How Hypothecation in Real Estate Works
How Hypothecation in Real Estate Works
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Hypothecation is a fancy word for borrowing money against a promissory note. Sophisticated investors use it to leverage cash-on-cash return. It is an area that savvy Colorado investors are using more and more today to raise money for purchasing bargain-priced, bank owned properties.
This smart use of Colorado hard money is allowing a select group of investors to take advantage of this new opportunistic area of real estate finance.
What is Hypothecation in Real Estate?
Hypothecation in real estate refers to the practice of using a loan or debt as collateral to secure further financing. This strategy allows investors to leverage existing assets to acquire additional funding.
Investors use hypothecation to buy bank-owned properties that are priced below market value. By using the loan documents of one property as security, they can raise capital to purchase these discounted properties, potentially leading to significant returns on their investment. This method is particularly effective for acquiring properties in foreclosure situations, where quick access to funds is crucial.
Bank Foreclosure Properties
No one knows the total number of bank owned properties that are in default, but we do know the number is very large. Once a borrower defaults on a property and the bank takes title to the property, it is well known that they are likely to suffer a significant loss in selling it.
First, they have to go through the foreclosure process to get the title. Next, they have to deal with the eviction of the homeowner – a process that doesn’t earn the bank many friends. Then, they turn the property over to their REO (real estate owned) division to clean it up, suggest resale value, and find a Realtor to sell it. Buyers that bid on bank owned properties typically offer far less than fair market value.
In order to avoid all of the difficulties above, many banks are now willing to sell the Promissory Note and Deed of Trust on their defaulted loans to investors at a discount. If the bank sells the Note, then the purchaser of the Note has to deal with completion of the foreclosure, eviction of the tenant, clean-up, and resale of the property. This can be an attractive alternative to the bank, and a good investment property opportunity for a buyer.
How a Colorado Hard Money Lender Can Help
The investor however has one significant problem to resolve before making a bid to the bank to buy the Note. Where are they going to get the money? If the investor has 100% of the funds in their checking account – no problem.
Otherwise, an investor in Colorado may be well advised to talk with a hard money lender, like Montegra, to see if they can obtain a portion of the purchase price by “hypothecating” the Note they intend to buy from the bank.
Example of Using Hypothecation with a Bank Foreclosure Property
Here is how using hypothecation with bank foreclosures works in Colorado. Investor “John Sharp” makes an agreement with “First Imaginary Bank” to buy their Promissory Note and Deed of Trust on a house now in foreclosure. The bank’s original Note amount is $200,000 but they will sell this Note to John for $150,000 – all cash – if John can close quickly. John believes the value of the house today is $225,000 so there is a substantial profit to be made. However, John only has $90,000 in cash. John can turn to a Colorado hard money lender, like Montegra Capital, to see if they will lend him the additional $60,000 cash he needs for the bank’s $150,000 sale price.
We’ll assume John decides to go with Montegra Capital for the additional cash. Montegra would discuss funding a loan to John where the bank transfers ownership of the Note to John (after receiving their $150,000 in cash). John in turn assigns the Note and Deed of Trust to Montegra as security for the loan – secured not by the real property (yet), but by the actual Note and Deed of Trust. Through a somewhat complex process, Montegra allows John to complete the foreclosure and take the actual title to the house.
Once the title is transferred to John by the Public Trustee, then John will give Montegra an actual Deed of Trust on the property. John, having obtained a one year loan from Montegra, evicts the former owner, cleans up the property and does minor remodeling. Then John is able to list the property for sale and realize close to its fair market value of $225,000. With a purchase price for the property of $150,000, plus the added remodeling costs and loan costs, John Sharp still makes a good profit on his invested dollars.
Buying Property at a Public Trustee Sale
More often investors are looking at buying foreclosed properties by bidding on them at the Public Trustee Sale. Again, if the investor has 100% of the cash necessary to make the bid then there is no need to look into borrowing funds. However, if the investor needs a loan to make up part of the bid, then the process can get complicated fast. This is another real estate situation where a hypothecation agreement can be used.
How a Public Trustee Sale Works
Before discussing how to borrow the money, first let’s review how the Public Trustee sale works. In this situation, a private investor can bid against the bank that is foreclosing and end up owning the property.
Roughly 4.5 months after a bank (or any lender) declares a loan in default and sends it to the Public Trustee for foreclosure, the Trustee holds a public auction where anyone can bid on the property against the lender. The lender is entitled to an automatic bid of the full amount of their loan principal, all default interest, and any legal and other costs they incurred.
Example of Hypothecation and a Public Trustee Sale
Here is an example scenario of hypothecation and a public trustee sale. John Sharpe bids against First Imaginary Bank to try to get title to a property. First Imaginary has given a loan to Joe Go to buy a single-family house located at 123 Happiness Lane. The home is for sale for $450,000 and the loan amount given to Joe was $300,000. Joe gave $150,000 in cash as a down payment, but then decided not to make the rest of his payments. First Imaginary filed a foreclosure (as they were entitled to do) and after the appropriate time period, the Public Trustee is selling the foreclosed property at auction.
First Imaginary ran up an additional $6,000 in interest that they were entitled to and spent $4,000 on legal fees. First Imaginary is bidding $310,000 for the house. John values the house at $425,000 and sees a chance to make a profit. John therefore comes to the actual auction at the Public Trustee’s office and makes a bid of $311,000, which is $1,000 higher than First Imaginary’s bid. The Public Trustee now declares that John wins the auction and gives John one day to bring in $311,000 in certified funds.
When John brings in his good funds, then the Public Trustee delivers to John a document called a Certificate of Purchase, which shows that he now has the right to get a deed to the house at 123 Happiness Lane – subject to the right of anyone else that has a claim on this property that is junior to the Deed of Trust. The Public Trustee waits approximately 8 business days to see if any one that had a recorded interest in the house (like a holder of a 2nd mortgage) wants to come in and pay the full $311,000 back to John Sharpe. If someone did do this, then John gets all his money back and the 2nd mortgagor could end up owning the house. This doesn’t happen often, and in this example, we’ll assume no one did come in so after 8 business days so John Sharpe is given what is called a “Confirmation Deed” by the Public Trustee. As soon as he records it, he now owns the property. Not a bad deal – getting an investment property John values at $425,000 for $311,000.
Colorado Hard Money Lending Can Help
If you’re an investor in Colorado and looking for more information on how to use hypothecation to buy bank-owned properties, Montegra Capital can help. Contact us today to discuss your possible real estate investment opportunity.