Tom Gimer

Let’s face it. If a seller is willing to sell a property to a buyer subject to an existing mortgage (which will remain on their credit), they probably have some financial problems they are trying to solve. And the unaffordable mortgage may not be the only thing troubling them. The prospect of that financially-plagued seller filing for bankruptcy at some point in the future must be considered by a subject-to purchaser.

The third risk I identified in my 2022 article about subject-to transactions was the seller filing for protection under the bankruptcy code. But why would a seller BK affect the buyer? The property has already been sold and therefore it’s not part of the debtor’s BK estate.

Unfortunately that doesn’t matter.

When the seller files for bankruptcy, he or she will have to inform the lender holding the mortgage note. In order to protect its interests, the lender will file as a secured creditor in the bankruptcy case. It is at this point that the lender will almost certainly discover that the property has been transferred out of the seller’s name… the liability shows on the debtor’s schedules but the property is not shown as an asset. The restriction on alienation (due on sale clause) has obviously been violated, and when faced with that scenario most lenders will choose to foreclose for the reasons pointed out in the prior post. Because the borrower covenants in the mortgage / deed of trust have been breached, the lender has the right (and perhaps the obligation, depending upon the lender’s circumstances) to pursue foreclosure.

The underlying issue common to all risks associated with sub-to is the buyer needs to be able to pay off the mortgage upon demand. And that demand can happen at any time… not always because of something the buyer did wrong.

Returning to this topic, the second issue of concern that I raised regarding subject-to transactions was the failure to have a good exit strategy in the event the loan balance is accelerated by the lender.

Once a lender discovers that the property has been sold without paying off their loan, they may decide to invoke what is known as the “due on sale clause”. Most mortgages/deeds of trust contain a DOS clause. It gives the lender the right — not the obligation — to demand payment in full.

A couple of questions might come to mind. First, how would a lender discover the transfer?

• name change on tax bill — since lenders monitor these records to be sure taxes are being paid, they would become aware of most title changes
• insured change on policy — lender would be notified since they are the mortgagee on the policy
• mailing address change
• monthly payment change that the buyer does not discover because they are not receiving notices
• automatic payments set up from an account named differently other than the original borrower
• seller admits the violation when contacted by lender

Second, why would a lender who is receiving timely payments care about the transfer?

• buyer is not bound to the covenants of the original loan
• compliance issues — loans pledged to FHLB would suddenly not be compliant; with loans sold to investors such as Fannie Mae or Freddy Mac the sub-to would violate seller/servicer agreements; fair lending scrutiny issues

So the issue of whether or not a lender invokes the due on sale clause and accelerates the loan balance (i.e., demands that the entire loan balance be paid within X days) often does not come down to simply whether a loan is performing (being paid on time) or non-performing. It’s a matter of the lender following regulations and contract terms.

What can a seller and buyer do when the due on sale clause is invoked? Pay the loan in full, either through cash on hand, refinance or resale. Don’t believe everything you read. There is no such thing as “due on sale insurance”. Nobody is going to step in and “fix” the situation once the lender demand has been made. It’s either pay off the loan or the property will be heading to foreclosure.

Last year around this time I wrote an article called “Subject to transactions on the rise” … and since that time mortgage interest rates have unfortunately continued to climb. As a direct result, subject-to as a strategy has exploded. Most deals that penciled a year ago just don’t work in today’s market. Values are still high, yet rates are the highest in ~40 years. But if you could keep the seller’s low rate in place, things still look great on paper. That means everything will work out perfectly, right?

My characterization “on the rise” was way understated. Many, many investors are trying to use the strategy. Plus it has become the shiny new thing REI gurus are teaching. Unfortunately, the gurus seem to be focused on sharing the strategy with inexperienced buyers as a way to get rich without having much cash. As a result, some of these inexperienced buyers are facing the potential problems I outlined in that post.

As promised, I’m circling back to discuss the main risks I identified with subject-to. Hopefully it will help you in your investing, or in dealing with a property you own.

I think subject-to is a great short-term strategy, even for new investors. It goes like this… buy subject-to existing financing, promptly take care of the improvements, and then resell at a higher profit than if you had to finance the acquisition. But that’s not how it’s being taught.

The first major risk I identified with subject-to was undercapitalization and buyer default. It’s just common sense that the buyer could default on payments, especially if the buyer intends to hold the subject property long-term as a rental. The longer the hold, the higher the risk. And if the buyer is undercapitalized – having little to no cash to respond if something were to go wrong, such is often the case for the new investors I referenced above – that’s where it can become a big problem.

If you’re an experienced landlord, you’ve learned to plan for and deal with tenant default. However, if you’re a new investor, tenant default may not be something you’ve adequately accounted for in your numbers. Evictions take time. Eviction attorneys are expensive. Clever tenants can hinder and delay the eviction process, especially in jurisdictions that are “tenant-friendly”. If a tenant defaults and eviction becomes the only solution, when the subject-to purchaser finally does regain possession of the property, it could be damaged. And after making any required repairs, finding a new tenant may not be quick and easy. Try finding a new tenant in the dead of winter! Of course through all of this, the mortgage payments still must be made. A single tenant default can create tens of thousands of dollars in unforeseen expenses and carrying costs with no rent coming in.

Even without tenant problems, the need to make large capital expenditures can materialize. Major systems and appliances fail. Roofs need replacement. The undercapitalized and unprepared subject-to purchaser may not be able to continue to pay the mortgage as well as the necessary expenses. Of course this can lead to default on the mortgage. If so, the seller’s credit will take a hit and the lender will eventually pursue foreclosure. It’s a potential disaster for all involved. And that’s before the lawsuits fly.

As a seller, how can you reduce the chance of your subject to deal going down this path? Don’t sell to someone who doesn’t have the financial ability to prevent it. Do your research on the buyer’s finances. Don’t sell subject-to to a buyer that doesn’t have significant cash reserves or at a minimum quick access to private money. And sell on a wrap or with a junior lien that can be foreclosed. Research the cost of foreclosure as a worst case scenario and factor that into your analysis.

As a buyer, how can you prevent the above? Don’t overpay for the property just to obtain the low interest rate. Have sufficient cash reserves or access to funding. And perhaps most importantly, know when to accept the loss, exit properly before the seller is damaged, and move on to the next investment.