As the economy continues to falter, more residential and commercial real estate owners are falling behind on their property taxes-creating opportunities for investors, who are increasingly looking to tax liens for attractive returns with virtually no correlation to stocks and bonds.

When an owner fails to pay property taxes, local governments will usually attach a lien for the balance of the delinquency, with the property serving as collateral until the taxes are paid. If the taxes remain unpaid, the taxing authority may sell the lien, often at public auction, and award the successful bidder a "tax lien certificate" as evidence of the purchase.

The tax lien certificate gives the purchaser the taxing authority's right to collect the unpaid taxes, plus interest and any applicable fees, as well as the right to foreclose on the property if the total is not paid before the mandated redemption deadline.

Selling tax lien certificates allows a county or municipality to collect needed revenue immediately from the investor. If the taxes are paid before the certificate reaches maturity, the lien is released and the government sends the investor its principal and interest.

Twenty-eight states and the District of Columbia sell tax liens. Interest rates are set by state statute and vary from 6% to 36%. Industry experts say that a diversified portfolio of these alternative investments can consistently return between 10% and 15% when the certificates are held to maturity, typically one to three years.

"Short-term, low-risk, moderate-to-high yield, well-collateralized debt receivables," is how Howard Liggett, a 30-year industry veteran, who recently retired as executive director of the National Tax Lien Association, characterizes these investments.

Redemption rates average 95% nationally, with 65% of the redemptions occurring in the first year, so investors stand a good chance of profiting fairly quickly, according to Liggett. The certificates are also secured by real estate, with lien-to-value ratios averaging 10% or less nationwide, he says.

Tax liens almost always have superior priority over any existing non-tax liens, including mortgages. On properties with mortgages, the first priority status of tax liens can encourage mortgagors (typically banks) to protect their positions by paying any back taxes and interest if the owner doesn't. This is a plus for investors, as it increases the chance that liens will be redeemed and decreases the chance that investors will have to foreclose. Foreclosure requires the investor to pay court costs and attorneys' fees, plus the costs associated with marketing and selling the property. Experienced investors, particularly in an unfavorable real estate market, usually prefer to recover their capital with a decent rate of interest-and no foreclosure hassles.

A Multi-Billion-Dollar Market
Television and Internet advertisements aimed at "mom and pop" investors endlessly promote tax lien investing as an easy way to make gobs of money with little risk or effort.  But this is a serious business for professionals and it takes a disciplined approach.

"It's not the shenanigans you hear about on late-night infomercials. This is a relationship between communities and investors who are willing to put their capital at risk," says Liggett.

He estimates that between $7 billion and $10 billion in tax liens are sold at auctions annually, although the volume of tax liens advertised for sale is much greater.  "If the auction is advertised, as required by statute, the owner or mortgagee will be the recipient of that advertisement and will often pay the bill before the sale begins," he says.

The market for tax liens has grown substantially in recent years.  According to one survey, the decline in the real estate market caused the supply of liens to grow by 30% in 2008 and 20% in 2009, because of the jump in delinquencies by property owners. A simultaneous rise in demand occurred, driven by hedge funds and banks seeking better yields (with less perceived risk) than those available in other debt receivables markets.

Getting In On The Action
While local auctions still attract retail investors, who typically buy tax liens only in the area in which they reside, the advent of online auctions has allowed hedge funds and banks bidding in volume to dominate the market. Competition is so fierce that reinvestment of idle cash from early lien redemptions is actually a major hurdle for some investors.

Several hedge funds and about five banks currently invest in tax liens, although players come and go in this ever-evolving industry. The largest hedge fund in this space is New York-based Fortress Investment Group. M.D. Sass Investors Services, another New York hedge fund, has almost two decades' experience in tax lien investing. Florida-based BankAtlantic is currently the oldest institutional purchaser of tax liens, while two other banks, Bank of America and JPMorgan Chase, recently sold their portfolios and exited the business.

For family offices and high-net-worth individuals, one way to enter this asset class is to buy into a fund. To date, there are no public funds in this alternative-investment space, but there are a number of private funds, with minimums typically ranging from $100,000 to $1 million.

Another option is to hire an acquisition and servicing firm to build a custom portfolio. These companies locate available liens, perform pre-purchase due diligence on the properties, bid at the tax auctions, handle redemptions, provide bank reconciliation and custodial services, foreclose on the properties if necessary and manage investors' portfolios. Most sophisticated investors, including hedge funds, outsource acquisition and day-to-day portfolio management to servicers, rather than attempt to navigate the complexity of varying state property tax laws and the quirks of local tax sale rules and real estate markets.

