"Foreclosing on Rental Property"
This article was provided to REALTOR Members by C.A.R.'s (California Association of REALTORS), Legal Department and is not intended to be used for Commercial purposes, merely

Table of Contents

 I.  Introduction

II.  Lender Issues

A. Lender Issues with the Owner (Questions 1-10)

1.  Rent Skimming
     2.  Before the Foreclosure
a. Mortgagee-in-Possession
b. Rents and Profits Clauses
3.  After the Foreclosure

  B. Lender Issues with the Tenants (Questions 11-20)

1. Before the Foreclosure
2. After the Foreclosure
a. When the Lease is Senior to the Lender’s Deed of Trust
b. When the Lease is Junior to the Lender’s Deed of Trust or Tenant has Periodic Tenancy
c. Security Deposit Issues

III. Owner Issues with the Tenants (Questions 21-22)

  A. Before the Foreclosure

  B. After the Foreclosure

IV. Property Management Issues (Questions 23-30)

A. Property Manager Issues with the Owner

B. Property Manager Issues with the Lender

C. Property Manager Issues with the Tenants

V. Conclusion (Question 31)

I. Introduction

When a lender begins a foreclosure, parties involved with the property in foreclosure may be uncertain as to how the process affects them. Not only are lenders often unaware of their rights and obligations, but borrowers (sometimes also referred to as "owner" or “mortgagor”) who are faced with losing ownership of property also are frequently lacking knowledge about the limit and extent of some of their basic responsibilities and rights.

When the foreclosed upon property is a rental, tenants are unwittingly forced into a position of uncertainty concerning their contractual and legal rights and duties. If the rental is managed by a real estate broker, yet another party may feel strained by the tension and possibly competing demands of the property owner, foreclosing lender, and tenant.

This legal article addresses some of the major issues faced by property owners, lenders, tenants and property managers involved with a foreclosure on rental property. Certain topics will not be addressed, such as the steps in a foreclosure, the circumstances under which a deficiency judgment may be obtained (see legal articles, Deficiency Judgments and California Law and Deficiency Judgment Chart), and discharge of indebtedness and other issues involved in a short payoff (see legal article, Short Sales), as these issues are germane to all foreclosure properties. Instead, the primary focus will be to highlight those areas of concern unique to rental properties.

II. Lender Issues

 A. Lender Issues with the Owner

1. Rent Skimming

Q 1.  What is rent skimming?

A  Foreclosures typically take place because a borrower does not make required payments pursuant to the loan documents. Foreclosing lenders are bound to be frustrated by an owner who is collecting rents yet not paying a loan. These lenders may want to try and stop the borrower from taking what they perceive as money which is owed to them. After all, isn't this rent skimming? And, isn't rent skimming a crime?

Rent skimming is defined as using revenue received from residential real property any time during the first year after acquiring the property without first applying the revenue to payments due on deeds of trust encumbering the property (Cal. Civ. Code § 890). Criminal penalties of up to one year in jail or up to a ten thousand dollar fine or both exist for rent skimming (Cal. Civ. Code § 892).  Thus, if it isn’t the first year of ownership, this remedy doesn’t apply.

Note:  There is also an “equity skimming” federal law; however, it is limited to residential one-to-four unit properties in default at time of transfer or in default within one year of transfer and those which are HUD properties, have HUD insured loans, or have VA loans. This federal law also requires a “pattern or practice” of purchasing such properties with an intent to defraud. (12 U.S.C. § 1709-2.)

Q 2.  What can a lender do, if anything, to respond to an owner engaging in rent skimming?

A  The decision of whether to pursue criminal action is in the hands of a government prosecutor (and outside the scope of this article). If rent skimming is involved, a lender can bring a civil action against the borrower for damages, costs, and attorney's fees. The court has the authority to also award exemplary (punitive) damages. (Cal. Civ. Code § 891(c).)

If the lender was a seller who carried back a loan (i.e., seller financing) and the borrower has engaged in multiple acts of rent skimming, a court must award exemplary damages of at least three times the actual damages (Cal. Civ. Code § 891(a)). The right to bring a claim based on rent skimming is not limited by either the one-action rule or anti-deficiency laws (Cal. Civ. Code § 891(g)).

