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by Mark Manoil, December 27, 2010

A Swiss man once explained to me his country's approach to remaining neutral in 20th Century European conflicts: prepare for war. The country made sure every able-bodied man was prepared to fight (trained and armed) in case of invasion. The Swiss had found that by being war-ready the need to actually defend themselves militarily seldom arose.

In the tax lien context, "being prepared for war" is having taken care of the prerequisite jurisdictional noticing, which must precede filing any tax lien foreclosure. In many cases, often more than fifty percent of a maturing or matured CP portfolio will get redeemed simply after the sending of the 30 day notice. That substantially cuts down on the need to go to "war" -- i.e., file the tax foreclosure suit. And noticing may prove to be a less expensive alternative to discounting the sale price of a tax lien to cash out from the investment.

Most tax lien buyers will willingly admit that they invest substantial resources in pre-purchase research and because they also incur non-refunded transaction costs, they might prefer to hold their CP investments a bit longer than a year to earn more interest and not have to find a reinvestment opportunity so soon. Besides, as a certificate holder they enjoy a statutory first right to subtax, i.e., pay the subsequent year delinquent taxes accruing on their CP parcels, on or after June 1 following the second half tax due date.

If a lien purchased at a February auction is not redeemed in three years, the holder  may initiate a tax lien foreclosure on the day after the third anniversary (assuming the notice of intent was properly given at least 30 days before). That means that in the interim between purchasing the tax lien and its maturing for foreclosure, the CP holder will have had the opportunitiy to pay and add to its CP three subsequent years of delinquent taxes--assuming the property owner did not pay any of those taxes--and earn the bid rate of interest for each susbseqent addition to the CP.

Each new subtax investment starts a new simple interest "clock" running on that portion of the investment. If all subsequent years are delinquent and subtaxed, the CP would represent four years of taxes, each year representing a different effective internal rate of return (because of the different starting date of that portion of the CP investment).

can i buy viagra The quality of interest earned on certificates of purchase degrades over time. Because Arizona law provides that the CP bid rate for interest accrues on a simple--not compounded--basis, over time that lack of compounding leads to a lower internal rate of return on the investment. Internal rate of return (IRR) is the compounded annual rate of return on the investment over its life, from and after the initial purchase date, applied to the principal amount of the purchase plus any subsequent contributions.

For example, a tax certificate purchased in February 2008 for $1000, and subtaxed for an additional $1000 in June and the months of June in the next two years, if purchased at a 16% bid rate, will have a January 2011 redemption value of about $5,227. The $4000 invested over three years will have earned about $1227 or a total return on investment of 30.67%. The internal rate of return, however, would work out to 14.37%. If the bid rate on the same CP was 7% instead of 16%, the final earnings would be only $537, an IRR of 6.62%. And if no subtaxes had been paid after the initial lien purchase, so that at redemption interest earnings were on the initial outlay of $1000 only, the $467 earned on the 16% CP would represent an IRR of 13.91%; the $204 earned on a 7% CP would represent a 6.52% IRR. Transactional and other costs, such as legal expenses, would further decrease the proceeds and IRR. (Setting up spreadsheets for these calculations are covered in Arizona Property Tax Liens -- Guide to Profit, Protection and Prosecution.)

Thus, to enjoy the highest rates of return (ignoring momentarily unrecovered transactional costs of investing), ideally a CP investor would experience redemption within twelve months from making its investment, and then get to reinvest those cash proceeds at the same or higher rate. In this way earned interest would be put to work as principal invested in the replacement and be the basis for additional future interest earnings.

Much has been written recently about large banks and hedge funds investing in property tax liens. Often the prime motivation for these investors is earning interest passively, not ultimately foreclosing on the tax lien parcels.

Historically, 80-90 percent of tax liens are redeemed before the three year anniversary that triggers foreclosability. What's left at the three year mark, then, often has a couple predictable features:
(i), the tax liens are less leveraged, i.e., more tax debt is owing against the property in relation to the property's value; and
(ii), the CPs are likely to need legal work to be either collected or foreclosed.

In our experience, the 30-day noticing process often yields a fifty percent or greater rate of redemptions in the CP portfolio being noticed. (The redemption rate is directly related however, to the types of properties the tax liens are on. For example, CPs on residential properties are more likely to be redeemed than those on raw land.)

What remains after the noticing period will more likely require commencement of a lawsuit to trigger redemption (or convert the CP to title of the property).

Thus, encouraging as much redemption as possible before the third anniversary of the tax lien purchase accompllishes two goals:
(i), getting back to cash on the CP investments to enable new tax lien investments at the next auction (which in turn enables a compounding effect on the money collected); and
(ii), minimizing the exposure to legal costs, time for foreclosure activity, and potential real estate-owned management issues (such as eviction, securing the property, fix-up, marketing).

Our office is pleased to assist investors with their pre-litigation notices; for those CP buyers who wish to prepare their own notices, see our special report: "," at cpexchange.com.