"The number one rule to remember in the tax lien business is that every state is different," says Dan Friedman, president of Elmhurst, Ill.-based Optimum Asset Management. Optimum provides acquisition and servicing for wealthy individuals, family offices and institutional investors with a minimum of $1 million to invest. The firm charges a 1% acquisition fee and an annual servicing fee of 1% of assets under management.

Friedman says his company concentrates on investing in six to eight states that offer good yields on liens and a friendly regulatory climate. "Some states are more protective of the property owner. Others are more weighted in favor of the investor. Obviously, we prefer the states that are favorable to investors," he says.  Currently, the states most popular with investors include Florida, Illinois and New Jersey.

When it comes to buying tax liens, Friedman thinks high-net-worth individuals and family offices with "friendly bankers" may have an advantage in the current low-interest-rate environment. "Investors who have access to borrowiwng are able to maximize their yield. If you can borrow at 6%, and buy tax liens that yield 16% or 18%, the returns can be remarkable," he says.

Minimizing Risk, Reaping Rewards
Investing in tax liens is not risk-free. Experienced servicers screen for a multitude of factors that affect lien values, including the assessed value and condition of the property, the location, the amount owed, the likelihood the debtor will eventually pay, whether the property is mortgaged or the owner has filed for bankruptcy and the possibility of other claimants taking the property (e.g., IRS tax liens).

Another risk is that of a quick redemption, which can lower the yield on a tax lien.  For example, if an investor buys a tax lien yielding 12% that's outstanding for only 6 months, the actual rate of return is 6%.

Perhaps the biggest risk is that the tax lien will not be redeemed and the investor will have to foreclose to recover its investment. Given historically high rates of redemption, especially on single-family residences that are owner-occupied and commercial properties with operating businesses, the risk that the investor will have to foreclose is relatively slim.

Still, it's essential to perform pre-purchase due diligence, just in case the investor winds up with the property. Liggett, who now serves as president of Distressed Real Estate Consulting Services, says his firm combs public and proprietary databases for detailed information on properties. He also gets broker price opinions and real-time photographs on some of the larger properties he's considering buying for clients.

Liggett recommends repeating the due diligence process before starting foreclosure proceedings, because of the time lag between the initial due diligence and when the investor acquires the property.  "A lot can happen to a property, good and bad, in that time period," he says.

There's one more important consideration if advisors and their clients decide the potential rewards of investing in tax liens outweigh the risks-taxes.  The bad news is that profits from tax lien investing are taxed as ordinary income. The good news is that IRS rules permit investing in tax liens within tax-advantaged retirement accounts.

Friedman says one solution is to set up a multi-member LLC and make one of the members a self-directed IRA. His firm provides this service to wealthy investors. "It can be done, it's just a little tricky.  High-net-worth individuals know better than any of us that it's not how much you make, it's how much you keep," he says.

A Controversial Investment
According to NTLA Executive Director Brad Westover, most local governments fund about 35% to 85% of their budgets through real estate taxes. When property owners don't pay their taxes, city and county governments have only three choices:  reduce services, increase taxes on those who do pay or borrow to cover budgetary shortfalls.

While auctioning off tax liens may cause hardship for property owners who must pay interest on their tax debt, the counter-argument is that local governments need cash flow to provide basic services, such as policing, fire protection and public education.

Nevertheless, the perception that investors are taking advantage of hapless property owners is one reason that most investors establish limited liability companies, trusts or other entities to bid on tax liens. Family offices and affluent investors in particular may not want to be publicly identified with an industry that critics say benefits from the economic misfortune of others.

The U.S. Department of Justice has recently prosecuted several high-profile cases of illegal bid rigging at tax lien auctions.  Some cases still under investigation allegedly involve tax lien servicers, hedge funds and banks.

The 70-member NTLA represents the interests of the hedge funds, banks, acquisition and servicing firms, title companies and law firms that agree to be bound by its code of ethics, which explicitly prohibits anticompetitive conduct. Westover says the code is strictly enforced.

"Shenanigans" like collusive bidding are why advisors should thoroughly vet tax lien funds and servicers before entrusting clients' money to them. Liggett says. "No family office should risk their reputation or their capital," he says.