This is a really important question because you might buy a piece of real estate at foreclosure, only to find out someone else is entitled to live there for the next several years, rent free! How does that happen?
Suppose the owner of a house signs a written ten-year lease agreement with her son. The son will maintain the house, make all repairs, and pay all insurance and taxes. The rent is $1 per year, and the son prepays the entire ten-year term by writing his mother a check for $10 and noting on it, “Payment in full for ten years’ rent on 123 Main Street.”
One year later the mother borrows $25,000 and gives a mortgage on the house. Another year later she defaults, the bank forecloses, and you buy the house at the foreclosure auction. The son has another eight years left on his lease. Can you kick out the son, or are you stuck for the next eight years, with no right to occupancy and no rental income?
In almost all states, if the lease was signed before the mortgage, then the foreclosure does not wipe out the lease. It still exists, and the foreclosure buyer must honor the terms of the lease. Check Appendix C for landlord/tenant resources in your state, and be sure to satisfy yourself on this issue.
Sometimes lenders will require preexisting tenants to sign subordination agreements. In real estate, a subordination agreement means an agreement to go under someone else’s rights. In this case, a tenant might agree that his or her rights are subordinate to those of a mortgage lender, even though the lease was signed first. If there is a foreclosure, the tenant’s rights will come to an end because of the subordination agreement.
The more typical case is when the mortgage is signed before the lease. In that instance, when the landlord’s rights end because of foreclosure, the tenant’s rights also end.
When investigating foreclosure properties, always ask about the possibility of tenants having rights. If the mortgage money was used to purchase the property, then obviously there could be no prior tenants. In all other instances, you will have to ask questions about this issue.