Distressed borrowers are not the only ones affected by the current spate of foreclosures and short sales. In many cases, residential tenants may be impacted as well. Questions arise in at least three situations. How might a tenant be affected if (1) the landlord is in default on the loan?, (2) the property is sold in a "short sale"?, or (3) the property is foreclosed upon by the lender? Before going further, we should note that this discussion has to do with properties in California; other states may differ.
First, and simply, we can observe that the status of the landlord's payment history has no effect on the rights or obligations of the tenant.The landlord may be behind in payments, or making no payments at all, but the tenant still has the obligation to make timely rent payments to the landlord. It is possible, though unlikely in most residential rental situations, that the lender would seek to collect the rents. Many trust deeds contain a clause that gives this right to the lender. Nonetheless, it still takes the agreement of both the borrower (the landlord) and the tenants. If permission is not given, the lender would have to seek a court order to enforce the clause.
What if there is a short sale? That is, what if the lender has agreed to let some third party purchase the property, even though the proceeds of the sale would be insufficient to pay the balance due on the loan? This also has no bearing on the tenant's rights and obligations. Suppose the tenant has nine months left on a one-year lease, and the property is sold. Whether it is a conventional sale, or a short sale, the new owner takes the property subject to the terms of the lease.
The only change is that the tenant now makes payments to, and interacts with, the new owner. It is important for both parties to realize that the new owner is going to be responsible for return of the security deposits at the end of the lease term. In a conventional sale, the deposits are usually credited to the buyer through escrow. That is a detail that can easily be overlooked in the fog of a short sale.
What about the case of foreclosure? Here, things get a little trickier and can sometimes be disadvantageous to the tenant. First, let us presume that the foreclosure takes place pursuant to a trustee's sale -- the typical foreclosure in California. (The rules are different if the foreclosure is judicial.) Much depends on whether or not the deed of trust (the instrument that secures the loan) is senior to the tenant's lease.
If the deed of trust was in place prior to the lease -- if the owner already had the loan before he rented the property to this tenant -- then the foreclosing lender will have the right to terminate the lease and remove the tenant after giving notice. The lender may, if he, she, or it chooses, allow the tenant to remain under the terms of the lease; but the tenant has the right to terminate.
Suppose, on the other hand, that the lease was in place prior to the loan being made. For example, the landlord might have refinanced after he had executed the lease with the tenant. If the lease had been recorded -- a very unlikely event -- or, if the lender knew of the lease (much more likely) when the loan was made, then the lease remains in effect. The lender would have to take the property subject to the rights of the tenant, just as in a sale.
Regardless of which circumstances apply, the lender becomes obligated to return unused security deposits to the tenant unless the borrower had returned the deposits prior to the foreclosure. It is, of course, extremely unlikely that the borrower would have returned those deposits. Actually, the borrower will still remain liable for return of the deposits, but, upon the foreclosure, the lender becomes jointly liable. Who is more likely to have the financial ability?
It is said that many of the current foreclosures involve loans made to investors rather than those who were owner occupants. Hence, it is likely that many of the homes to be foreclosed are occupied by tenants. They should know their rights, or, in some unfortunate cases, their lack of them.