February 28, 1994 - From the February, 1994 issue

Legal, Financial Obstacles to Rebuilding L.A.’s Housing Stock

The Northridge earthquake will force the Los Angeles government agencies, lenders, private industry, landlords, and tenants to work together to rebuild the housing stock. Jennifer Shawa graduate of Georgetown University Law Center and a partner in Saltzburg, Ray and Bergman of Westwood, California, argues that the current mortgage loan defaults will delay this cooperative rebuilding process. Mrs. Shaw's comments are based upon her experiences in dealing with land use and redevelopment casts, and complicated mortgage loan defaults during the last three recessions and two major earthquakes.

Prior to the Northridge earthquake, mortgage lenders customarily did not require apartment or commercial building owners to carry earthquake insurance. As a result, substantial damage to apartment buildings in the San Fernando Valley and other parts of the region, as well as owner's failure to carry earthquake insurance to fund repairs, may lead to hundreds of foreclosures in the next year, leaving the rebuilding of Los Angeles' housing stock in the hands of the lending community or the city, but only after much delay. 

Prior to the earthquake, for example, a building might have a fair market value of $4,400,000, and a mortgage loan balance of $3,900,000. The building's owners hold title as general partners and are personally liable on the mortgage loan. As is common in most of Los Angeles, on the date of the earthquake, the owner had little equity, i.e., a 95% loan to value ratio, since the value of apartment buildings has steadily declined during the recession. And now, with $100,000 in repair costs, they have no equity. 

Unfortunately, this could been a very real scenario for many properties owners in Los Angeles with no equity in their property when the cost of earthquake repairs is factored in. As a result, the owners have no incentive to pay for repairs, and may simply allow the mortgage lender to foreclose, producing in the interim, boarded up and abandoned building all across Los Angeles. Furthermore, since most mortgage payments are not due until February 1st, the default process may not begin until mid-April and if the lender’s workout department is backlogged in analyzing and action on defaulted loans, even more delays in beginning the foreclosure process will occur. 

As most property owners know, after a lender files a Notice of Default with the County Recorder and takes other procedural steps, a trustee’s sale foreclosure on a vacant building can occur within approximately 120 days, assuming no resistance by the borrower. If the cost/benefit analysis tells the lender to demolish, or if the building is simply unrepairable, the lender is not likely to take any steps to take possession of the building or demolish it until after the foreclosure. If this process is undertaken, the timeline to rehabilitate the housing or land has extended to mid-August of this year. 

If the lender determines that the building should be repaired and re­rented, the lender will follow the second track in the foreclosure process, filing a lawsuit against the borrower. Such a suit would allow a receiver to take possession of the building prior to foreclosure in order for the lender to then spend additional funds to repair the building prior to foreclosure. Thus, in this second track the lender could rehabilitate the building to re­rent the building, and ultimately collect rents from new tenants. However, if a lender gains possession of a building that is severely damage or demolished, the lender has little incentive for the appointed receiver of the property to order a "tear down" since there is no economic harm to the lender in demolition delay. Thus, the city and the building’s neighbors goals of quick clean-up and neighborhood renewal are contrary to the lender's likely decision making. 

Still another legal track to pursue is a judicial foreclosure, a lawsuit against borrower, general partners and guarantors to hold them personally liable for the “deficiency”, which is the difference between the amount due on the loan, including the repair or demolition costs, and the fair market value of the property at the time of the foreclosure. If the lender is sincere in its intention to obtain a deficiency judgment, the lender cancels its trustee’s sale, and waits for a trial date on its lawsuit. That waiting time is approximately one year. As a consequence, if the lender has determined that the building is a tear-down, and decides not to take possession before foreclosure, but wants a deficiency judgment against the borrower, the foreclosure trial probably will not be held until May or June of 1995 or a year and one-half after the quake. 

The trial is usually relatively short, since the borrower, guarantors and general partners generally have no defense to their obligation to pay the loan. However, it is important to keep in mind that the lender may then use its deficiency judgment as the basis for recording liens against and foreclosing on other assets of the borrower, its general partners and the guarantors. However, the recoveries go to compensate the mortgage lender for its loss, not to rebuild the community

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What one is likely to see as a result, is property owners offering to surrender earthquake damaged buildings to mortgage lenders, who in turn, will most likely refuse to lake the property back and refuse to release the borrower. Another likely scenario is the lending institutions offering to lend to property owners the funds for repairs with a reduced interest rate and a delay in the loan’s final due date, so that the post-repair rental income form the building matches the monthly payment on the loan. 

To date, California banks have made generous offers of loan work-outs and new loans to repair earthquake damage. However, in reality, to the extent that Los Angeles apartment buildings had little owners' equity prior to the earthquake, most property owners would have no equity or negative equity post-earthquake. With "bad" loan to value ratios, banks, savings and insurance industry regulations discourage further real estate lending, with the final cost being the continued community blight. And while alternative repair loans such as FEMA/SBA loans and commercial loans are available for repairs, they also carry with them the stigma of personal liability to repay the loans. That sort of additional risk-taking is not always palatable to guarantors and general partners in a post disaster rental market, where tenants are moving away, and market rents are declining. Further personal liability for disaster repair loan repayment often encourages building abandonment rather than rebuilding. 

Of course, there is also the option of filing Chapter 11 bankruptcy for the borrowing entity, in cases where lenders refuse to lend funds for additional funds to make repairs or change payment terms to reflect losses of tenants and declining market rents. However, while the court has the power to change payment terms, it does not have the power to force the reluctant mortgage lender to fund new dollars for earthquake repairs. As a consequence, in the case of a severely damaged building with no tenants, the Chapter 11 process could turn a recalcitrant mortgage lender into a more realistic one. 

Many landlords faced with a damaged building may simply decide to "walk away" from the damaged property, but should beware that they may receive a notice from the city indicating that the landlord is financially liable for the city's impending demolition of the building. As a practical matter, as long as the landlord/borrower is the party shown on the land records as the owner of the building, they are the one responsible to the city. 

Needless to say, all of the legal maneuvering by borrowers, lenders, receivers and bankruptcy trustees are designed to protect their own economic interests, and can have a seriously detrimental effect upon the desirability of the neighborhood surrounding damaged, abandoned buildings. The delays inherent in the system negatively affect the market value of homes and apartments which otherwise escaped from the earthquake unscathed. There is virtually nothing individuals or groups of affected neighbors can do, directly, to intervene and protect the value of their neighborhood. However, the various municipalities affected by the earthquake do have the opportunity to use their police and eminent domain powers to demolish and acquire abandoned, earthquake damaged properties, and also make use of the redevelopment process and the redevelopment agency's powers to raise money through municipal bond sales to make cleared land available for sale and rebuilding. 

Finally, in order to avoid destruction of earthquake damaged neighborhoods through abandonment, decay, and vandalism, cities should be aggressive in sweet-talking or arm-twisting mortgage lenders to fulfill their "higher civic duty" to quickly take possession of abandoned damaged buildings through receivers, and to diligently demolish or repair pre-foreclosure. Cities must also be aggressive in taking physical control of abandoned buildings when it is reasonably clear there is no intent or ability to finance rebuilding on the part of the landlord or mortgage lender. Rebuilding the region’s housing stock will take unprecedented cooperation between government agencies, lenders, private industry, and landlords and tenants, but it must be a priority to sustain Los Angeles neighborhoods damaged in the Northridge earthquake. 

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