2. Before the Foreclosure

Q 3.  Prior to foreclosure, what are the owner’s obligations to the lender?

A  Prior to title transferring at a foreclosure sale, the borrower has a contractual obligation to make the payments specified in the note. Aside from the potential criminal and civil issue of rent skimming, the borrower has no obligation to use the specific rents received to pay off the loan. If the lender wishes to gain access to the property as a mortgagee-in-possession the borrower can deny the lender permission. (Cal. Civ. Code § 2927.)  Similarly, if the lender attempts to peacefully exercise a rents and profits clause without bringing a judicial action, the borrower can prevent this voluntary exercise by refusing permission and instructing any tenants to continue making payments as called for in the lease and not to the requesting lender.

Q 4.  How can the owner defeat an action brought by the lender to appoint a receiver?

A  If the lender brings a legal action to appoint a receiver to enforce a rents and profits clause, the borrower can oppose the action. The appointment of a receiver is discretionary, not automatic (Cal. Civ. Proc. Code § 564(b)(8).) Where a rents and profits clause does not exist and the lender applies to the court for appointment of a receiver, the borrower may defeat the action if the borrower can show the following:

(1)  The property is in no danger of being lost, removed, or materially injured; or
(2)  That even if a condition has not been performed, the property is sufficient to satisfy the debt (Cal. Civ. Proc. Code § 564(b)(2).)

a. Mortgagee-in-Possession

Q 5.  Prior to the foreclosure sale, what are the lender’s rights?

A  A lender who wishes to enter the property for the purposes of collecting rents may do so with the express consent of the owner/borrower in default even without additional consideration or a formal agreement (Cal. Civ. Code § 2927; Hooper v. Young (1903) 140 Cal. 274). A lender who does so is a mortgagee-in-possession. However, a lender who enters the property without the consent, or over the objection, of the owner/borrower in default becomes liable to the owner for forcible entry and trespass. (California Hotel Co. v. Bank of America Nat'l Trust & Sav. Ass'n (1939) 31 Cal. App. 2d 295; Mcguire v. Lynch (1899) 126 Cal. 576).

Q 6.  How does the lender become responsible to the tenant upon becoming a mortgagee-in-possession?

A  A lender who becomes a mortgagee-in-possession enjoys the advantage of directly collecting rent and applying it toward the unpaid debt.  However, the lender is responsible to the borrower and junior lien holder for losses caused by negligence or failure to act in a business-like manner. (Johns v. Moore (1959) 168 Cal. App. 2d 709. )

For lenders who find the advantages outweigh the disadvantages, although not required, a written agreement is advisable in order to avoid conflicts over whether consent was granted or withheld, as well as to have documentation which will support the lender's claim to rents if questioned by tenants.

b. Rents and Profits Clauses

Q 7.  How is the lender legally able to invoke the status as mortgagee-in-possession (i.e., how does the foreclosing lender pursue the direct collection of rent)?

A  Today, most deeds of trust contain a rents and profits clause. This can be an absolute assignment of rents, an absolute assignment of rents conditioned on default, or an assignment of rents as additional security. This last type of clause is typically found in short form deeds of trust recorded in each county and referred to by a short form trust deed.

An example of such a clause appears below:

As additional security, Trustor hereby gives to and confers upon Beneficiary the right, power, and authority, during the continuance of these Trusts, to collect the rents, issues, and profits of said property, reserving unto Trustor the right, prior to any default by Trustor in payment of any indebtedness secured hereby or in performance of any agreement hereunder, to collect and retain such rents, issues, and profits as they become due and payable. Upon any such default, Beneficiary may at any time without notice, either in person, by agent, or by a receiver to be appointed by a court, and without regard to the adequacy of any security for the indebtedness hereby secured, enter upon and take possession of said property or any part thereof, in his own name sue for or otherwise collect such rents, issues, and profits, including those past due and unpaid, and apply the same, less costs and expenses of operation and collection, including reasonable attorneys' fees, upon any indebtedness secured hereby, and in such order as Beneficiary may determine. The entering upon and taking possession of said property, the collection of such rents, issues, and profits, and the application thereof as aforesaid, shall not cure or waive any default or notice of default hereunder or invalidate any act done pursuant to such notice.

