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Investing in Deadbeats

Ordinarily, serious investors aim to steer clear of financial instruments that are sold on late-night infomercials, but tax liens on real estate might well be the exception to this rule. In fact, the very things that makes such investments seem dicey the fact that they are lightly regulated and unregistered are the reasons tax liens offer opportunities for such good returns. For qualified investors

Ordinarily, serious investors aim to steer clear of financial instruments that are sold on late-night infomercials, but tax liens on real estate might well be the exception to this rule.

In fact, the very things that makes such investments seem dicey — the fact that they are lightly regulated and unregistered — are the reasons tax liens offer opportunities for such good returns.

“For qualified investors interested in alternative investments, establishing a position of up to 10 percent of a portfolio in a well-managed basket of liens offers substantial ballast,” says Neil Harreveld, vice president of the North Palm Beach, Fla.-based American Tax Funding Servicing. Harreveld's company, an institutional investment firm, has privately invested $330 million in real estate tax liens since August 2000, realizing annualized returns ranging from 6.75 percent to 11.50 percent.

The rub is that liens are not your average financial instrument. The lack of regulatory oversight and dearth of reliable performance benchmarks mean they require more monitoring than more traditional investments.

Still, an increasing number of reputable firms are intrigued. For instance, Richard Chen, a former Citigroup vice president, recently started Orion Partners, a hedge fund that invests in tax liens. He contends that because the industry is rife with so many fraudulent players, a sharp, legitimate fund manager can help investors exploit the underlying profitability of tax liens.

MD Sass, a $6 billion registered investment advisor, also has embraced liens. “Tax lien products have proven appropriate for institutions that need to generate a constant stream of returns to match projected payouts,” says Vinay Jessani, portfolio manager at MD Sass.

A Little Perspective

Dating back more than a century, property tax liens were devised to help towns and counties to get ahold of back taxes before they were actually repaid. While rules vary across the 28 states that authorize the sale of liens, when a property owner is more than one year late in paying his real estate taxes, the town or county has the right to auction off these obligations. In exchange for fronting governments the money owed, investors receive sky high interest rates that can range up to 24 percent a year — plus property rights if the owners fail to pay up.

Howard Liggett, a former tax collector, lien investor and now executive director of the National Tax Lien Association — a trade organization that brings together various government and private interests — says that liens play a valuable role in public finance from which the savvy accredited investor can handsomely profit.

While 95 percent of owners redeem their liens, some investors, like Richard Chen, look for foreclose opportunities. In such a proceeding, the lien holder takes on a superior position to virtually all other claims on a property — including those of a primary mortgagee. Property values are normally worth many times more than their associated liens.

“Lien-to-property value ratios are on average typically below 10 percent,” Liggett notes.

Still, investments in these instruments do not come without risks, many of which are associated with the properties themselves, rather than with market fluctuations or interest rate exposures. The discovery of environmental hazards, prohibitive development restrictions, lawsuits involving incidents on the property and real estate market value fluctuations all can effect a lien investment.

Further, the lack of industry data and trend analysis make risk assessment tricky business. Paradoxically, this lack of transparency is precisely what enables the investor who is well-steeped in the intricacies of tax liens to reap attractive gains.

Getting Started

While brokers can personally bid on specific tax liens, most are likely to pursue a less time-consuming approach, such as purchasing a basket of liens. This is not only easier, but diversifies the investment, reducing volatility and risk. The most important thing is choosing your partner carefully.

Agents can establish your positions as well as manage and resell foreclosed properties. One of the more successful agents is Charleston, S.C.-based Lennox Group. Since its inception in 2001, it has amassed more than 100 clients and $15 million in assets under management with a portfolio of liens ranging across 13 states. Accredited investors must ante up a minimum of $50,000, upon which a front-load research fee of 13 percent is levied (very expensive compared to, say, a mutual fund load but not so much in relation to hedge funds, which typically keep 20 percent of the profit). The firm passes on all accrued interest to clients, which typically ranges between 10 and 15 percent per annum. Though it encourages investors to sustain commitments for at least three years, Lennox does offer 30-day liquidity. Agents may find themselves in regulatory difficulties when collecting fees for first buying liens and then selling properties. While the laws are vague, some observers believe taking charges on both ends could technically reclassify these investments as securities, which would open up agents to far greater scrutiny. In response, there has been an increasing shift toward tax lien funds, whose status is more clearly defined.

Funds are rising in popularity. They typically cater to accredited investors and encourage or require multi-year commitments with minimum investments starting between $10,000 and $20,000. Chen's Orion Partners, based in Chapel Hill, N.C., seeks well-collateralized liens that are likely to move into foreclosure. For investors looking for a fixed annual return, Elmhurst, Ill.-based Optimum Fund promises an annual yield of 8 percent, which it has yet to miss. A third firm, New York-based MD Sass, seeks to boost returns by leveraging equity, raising 200 to 400 percent in additional capital through debt. The company's annualized returns are running between 8.9 and 13.5 percent. Closed to new investors, Saas plans a new offering in 2005.

Securitizations of tax liens trace their origins to Jersey City, N.J. in 1991. The city's then-mayor, Bret Schundler, was looking for a way to turn a truckload of property tax receivables into cash, and he found that by placing liens into a trust, bonds could be issued, backed by the revenue flowing from lien redemptions and property sales. Securitization has not caught on nationwide because of the relatively low yields involved. “Converting liens into bonds goes through a number of steps, with each participant taking a piece of the pie,” says Dan Friedman, a managing member of the Optimum Fund. “By the end of the process, investors often find bond yields are roughly equivalent to comparably-graded corporates.”

For an investor willing to be alert, tax liens offer great opportunity. “If you cut corners on your due diligence, you're going to run into trouble,” warns lawyer Joel Moskowitz, author of the tax lien investing book, The 16 Percent Solution. But when done right, Moskowitz has found that tax lien investments traditionally outperform the bond and stock markets, without suffering the latter's volatility.

And, in the end, that's what makes these receivables worth a look.

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