Real estate practitioners are accustomed to helping their clients obtain the appropriate type of real estate appraisals for property purchases and financing. The appraised value can be even more critical if the owner defaults in the repayment of such financing and seeks to challenge a resulting foreclosure sale as a fraudulent conveyance in bankruptcy. This article briefly summarizes the basic types of appraisal and approaches federal courts have taken in valuing foreclosed properties in bankruptcy proceedings.
Real Estate Sales Versus the Distressed Sale
Under normal conditions, a seller typically begins the real property sale process by signing a listing agreement with a real estate agent. For a description of the three types of listing agreements, see The National Association of Realtors’ Handbook on Multiple Listing Policy, https://bit.ly/2YebBm0. In exchange for a commission based on the sales price, the real estate agent lists the property in a local Multiple Listing Service (MLS), conducts open houses, markets the property in different websites, and ultimately finds a ready, willing, and able buyer through her own efforts or through a cooperating agent. The buyer either has the funds available or has been approved for a mortgage and makes an offer with a sales price affected by supply and demand in the current market conditions. A ready, willing, and able buyer is generally willing to pay fair market value for a property, but an investor who intends to hold on to a property for some time and rent it to tenants or to flip the property for a quick return is always looking for a more wholesale value.
After the seller accepts the buyer’s offer, the buyer and seller sign a contract (ideally after attorney review), and the parties move forward to clear title, obtain funding, and proceed to the closing table. Before making the loan, the buyer’s lender requires an appraisal to confirm that there is enough value in the property to support the amount of the loan.
This valuation is crucial. See Israel Shaked & Robert F. Reilly, A Practical Guide to Bankruptcy Valuation 369–412 (Am. Bankr. Inst. 2017). The appraiser hired is a neutral, licensed professional who is compensated for generating an appraisal report governed by the Uniform Standards of Professional Appraisal Practice (USPAP) standards. Id. at 369. The appraiser considers different factors in conducting the valuation, including the property’s overall age and condition, improvements, construction type, marketability, and most importantly, the property’s location using neighborhood, city, and location data. Id. at 372–82.
The appraiser uses one of three approaches to value in conducting the valuation of the property, as follows: (i) the income capitalization approach; (ii) the cost approach; and (iii) the sales comparison approach.
The income capitalization approach is most commonly used in valuations pertaining to income-producing properties, such as investment homes, apartment buildings, and malls. Christina Berger, Determining Market Value: Reconciling the Three Approaches to Real Estate Valuation for Ad Valorem Taxes, 25 J. St. Tax’n 31, 34-35 (2007). This approach “seeks to value a property by capitalizing the net income the property will generate over the property’s useful economic life. . . . The main advantage of the income approach is that it approximates the thinking of a typical investor that is interested in the return-on-investment in income-producing real estate.” Id. at 35. This method “is preferred when the property is rental property or when the income data is readily available for comparable properties.” Investors are particularly interested in knowing the property’s net operating income in order to arrive at value and decide whether it is a transaction that is appealing to the investor and makes sense money-wise. After all, the investor is buying this property only because it generates income. In the end, this investment generates to the investor not only tax deductions and write-offs but also a return on investment from cash to the investor on a monthly or yearly basis and, it is hoped, also capital gains when the investor resells the property in the future. In the income capitalization approach, the appraiser arrives at value by “projecting cash flow over a typical holding period and discounting the cash flow to a present value estimate using a discount rate.” Shaked & Reilly, supra, at 384.
The cost approach estimates the highest and best use of the property and considers the replacement costs. See Berger, supra, at 33 (“[t]he cost approach to valuing property is based on the premise that a piece of real property is worth what it would cost to replace or reconstruct the property in its current condition”). The cost approach is generally used in determining value for new construction. This approach is generally less reliable for existing and older properties. The cost approach also considers accrued depreciation in the form of physical deterioration, functional obsolescence, and external obsolescence. Shaked & Reilly, supra, at 384, 379–81.
Lastly, the sales comparison approach is the most commonly used approach for resales of single-family homes, condominiums, and multi-family homes, including two- and three-family homes. Id. at 38–83. When conducting a valuation under the sales comparison approach, appraisers generally compare the subject property to recently sold comparables in the particular neighborhood, usually covering up to a one-to-two-mile radius. See Berger, supra, at 32–33. Under the sales comparison approach, the appraiser makes adjustments that account for date of sale, lot size, size of property, amenities, and financial terms of the sale, among other factors. Id.
