Tax Lien Investing: The Top Three Risks That can Derail Your Profits!

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As 2013 comes to a close, I like taking the week after Christmas sitting in my favorite coffee shops plotting my investment strategy for the upcoming year. As I sit sipping my favorite latte typically something with chocolate or mocha I try to sketch out the risks in the asset classes that I would like to invest within. One of the asset classes that I am extremely bullish on for 2014 are tax liens.

In 2011, I made my beta investment into tax liens after reading books and blog entries. After nearly 2 years of waiting and testing out the investment, I was able to complete a successful investment within the asset class and establish a partnership for the purpose of tax lien investing. As me and my partner researched deeper into the asset class, we realized that the tax lien asset class was not riskless as many books try to portray.

Tax lien investing is a high sharpe ratio investment (fancy way of saying a high risk adjusted investment). Gurus, Books and education based websites tend to neglect discussing the risks associated with delinquent property tax liens and certificates. Here is a safe rule of thumb to live by: Higher returns generally correlate with higher risks.

My partner and I started noticing these risks as we worked on investing our partnership funds into Over the Counter liens. The top three risks that we realized can have a material impact on your returns and potentially your principal are as follows:

Top Three Tax Lien Risks

1. Municipal Risk:

Municipal risk encompasses risks associated with fines, condemnation and demolition. As tax lien holder you have little or no control over the asset (as it is still owned by the equity holder) who can trigger one or more of the municipal risk. The actions of the equity holder can place the asset in the cross hairs of the code enforcement office and trigger the outlined municipal risks. To help clarify these risks, let review a hypothetical example:

Let’s say you are a tax lien investor who owns a lien on a vacant asset. The owner is not caring for the asset and over the summer the grass grows and in the winter no one shovels the snow. What do you think the municipality will do to with this asset? Municipalities are in need of cash given the declining property value base which has caused municipalities levying fines up to $500 each time the city comes out to cut the grass or shovel the snow.

These fines can add up quickly and can become your responsibility especially if you want to maintain your primary position as a tax lien investor or take over the asset through a tax foreclosure. The risk of municipal fine is low in my risk spectrum compared to the municipality ability to condemn and demolish properties.

Condemnation and Demolition risks have the possibility of causing principal losses in your tax lien portfolio. The federal and state government since 2008 have been giving out grants for cities to demolish whole blocks of older and decrepit properties to help revitalize neighborhoods. So what you thought was a nice but older property to have a tax lien on could be on the condemnation list and demolished. As a tax lien investor this can have major consequences to your return profiles and potentially your capital invested.  Don’t believe me? Let me show you this risk with a quick example below:

For the sake of simplicity let’s assume that you have invested $10,000 of your funds into a lien that is backed by nice but older property. You feel fairly safe as your investment exposure ratio is only 10% of the value of the property

Lien Face Value:                       $5,000

Subsequent investment:          $5,000

Value with Building:                 $100,000

Exposure Ratio:                        10%

However, you did not account for the condemnation risk and your nice but older property turned out to be on the demolition list. The municipality during your investment holding period demolishes the building thus changing your tax lien investment profile as follows:

Total Investment:                     $10,000

Land Value:                              $25,000

Building Value:                         $0

Exposure Ratio:                        40%

Now your lien is backed only by the value of the land thereby increasing your exposure ratio and putting your investment at greater risk. Additionally, you may have to invest another $20,000-$30,000 for the lien associated with the demolition costs especially if you want to take over the asset or keep lien priority. As you can probably tell the municipal risk can cause a severe volatility to your expected returns and even cause an abandonment of principal as you may not want to spend good money after bad.

2. Bankruptcy Risk

Normally if a delinquent taxpayer filed for bankruptcy protection, a tax lien investor would still earn interest and be a higher priority over just about every creditor. This kept the bankruptcy risk nominal but the risk has become more severe since the foreclosure crisis began in 2008. Spurred on by the mortgage foreclosure crisis, bankruptcy judges began to deviate from historical norms by cramming down on secured and priority creditors putting tax lien creditors in the cross hairs.

The judges can impact the tax lien investor in one of two ways: A) Priority and B) Rate of Interest as bankruptcy petitions have been creatively utilizing “lien stripping” given the nature of real assets being encumbered by more liens than the total value of the asset. This risk is a form of downside surprise as a tax lien investor can be forced to just accept the face value of lien and forgo all the interest that they may have earned during the investment holding period. There is no way to mitigate this risk but it is important to recognize it when compiling bidding

3. Government Errors

Errors can occur by the tax assessor, the courts, and even the computer systems handling tax delinquency and payments. If an error is found, the tax collector will declare your tax lien a “sale in error” and return your investment with little interest beside a low statutory rate. This risk is what I call a downside surprise as your principal is not at risk but the investment that you thought was earning 10%+ per annum is suddenly sent back to you with a low statutory interest rate because of a clerical error.

All in all, tax lien investing is relatively safe asset class compared to the risks of investing in other asset classes.  It is important to be a prudent investor and not just accept the notion that tax lien investments are risk free. Performing due diligence is a simple way to mitigate these risks so be prudent.

Until next time

Happy Investing!
Photo Credit: Phillip

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.