — again whether residential or commercial property is at risk. Hence my inquiry into a commercial insurer solution for MLO deals. I see the issue as no different from the need for fire insurance on a house being rehabbed. Some investors “go bare” and some don’t. How much would you tolerate at stake “going bare?” My thought is the higher the value at risk, the less my tolerance for risking it. Would you agree?
—Dee
Your insurance (safe guards) would come by two things:
(1) You should always insist on making the payments on the underlying loan if there is one.
(2) your option should be secured with a recorded deed of trust/mortgage which puts you in to a junior lien holder position. If there is a default, all junior lien holders have to be notified.
You can be named as additionally insured on the insurance policy to insure against natural disasters, fire. etc. But that’s the only kind of insurance you can get.
Put protection in to the deal by controlling all the moving parts. Don’t let fear of problems stop you from doing deals.
First, I genuinely appreciate everyone’s interest and participation in this puzzle about ways to protect a long term option.
Now, Jackie, you may well be correct that no insurance is available to protect an option against foreclosure. There’s more to this puzzle.
It also may well be the case that having the right to make the payments (upon an owner default) may be sufficient to protect an option for residential property, though I’m not so sure as the dollars involved go up, as in Jumbo residential loan.
Here’s what I’m seeing on the commercial side. A north Texas bank is in deep doo-doo with the federal banking regulators, and is desperate to raise cash, or cut the mandate they’re under to get loans off their books, either by foreclosing, or by being such jerks that they persuade the borrower to get a replacement loan. When the borrower, who had never ever missed a payment, couldn’t find a refi, the bank tried several times (I can’t disclose exact numbers) to foreclose by lying to the court that the borrower was in violation of other loan requirements. He wasn’t, but had to spend big bucks in several court fights (some still ongoing) to stiff-arm that bank. Had I had an option on that property, simply making the payments would not have stopped the legal court fights. The loan balance is in the mid $3M range, not unheard of as well on residential properties in high end communities.
Had a bank tried that stunt repeatedly on a residential property under a master lease option as David Tilney teaches, simply making the payments and being notified of an alleged default wouldn’t have touched the problem. And it certainly wouldn’t have solved the problem with a master lease option on commercial property, where Tilney explained that he learned the MLO processes.
I came into this puzzle by learning about how the banks (beholden to federal regulators) are being crippled by new FASB (Financial Accounting Standards Board) rulings putting them under grossly unfair rules, and the OTS (Office of Thrift Supervision) mandates to raise cash that are being slapped on those banks. As a result the banks sometimes use dishonest ways to behave toward legitimate, honest and capable borrowers. If there’s anything I’ve learned looking at the commercial side, it’s to do extreme due diligence on the condition and regulatory pressures on the lending bank — before considering a LONG TERM option (whether part of an MLO deal, or a standalone).
There are also some nasty stories in the press about Bank of America foreclosing illegally on a number of residential properties. BofA, being one of the TBTF banks which can get away with regulatory feather slaps, will have an FDIC tax subsidy in place called “Shared Loss Agreement” (or SLA fund) which, if they foreclose, can suck on an extreme FDIC fund to make up any loss they would suffer on that foreclosure, plus pick up some handsome profit on top. I’ve already seen ex-Wall Streeters form banks for the purpose to milking that SLA money, and foreclosing on borrowers who have the ability to do a legitimate loan workout. The dickens is that the SLA money can be applied to both commercial AND residential foreclosures. Hence the need to do extreme due diligence on the lender before doing any kind of long term option (or MLO) deal. Smaller local and regional lenders generally don’t have access to that SLA slush fund.
(I don’t see these concerns being relevant to short term options, such as what we use for quick turn highest bidder sales.)
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