Regardless of which appraisal method is used, the secured lender issuing a loan to the borrower must protect its interest by making sure that there is sufficient value that exceeds the extent of its lien. See Marty Strelecky and Michael R. Sher, Foreclosures and Other Transfers of Distressed Commercial Property, 33 GPSolo 22 (2016). If the borrower defaults after unsuccessful attempts to cause the borrower to pay the amount in arrears, the secured lender will likely begin foreclosure proceedings in order to sell the property at a sheriff’s sale. The lender will either place its own credit bid at the foreclosure sale and take possession of the collateral or receive proceeds from a winning third party bidder at the auction to apply to the debt owned. See James B. Jordan and Justin Lischak Early, Buying Distressed Commercial Real Estate: What are the Alternatives, 16 Ga. B.J. 18, 20 (2010) (describing process in Georgia).
Real estate valuations are also important at the time of foreclosure because of the risk that the borrower may file bankruptcy. Even if the property has been sold prior to the bankruptcy filing, the bankruptcy trustee has the power to set aside a prebankruptcy sale that is determined to be a fraudulent transfer under Bankruptcy Code’s requirements. See 11 U.S.C § 548(a). A commentator has noted that valuations in bankruptcy can get really “messy,” because bankruptcy courts are faced with the tremendous challenge of “assigning a monetary value to an asset for which there is either no seller or no buyer, and often no market.” See Bruce A. Markell, Fair Equivalents and Market Prices: Bankruptcy Cramdown Interest Rates, 33 Emory Bankr. Dev. J. 91, 92 (2016). See also Stan Bernstein, Susan H. Seabury, and Jack F. Williams, Squaring Bankruptcy Valuation Practice with Daubert Demands, 16 Am. Bankr. Inst. L. Rev. 161 (2008). But, as others have noted, “value in bankruptcy is rarely about the actual value and instead it is all about the remedies.” See Robert J. Stark, Jack F. Williams, and Anders J. Maxwell, Market Evidence, Expert Opinion, and the Adjudicated Value of Distressed Businesses, 68 Bus. Law. 1039 (2013). These authors note that:
Valuing . . . is tricky. . . . Even in an optional transaction . . . where the price is determined by intelligent and arm’s length negotiation, there likely is no agreement as to intrinsic value. Voluntary buyers tend to offer only where they think they are getting a good deal . . . , while voluntary sellers tend to accept only where they think they are getting a good deal . . . .
Id. at 1039-40. After all, in bankruptcy proceedings, either the trustee or one of the parties in interest, usually a secured creditor, will object that the subject property could have been sold for more money at the foreclosure auction. Gary W. Marsh, Legal Issues Every Player in the Distressed Market Should Know, 3 Pratt’s J. Bankr. L. 291 (2007). The fraudulent transfer provisions of the Bankruptcy Code provide a remedy whenever a prebankruptcy transfer was intentionally or constructively fraudulent. Most importantly for purposes of this article, constructive frauds include transfers in which the debtor received “less than a reasonably equivalent value in exchange for such transfer” 11 U.S.C § 548(a). See also Scott A. Lessne and Vincenzo Paparo, Maximizing Recovery of Distressed Debt, 22 Com. Lending Rev. 19 (2007).
Fair Market Value Versus Reasonably Equivalent Value
For many years, there has been an ongoing discussion as to what constitutes “reasonably equivalent value” as required under the Bankruptcy Code and whether “fair market value” is equivalent to “reasonably equivalent value.” The Court’s decision in BFP v. Resolution Trust Corp., 511 U.S. 531 (1994), discussed below, is a landmark case but still left many questions unanswered regarding valuation and standards of both “fair market value” and “reasonably equivalent value.”
Governing Law & Relevant Cases
Under 11 U.S.C § 548 (a), a prebankruptcy transfer may be avoided if it was intentionally or constructively fraudulent. In order to avoid a “fraudulent transfer,” a trustee must prove: “(1) that the debtor had an interest in property; (2) that a transfer of that interest occurred within two years of the filing of the bankruptcy petition; (3) that the debtor was insolvent at the time of the transfer or became insolvent as a result thereof; and (4) that the debtor received ‘less than a reasonably equivalent value in exchange for such transfer.’” BFP, 511 U.S. at 534 (one year when case was decided, but currently two years). The Bankruptcy Code’s definition of “transfer” includes “foreclosure sales.” 11 U.S.C. § 101(54).