Q 8.  Does the existence of a rents and profits clause mean the lender can invoke the mortgagee-in-possession status without doing anything else?

A  It depends.  The collection of rent pursuant to a rents and profits clause does not, in and of itself, impose mortgagee-in-possession status on the lender. (Strutt v. Ontario Sav. & Loan Ass'n (1972) 28 Cal. App. 3d 866.) The lender must take steps before proceeding to collect. However, a demand upon the tenant or borrower to turn over the rents, coupled with their cooperation is all that is needed (Lee. v. Ski Run Apartments Assoc., (1967) 249 Cal. App. 2d 293).

If neither party cooperates or if the borrower objects (even if the tenant agrees) the lender needs to file a judicial action for appointment of a receiver.

The legal action is one for specific performance of the borrower's promise as contained in the trust deed. The request for a receiver is secondary to this specific performance action (Cal. Civ. Proc. Code § 564 (b)(8)). A receiver is an agent of the court, not the lender, and must maintain control of the rents until ordered to pay them out. The order for appointment of the receiver can direct the receiver to apply collected rents:

(1)  First to pay the expenses of the receivership (administrative and management);
(2)  Then to payment of taxes and senior secured debts; and
(3)  Followed by the maintenance of a working capital account before any funds collected are to be made available to the lender. (See, California Mortgage and Deed of Trust Practice, 2nd ed., Roger Bernhardt (hereinafter referred to as "Bernhardt") pp. 259-260.)

Monies collected by a receiver pursuant to an additional security rents and profits clause can be received by a lender following a trustee's sale without violating either the one-action or anti- deficiency rules (Bernhardt, supra Section 5.22).  In the absence of a rents and profits clause it may still be possible to have a receiver appointed, but the burden is much greater on the applying lender than where a rents and profits clause exists (Cal. Civ. Proc. Code § 564(b)(2)).

3. After The Foreclosure Sale

Q 9.  If the borrower is an occupant of the property, and the lender forecloses judicially (not trustee’s sale), can the lender evict the borrower?

A  If the borrower occupies one of the units in the rental property and the lender has foreclosed judicially, then the borrower is entitled to possession throughout the statutory redemption period (either three months or one year depending on the amount received at the judicial foreclosure) (Cal. Civ. Proc. Code §  729.030). The foreclosing lender can charge the borrower rent for this occupancy equal to the value of use and occupation (Cal. Civ. Proc. Code §  729.090(a)).

However, if the occupant/borrower fails to pay rent, the lender probably lacks the ability to evict during the redemption period. After the redemption period, the lender should be able to pursue an action for collection of unpaid rents. (Cal. Civ. Proc. Code §  729.090(a).)

Q 10.  If the borrower is the occupant of the property, and the lender forecloses through a trustee’s sale, can the lender evict the borrower?

A  Yes.  If the lender has foreclosed by way of a trustee's sale, the borrower can be evicted immediately following a three-day Notice to Quit. (Cal. Civ. Proc. Code § 1161a(b).)

B. Lender Issues with the Tenants

1. Before The Foreclosure

Q 11.  Prior to the foreclosure sale, is the tenant required to turn rent directly over to the foreclosing lender?

A  No.  A lender may request that a tenant make payments directly to the lender rather than the borrower in an attempt to create a voluntary exercise of a rents and profits clause or to establish the lender as a mortgagee in possession. The tenant may comply but is not required to do so.

If the lender goes to court and has a receiver appointed with the power to collect rents, a tenant will be obligated to pay the receiver. There is no apparent right in California law permitting a lender, or receiver, to evict a tenant for a breach of a lease. Indeed, there is a danger in doing so if, in fact, the borrower reinstates the loan prior to a foreclosure sale and is damaged by the loss of a tenant.

2. After The Foreclosure

Q 12.  Following a foreclosure sale, what are the tenant’s obligations to the lender?

A  Following a judicial foreclosure sale, the tenant, after receiving notice of the sale, must pay rent to the lender or the appointed receiver from the time of the sale until a redemption by the former owner (Cal. Civ. Proc. Code § 729.090(a), Cal. Civ. Code § 1111). 

