“Can I just give the bank a deed in lieu?”

Plenty of collateral? Suppose John Doe and Peter Doe want to start a mini-warehouse facility. They start a limited liability company called Doe & Doe, LLC, and go to Main Street Bank to borrow the $1,000,000 they need to buy the land they’ve picked out and build their buildings.  The LLC signs a promissory note that is interest only for the first 18 months, and John and Peter both sign personal guarantees of the LLC’s debt. They give the bank a mortgage on the entire property, and off they go. They have the value of their property pegged at $1.5 million when completed, so if things do not go right, they feel comfortable that there will be plenty of collateral for the loan that should satisfy the bank.

John and Peter do not know it, but UHaul is in the process of planning a modern, multi-story, climate controlled storage facility across town at the same time, and it will compete directly with theirs. UHaul’s facility opens a few months after John and Peter’s, and they find it impossible to attract tenants despite a dedicated and expensive marketing campaign. Six months after their warehouses open, they are out of cash and options.  They start falling behind on their payments to the bank and see no future in their project. Having talked to their developer friends, they have a plan to simply give the collateral back to the bank and call it even. They go and talk to their banker and raise the possibility of a “deed in lieu.” The banker says he will have to get back with them. The bank has the property appraised. The banker calls them back with bad news; the property appraised for [gasp] $750,000! It seems that UHaul’s facility has really put a dent in the local mini-warehouse market.

What is a deed in lieu? In these economic times, the “deed in lieu” has taken on almost mythical proportion. Everybody has a friend of a friend of a cousin’s friend who “just gave the property back to the bank and walked away.” In reality, deed in lieu transactions are much more complicated, and to say the bank is going to take the collateral back is only part of the analysis.

When a Georgia borrower takes out a loan secured by real estate, he “owns” his property so long as he pays the debt to the bank in a timely fashion. However, if the debt is not paid off, then the bank has the right to foreclose against the property, i.e., sell it on the courthouse steps to the highest bidder (the highest bidder is most often the bank that made the loan in the first place). The foreclosure process can be expensive and complicated for the bank. The prospect of an ad running in the local newspaper talking about loan defaults and foreclosure sales (a necessity in any non-judicial foreclosure) is embarrassing and something most borrowers want to avoid. So, the borrower and bank can often agree that the borrower will sign a deed – a “deed in lieu” – whereby the borrower transfers his interest back to the bank and foreclosure is avoided. But what about the debt that gave rise to the problem in the first place? The deed in lieu, standing alone, is not a silver bullet that is going to kill the entire debt. Let’s return to our hypothetical.

How do we resolve the debt? There can actually be situations where deeds in lieu are unfavorable to the borrower. While Peter and John missed the mark on their valuation of the collateral, if they had been right and the property had been worth $1,500,000, then their simply giving the property back to the bank would result in a $500,000 loss to them (the $1,500,000 value of the property less the $1,000,000). If the bank could find a buyer at $1,500,000 two weeks after the deed in lieu is signed, then it would recognize a $500,000 windfall at John and Peter’s expense. John and Peter would prefer to put the property on the market, sell it for $1,500,000, and pocket the $500,000 at closing instead of the bank getting it. Sometimes that may not be possible because of the time it takes them to sell and the unwillingness of the bank to wait on a loan that is in default, but the point is that any borrower considering a deed in lieu first needs to know what the collateral is worth.

But collateral valued above a loan amount is a luxury that not many commercial property buyers have given the rapid fall of values of most categories of property following 2008 and the slow recovery once the markets bottomed. This is the situation that John and Peter find themselves in. As soon as Main Street Bank gets the $750,000 appraisal back, even assuming it is willing to take the collateral back, which is not always a safe assumption (see this article), then the next question the bank will ask is, “What are you guys going to do about the $250,000 deficiency?”; i.e., how will John and Peter pay the $250,000 difference between the $1,000,000 loan amount and the $750,000 collateral value? If they are smart, before John and Peter will sign the deed in lieu, they will demand that the bank release them from the remainder of the debt. Especially where John and Peter filled out personal financial statements when the loan was made showing significant personal assets (a likelihood given that the loan was made in the first place), the bank will resist that request. Though there are rare cases where the bank will conclude that it has no chance of collection against John and Peter and accept their request to cancel the rest of the debt, that is the exception and not the rule. In this situation, it is likely that the bank will look to John and Peter to write checks to satisfy the balance if they are able.

As you can see, in John and Peter’s case, the seemingly simple “deed in lieu” gets complicated. If they are smart, John and Peter will hire a qualified lawyer to help them through the process. That lawyer will help them negotiate the appropriate settlement and then draft the necessary documents to make sure that their interests are protected and that the debt does not haunt them in the future. Complicated issues will often arise during the process pertaining to liens and other title issues that the attorney can help resolve. The bank will have many questions about the status of the leases and tenants and will ask for certifications regarding the status of the property. The bank will also often ask for representations and warranties in the closing documents about, e.g., environmental issues on the property, and those must be carefully considered and negotiated, preferably with counsel. So, even once a deed in lieu has been agreed on and a settlement of the deficiency reached, complex issues will likely arise in getting the deal closed.

Deeds in lieu of foreclosure can be a useful tool for resolving a debt, but they are no panacea. If you have a loan in default and want to approach your bank about giving your collateral back, then seek the advice of a qualified attorney first. Understand the upsides and downsides to the idea before you present it and know that you are initiating what can be a very complicated conversation.

 

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