The issue of valuation in foreclosure sales and bankruptcy proceedings came to the forefront through a series of cases in the early 1980s. See Note, Defining Reasonably Equivalent Value Under Section 548 (a) of the Bankruptcy Code: Is Ristich the Answer?, 44 Wash. & Lee L. Rev. 237 (1987). The courts began taking different approaches as to how to deal with the unresolved question. Eventually, the circuits became split as to the efficacy of non-collusive foreclosure sales. See Irving D. Labovitz, The Ongoing Development of “Fair Market Value” Under Section 506, 98 Com. L. J. 162, 173 (1993).
In one of the seminal cases on the subject, the Fifth Circuit in Durrett v. Washington National Insurance Co., 621 F.2d 201 (5th Cir. 1980), held that a foreclosure sale that yielded 57 percent of the property’s fair market value could be avoided as a fraudulent transfer. In dicta, the court stated that it was unable to find any case in which a court upheld a transfer for less than 70 percent of fair market value. Id. at 203.
A second major opinion, In re Madrid, 21 B.R. 424, 426–27 (Bankr. 9th Cir. 1982), rejected the 70 percent rule in Durrett, taking the position that “a regularly conducted sale, open to all bidders and all creditors, is itself a safeguard against the evils of private transfers to relatives and favorites.” The court, therefore, held that the price obtained at a nonjudicial foreclosure sale satisfies the “reasonably equivalent value” requirement of the Code.
In re Bundles, 856 F.2d 815 (7th Cir. 1988), rejected both Durrett and Madrid, and instead adopted an approach resembling a “totality of the circumstances” method to determine “reasonable equivalence.” The court observed that “it would be appropriate to permit a rebuttable presumption that the price obtained at the foreclosure sale represents equivalent value.” Id. at 824. But the court emphasized that the courts must also consider additional factors to ensure that “the procedures employed were calculated not only to secure for the mortgagee the value of its interest but also to return to the debtor-mortgagor his equity in the property.” Id. See also In re Grissom, 955 F.2d 1440 (11th Cir. 1992) (endorsing a totality of the circumstances test similar to that in Bundles.)
The courts remained split on this important issue until the matter was resolved by the Supreme Court in 1994. In BFP v. Resolution Trust Corp., the Court was presented with the question whether the requirement of “reasonably equivalent value” as set forth in § 548(a) of the Bankruptcy Code is satisfied when the purchaser pays “consideration” at a noncollusive foreclosure sale “in conformance with applicable state law.” Id. at 533. In BFP, the Supreme Court agreed with the third approach followed by the Ninth and Sixth Circuits. The Court in BFP held that “reasonably equivalent value” is “the price in fact received at the foreclosure sale, so long as all the requirements of the State’s foreclosure law have been complied with.” Id. at 545.
The plaintiff in BFP was a partnership formed by two private investors in order to purchase a home in Newport Beach, California, which is considered not only a great neighborhood, but “[one] of the most expensive U.S. cities to buy a home.” See Amy Hoak, The 10 Most Expensive U.S. Cities to Buy a Home, MarketWatch, June 15, 2011, https://on.mktw.net/2oeLTx1. The property was purchased by BFP from Sheldon and Ann Foreman in 1987. BFP v. Resolution Trust Corp, at 533. BFP borrowed $356,250 from Imperial Savings Association and provided Imperial with a first deed of trust on the property. Id. BFP also gave the Foremans a second deed of trust to secure a promissory note in the amount of $200,000. Id. Imperial began foreclosure proceedings when BFP defaulted two years later.
At the foreclosure sale in July 1989, the home was sold to Paul Osborne for $433,000. Id. at 534. The foreclosure sale was conducted in conformance with California state law. BFP then filed under Chapter 11 of the Bankruptcy Code in October 1989 and filed an action in the bankruptcy court to set aside the property’s transfer as a fraudulent conveyance. BFP alleged that the home was in fact worth $725,000 at the time of the foreclosure sale and that the market value should be the reasonably equivalent value. Id.
Finding that the foreclosure sale had been conducted in compliance with California law and was neither collusive nor fraudulent, the bankruptcy court denied BFP’s claim and granted summary judgment to Imperial. The United States District Court for the Central District of California affirmed the bankruptcy court’s dismissal, and a bankruptcy appellate panel affirmed the judgment. Id. On appeal, the Court of Appeals for the Ninth Circuit also affirmed. BFP petitioned the United States Supreme Court for certiorari, which the Court granted. Id.