Following a trustee’s sale foreclosure, the tenant must also pay rent to the lender (or a receiver if one had been appointed) from the time of the sale (Farris v. Pacific States Auxiliary Corp. (1935) 4 Cal. 2d 103, 105).  There is no period of redemption after a trustee’s sale; however, some refer to the right to “cure the default” any time prior to five business days before the date of the trustee’s sale as a “right of redemption” (see Tomczak v. Ortega (1966) 240 Cal. App. 2d 902).

a. When the Lease is Senior to the Lender’s Deed of Trust

Q 13.  If the lease is senior to the deed of trust of the foreclosing lender, what are the tenant’s rights after the foreclosure?

A  When the lease is senior to the deed of trust (i.e., the deed of trust was recorded after the date of the lease) or the lender had knowledge of the tenancy at the time the loan was made, the lender takes the property subject to the rights of the tenant (Cal. Civ. Code §§ 1214, 1215, Dover Mobile Estates v. Fiber Form Products, Inc. (1990) 220 Cal. App. 3d 1494, 1498.) The tenant becomes obligated to the lender as if the lender were the former owner (Cal. Civ. Code §§ 821, 1111).

b. When the Lease is Junior to the Lender’s Deed of Trust or Tenant is on a Periodic Tenancy

Q 14.  If the deed of trust of the foreclosing lender is senior to the lease, (i.e., the deed of trust was recorded prior to the date of the lease) or the tenant doesn’t have a lease, what are the tenant’s rights after a foreclosure?

A  The foreclosing lender or the immediate successor-in-interest at foreclosure (e.g., the purchaser at the trustee’s sale) who wishes to terminate the tenancy must give the tenant the following notice to terminate the tenancy:

3 days:  If the tenant is the mortgagor (borrower), then s/he must receive a 3-day Notice to Quit prior to termination of the tenancy.  Also, if the tenant is a party to the mortgage note, then s/he must receive a 3-day Notice to Quit to terminate the tenancy.  (Cal. Civ. Proc. Code §§ 1161a, 1161b, P.L. 111-22.)

60 days:  If the tenant is the child, parent or spouse of the mortgagor (borrower), then s/he must receive a 60-day Notice to Quit prior to eviction.  If the tenancy is not the result of an arms-length transaction or the rent is substantially lower than fair market rent, then s/he must receive a 60-day Notice to Quit to terminate the tenancy.  (Cal. Civ. Proc. Code § 1161b, P.L. 111-22.)

90 days:  If the tenant is not the mortgagor (borrower) or is not a child/parent/spouse of the borrower or the tenant is on a periodic tenancy and the tenancy is the result of an arms-length transaction and the rent is not substantially lower than fair market rent, then the tenant is entitled to a 90-day notice to terminate the tenancy. (P.L. 111-22.)

Full term of the lease:  If the tenant is not the mortgagor (borrower), or is not a child/parent/spouse of the borrower, and the tenancy is the result of an arms-length transaction and the rent is not substantially lower than fair market rent and the tenant has a lease, then the tenant is allowed to occupy the property until the end of the lease term.  However, if the foreclosed property is sold to a buyer who will occupy the property, then the lease can be terminated with a 90-day notice.  (P.L. 111-22.)

Q 15.  Why is there no 30-day notice option in Question 14?

A  A 30-day Notice to Terminate a Tenancy can be used when the property is not a foreclosure property and the tenant has resided in the property for less than one year (60-day notice if the tenant has resided in the property for one year or longer) (Cal. Civ. Code § 1946.1).

Q 16.  Do the notice periods in Question 14 still apply if the tenant is not paying any rent at all?

A  It depends.  If the lender foreclosed by judicial foreclosure and the tenant is the mortgagor (borrower), the lender probably lacks the ability to evict during the redemption period. After the redemption period, the lender should be able to pursue an action for collection of unpaid rents. (Cal. Civ. Proc. Code § 729.090(a); Bernhardt, Section 5.37.)  For other tenants who aren’t paying any rent, after the judicial foreclosure the lender may give a 3-day Notice to Quit (Cal. Civ. Proc. Code § 1161(2)).

If the lender has foreclosed by trustee’s sale (and, thus, there is no period of redemption), the lender may evict a non-paying tenant or mortgagor (borrower) by giving a 3-day Notice to Quit (Cal. Civ. Proc. Code § 1161(2)).

