Alert November 24, 2009

Evaluating REO Property in Mello-Roos Districts

REO portfolios continue to grow, and many new REO properties are located within a Mello-Roos community facilities district (a “CFD”). In this period of falling property values, tight credit, and loan and tax delinquencies, evaluating CFD property can pose a significant challenge. The following are a few tips that should be considered when evaluating CFD property. For a detailed discussion of how to understand and maximize the value of CFD property, please see Goodwin Procter’s publication “Mello-Roos Community Facilities Districts: Top 10 Tips Every Lender and Property Owner Must Know.”

Look at Special Tax Delinquencies.   Special taxes are typically collected on the secured tax rolls of the local county in the same manner, and with the same delinquency penalties, as general property taxes. If the special taxes are not paid for a year after foreclosure, the penalty can grow to 28%. If the CFD property is delinquent, the owner can and should negotiate with the local agency regarding the payment of all delinquencies. The local agency has the authority, and is often willing, to reduce or waive penalties and interest.

Beware Deficient Title Reports and Tax Bills.   Due diligence for any REO property includes a review of the preliminary title report and the most recent tax bill. Unfortunately, those documents don’t always tell the full story. For instance, neither the title report nor the tax bill will show (a) maximum special taxes, (b) the amount of delinquencies, penalties, and interest due, (c) special tax buy-down provisions, (d) the amount of any annual escalator in the special taxes, or (e) the amount of special taxes applicable upon reclassification of property. Any evaluation of CFD property should, therefore, include a careful review of the special tax formula to clarify those and other issues that are not always revealed in a typical due diligence review.

Taxation Can Occur Without Bonds.   If special tax bonds have not been issued, a CFD can be restructured, which can alleviate or eliminate the potential problem of premature special tax levies. In addition, to the extent special taxes have already been paid, a refund may be obtained for the property owner. Such restructuring can also match the special tax rates with the current home prices so that the total tax rate is within acceptable levels without requiring a special tax prepayment.

Beware the Buy-Down.   In many special tax formulas, local agencies provide for a mandatory buy-down of special taxes in the event home prices drop below a certain threshold. Most local agencies limit the overall tax rate to an established threshold, commonly 2% of the expected home prices. Owners of CFD property should always review the mandatory buy-down and prepayment provisions of the special tax formula to determine if there is an ability to minimize the impact of such buy-down provisions.