In a five-to-four decision, the Court ruled that a foreclosure sale of real estate may not be challenged as a fraudulent transfer based solely on the sales price, because the Bankruptcy Code does not require that the transfer be made for the property’s fair market value. Id. at 537. The Court concluded that, so long as the foreclosure sales follow applicable state law, it is enough to meet the standard as required under the Bankruptcy Code because it may be more difficult to obtain a buyer that is willing to pay “fair market value” in a foreclosure sale. The Court reasoned that because such a sale at an auction is a distressed sale, there may not even be buyers willing to purchase the property. The court noted that when property is sold under normal conditions, the sale is not a “forced” sale, and thus there is more than enough time to find a purchaser. In a foreclosure sale, the sale is under a time constraint and other factors affect the sales price of the property. “No one would pay as much to own such property as he would pay to own real estate that could be sold at leisure and pursuant to normal marketing techniques.” Id. at 539.
The dissent in BFP made some interesting points, but surprisingly the one that is most often discussed is the reference to what happens when the foreclosure sale generates an amount that is “unreasonably low” compared to the property’s “fair market value” at the time of the sale. Id. at 561. Addressing this argument in the majority opinion, Justice Scalia suggested that the dissent’s inquiry does not answer the key question of “What is a foreclosed property worth?” Id. at 547 (emphasis added). Justice Scalia observed that the dissent generally refers to “worth of the item when sold,” but does not explain “how the . . . impact of forced sale is to be conducted.” Id. at 548.
[F]oreclosure has the effect of completely redefining the market in which the property is offered for sale; normal free-market rules of exchange are replaced by the far more restrictive rules governing forced sales. Given this altered reality, and the concomitant inutility of the normal tool for determining what property is worth (fair market value), the only legitimate evidence of the property’s value at the time it is sold is the foreclosure-sale price itself.
Id. at 548–49.
As a policy matter, Scalia observed that other tests adopted by the lower courts would undermine state foreclosure sales. Id. at 546. “The title of every piece of realty purchased at foreclosure would be under a federally created cloud. (Already, title insurers have reacted to the Durrett rule by including specially crafted exceptions from coverage in many policies issued for properties purchased at foreclosure sales.)” Id.
Is it in fact “reasonably equivalent” for a purchaser to pay, as in the case of BFP, about $300,000 less than the fair market value for a property at a foreclosure auction? Absolutely. In most real estate auctions, there is either great demand for a specific piece of property, if a couple of investors are ready to outbid the other, or there is simply no one interested in purchasing the property.
There are many factors that come into play that can negatively affect the marketability and valuation of a property. For example, it may be a time of recession, the property may be in such a poor condition that even fixing it does not allow an investor to make a good profit unless it holds the property for some time as a rental, or the property may be located in a neighborhood where there have been many occurrences of violence and crime.
Many real estate law professionals as well as bankruptcy law professionals agree that as long as there was compliance with state law in a foreclosure sale, then the highest bid should be considered “reasonably equivalent” under section 548 of the Bankruptcy Code. Additionally, many agree that under such circumstances a foreclosure sale should not be considered a “fraudulent conveyance” unless there’s a showing of collusion or that it was a non-arm’s length transaction. Real estate and expert valuation evidence is a highly-debated subject that greatly affects not only real estate legal practice and our economy as a whole but also decisions that buyers and investors make when considering whether to buy single-family homes, multi-family homes, condominiums, cooperatives, and commercial properties.
The Supreme Court made it easy to determine whether property sold at a foreclosure sale is subject to the fraudulent transfer rules of the Bankruptcy Code. If the sale was in compliance with the state’s foreclosure procedures, then the consideration paid in that sale constitutes the “reasonably equivalent value” of the property—even if the sale price differs substantially from the “fair market value” that the property might bring under normal market conditions; as a result, the bankruptcy trustee cannot avoid the sale as a fraudulent transfer.
Valuation challenges remain, however, for sales that fail to comply with the applicable state law. A bankruptcy court would then have to determine if the sale price received from the sale was “reasonably equivalent to the property’s actual value at the time of the sale,” which, according to the majority in BFP, “would be the price that would have been received if the foreclosure sale had proceeded according to law.” BFP, 511 U.S. at 546. The Court also emphasized that its decision was applicable only to real estate foreclosures. “We emphasize that our opinion today covers only mortgage foreclosures. The considerations bearing upon other foreclosures and forced sales (to satisfy tax liens, for example) may be different.” Id. at 537, n.3.