Q 17.  If the deed of trust of the foreclosing lender is senior to the lease, (i.e., the deed of trust was recorded prior to the date of the lease), can the lender enforce the lease if the tenant wants to terminate it?

A  No.  When the deed of trust of the foreclosing lender is senior to the lease, the lender who finds that the lease is favorable and wishes to continue to enforce it may be disappointed to discover that the tenant has the right to terminate the lease after foreclosure. (Dover Mobile Estates v. Fiber Form Products, Inc. (1990) 220 Cal. App. 3d 1494.)

c.  Security Deposit Issues

Q 18.  After foreclosure, what party is responsible for returning the tenant’s security deposit?

A  Upon termination of the borrower's interest in the property, security deposits which are not returned to a tenant should be transferred to the borrower's successor-in-interest, the lender (Cal. Civ. Code §§ 1950.5 (g), 1950.7(d)).  In the event the owner fails to comply with this requirement, and the rental is residential, the owner remains jointly responsible with the lender for repayment of security to the tenant.(Cal. Civ. Code § 1950.5(i)).

Q 19.  After foreclosure, to whom does the tenant go to get the security deposit back?

A  An owner who is about to lose property through foreclosure is unlikely to either:

(1)  Transfer any security deposits to the foreclosing lender; or
(2)  Return the security deposits to the tenants as is required by law.

(Civil Code Sections 1950.5(g), 1950.7(d).)

In the event the owner who has lost the property through foreclosure has not done either option above, and the rental is residential property, the foreclosing lender is jointly and severally liable, along with the former owner, for repayment of any security to which the residential tenant is entitled (Cal. Civ. Code § 1950.5((i)).

Possibly this express statement of joint and several liability can be used by the lender to bring a legal action against the borrower for recovery of any sums properly paid to residential tenants for security deposit claims by the lender without violating the one action or anti-deficiency rules. (See California Real Estate, Miller & Starr § 19:143 (online).)

Q 20.  Upon foreclosure, must the lender return the tenant’s security deposit?

A  Regardless of the form of foreclosure used, a residential lender becomes obligated to return unused security deposits to any residential tenants unless the borrower returned these sums to the tenants prior to the transfer of title. (Cal. Civ. Code §§ 1950.5, (i) and (j).)

Commercial lenders who acquire the property through foreclosure do not have the same statutory obligation to return deposits to tenants if the lender does not receive the security deposit money from the former owner (Cal. Civ. Code § 1950.7).

III. Owner Issues with the Tenant

A. Before the Foreclosure

Q 21.  After the owner’s default but prior to foreclosure, what are the tenant’s obligations to the owner?

A  The borrower is contractually entitled to receive rent from the tenant even though in default on the note. A default on the note, in and of itself, does not create a breach of the covenant of quiet enjoyment of the leased premises or a denial of possession to the tenant. Thus, the tenant who ceases payment of rent can be evicted by the owner or sued for breach of the lease. (Cal. Civ. Proc. Code § 1161.)

B. After the Foreclosure

Q 22.  Following foreclosure, what are the owner’s/borrower’s obligations regarding the tenant’s security deposit?

A  After the foreclosure sale, the owner must return the security deposit to the tenant or transfer it to the foreclosing lender in order to be relieved of liability for the security deposit to the tenant (Cal. Civ. Code §§ 1950.5 (h), 1950.7 (d)). The owner/borrower who in bad faith fails to return a security deposit to a tenant can be held liable to the residential tenant for up to twice the amount of the security, in addition to actual damages (Cal. Civ. Code § 1950.5 (l)).  For a commercial tenancy, the owner/borrower can be held liable to the tenant for bad faith retention of the deposit in statutory damages not to exceed two hundred dollars, in addition to any actual damages (Cal. Civ. Code § 1950.7 (f)).

V. Property Management Issues

Q 23.  Does the owner’s default entitle the property manager to neglect or deviate from the property management agreement?

A  No, the default of the owner does not entitle the manager to neglect responsibilities identified in the property management agreement. Prior to a foreclosure sale, the property manager has contractual and fiduciary obligations to the owner of the property. If the management agreement provides for the collection of rent, then such activity, consistent with the terms of employment, is done on behalf of the owner. Honoring a request of the lender for disbursements of rents received, without the express permission of the owner would be grounds for breach of the manager's contractual and, possibly, fiduciary duties.

Q 24.  How does a court-appointed receiver affect the property manager’s rights and obligations to the owner?

A  Once a receiver has been appointed by a court, if the power of appointment directs the manager to hand over received rents, then the request of the court-appointed representative should be satisfied. The property manager should request a copy of any court order.  If the receiver collects rents directly, and takes over other management functions from the property manager, this would have the effect of terminating the agency and contractual obligations of the manager and establishes probable grounds for a manager's breach of contract claim against the owner. Monies held by the manager should be disbursed in accordance with the instructions of the owner unless directed otherwise by a receiver who has been granted that authority.

Q 25.  Can the property manager make a breach of contract claim against the owner following the foreclosure sale?

A  After the foreclosure sale, the subject of the agency--the owner's interest in the real property-- becomes “extinct,” thus terminating the agency (Cal. Civ. Code § 2355(b)). As a consequence, the owner may be liable to the property manager for breach of contract damages. However, disbursement of previously-collected sums still requires direction from the former owner or court.

Q 26.  Does the property manager have any obligation to comply with requests from the foreclosing lender?

A  The property manager is the agent of the owner and has no obligation to honor any request for disbursement of rents made by a foreclosing lender. Upon receiving such a request, that agent's duty of full disclosure would impose upon the manager a requirement to inform the owner of the lender's request. If a lender has a receiver appointed, the manager can presumably enter into an agreement with the receiver to continue performing property management functions, for a fee. Such an agreement would affect rents collected and services performed after the date of the agreement.

Q 27.  Following the foreclosure sale, may the property manager enter into a new property management agreement with the lender?

A  Yes.  After the foreclosure sale terminates the owner's interest in the property and the agency relationship between the owner and manager, the manager may enter into a new property management agreement with the lender, just as the manager could with any owner of property.

Q 28.  Does the property manager have the right to release tenants’ security deposits to the lender?

A  No.  Should the lender demand that the manager release previously-held tenants' security deposits, the manager should refuse. These funds are held in a trust account for the benefit of the former owner and are not the property of the manager (Cal. Bus. & Prof. Code §§10145, 10176(e)).

Q 29.  Should the property manager inform tenants that the owner is in default and facing foreclosure?

A  One issue facing a property manager is whether to inform tenants that the property owner is in default and facing foreclosure.  What should the manager do? If during the lease negotiations the manager acted as a dual agent, then the manager's fiduciary responsibilities would require disclosure of the foreclosure. If there is no agency relationship with the tenant, then the manager needs the owner’s permission to disclose the fact of the foreclosure to the tenants.

Q 30.  Following foreclosure, can the tenant establish a claim against the property manager in order to secure the return of their security deposits?

A  Once the foreclosure sale has been completed, tenants whose leases have terminated and who desire a return of their security deposits might try to sue the manager.  Typically, the property manager is not the owner of the property and is acting solely in an agency capacity.  Thus, there shouldn’t be any personal liability.  However, that may not discourage the tenant from suing the property manager.

VI. Conclusion

Unfortunately, many areas of the state are experiencing record levels of foreclosures. REALTORS® in these areas, as well as anywhere else where a foreclosure is occurring, are often asked questions by the principals involved with the property. Owners, lenders and tenants of rental property in foreclosure who are, have been or anticipate having a working relationship with a REALTOR® may seek advice from the real estate licensee. While a licensee should avoid giving legal advice, it is helpful for a REALTOR® to have an understanding of some basic issues facing these principals. Such an understanding can help guide the REALTOR® away from problems and toward solutions.

When a rental property is being foreclosed upon, the duties and relationships between and among the principals and agents change depending on the strategies employed by the foreclosing lender, the needs and desires of the property owner, and the type and priority of the tenants' leases. Another critical factor affecting the relationships is whether or not the default has resulted in an actual sale of the property. This article has identified many of the issues most likely to be faced by a real estate licensee. The purpose is to enable a REALTOR® to identify issues and problems so that appropriate steps can be taken, or appropriate referrals made, to enable the principals and REALTORS® alike to make their way through a difficult situation with as much information and ease as possible.