Why Won't Many Commercial Lenders Allow Second Mortgages?
These days, it’s pretty well known that commercial lenders don’t allow subordinate mortgages to be attached to properties they lend on.
An interesting news article came across my desk saying that commercial real estate lenders are now finding that subordinated lending can be profitable. This surprised me since not many conventional lenders allow second mortgages on commercial real estate. I then reread the article more carefully and saw how they structured this subordinated financing.
In the residential house flipping heydays of pre-2008, it was common to be able to get a first mortgage loan against a property with either the seller taking back a second mortgage or another lender providing a second mortgage loan. Apparently, it’s not so easy to get a second mortgage on a commercial property when a conventional lender holds the first mortgage.
What’s the big deal if commercial lenders allow for second mortgages or not?
When I first started learning about commercial real estate finance, I recall instructor and apartment house guru, David Lindahl, telling us that Fannie Mae doesn’t allow for second mortgages to be attached to the apartment complexes we wanted to buy. Well, so much for all the other so-called “gurus” teaching us about their “seller financing techniques” where we are supposed to convince the seller to take back a second mortgage to lower the amount of money we have to bring to closing. Dave is a true guru who is doing many large deals so I didn’t have to verify what he told us, but I’ll admit that I didn’t understand what he said. If I were a lender and held the first mortgage on a property, what’s the big deal about allowing second mortgages on a property? I’m in first position so I’d be the first to get my money back in case of a default on the loan, right? Wellll, this ain’t always true.
Let’s say that there are two or more mortgage loans placed against the same property. If there is an irreparable loan default by the debtor and the property is headed to foreclosure, one of several possible things can happen, usually the worst for the debtor being completion of the foreclosure and transfer of property out of the debtor’s ownership to someone else. In a normal foreclosure, debts are repaid according to priority of the liens attached to the property with the first mortgage (lien) holder getting paid first. But let’s say, rather than letting the property go to foreclosure, the debtor declares bankruptcy? In this event, lien seniority is irrelevant. My first question, if I were reading this post, would be, “Gee, Bob. Why wouldn’t the first mortgage holder get paid before a lower lien holder in the event of a bankruptcy?”
Unlike just getting a judgment against someone for ripping you off, evicting a tenant for being a deadbeat, or even foreclosing on a piece of real estate, bankruptcy is automatically a federal issue and the bankruptcy judge, having federally mandated authority, has the almighty power of Zeus, ruler of the gods in Greek mythology, to do pretty much anything that he or she wants to do regarding who gets paid and how much. This all-powerful being can subordinate debt owed to a senior lien holder, reduce the balance owed by the debtor to creditors, or even eliminate the debt completely. A bankruptcy judge is not someone to play a prank on when April Fool’s Day comes rolling around each year.
In a nutshell, THERE IS NO LIEN PRIORITY WHEN DEBTORS DECLARE BANKRUPTCY. This is why many mortgage lenders will not allow other mortgages to be taken out on the property even if there is a lot of equity in it. In the event that the debtor declares bankruptcy, the lender wants to have the entire collateralized security and not risk that a judge will award priority to another lien holder who also has rights to the property. Legitimate subordinated financing often takes the form of mezzanine loans that hold shares of the company that owns the property as its security, but not the property itself, or this second loan is cross-collateralized by a completely different property. In bankruptcy, the only real priority of payoff is that secured lien holders get paid before unsecured creditors. The unsecured creditors often only get pennies on the dollar of what they are owed or get wiped out completely.
Getting back to the article I first mentioned, the subordinated loans that are becoming popular are not mortgage loans that get attached to the property. They are usually mezzanine loans that hold the shares of the entity that owns the property as collateral. If the debtor defaults on a mezzanine loan, he or she risks losing the entity that owns the property and, therefore, risks losing the property as well. This way, the senior mortgage holder can hold the only mortgage on a property while still allowing for subordinated financing on it and still have a much stronger claim to debts owed than that by any junior creditors.
Just one of many tricks by commercial lenders to watch out for if you decide you want to play the game of commercial real estate.
Here are a few related sites that may give you more information relevant to your needs. Thanks for visiting Aesir Group commercial finance.
Impact of the SAFE Act on Owner Financing
Twitter / @becomingLVlocal/Real Estate/Finance
Due diligence | Define Due diligence at Dictionary.com
Barry Sternlicht the Real Estate Bargain Hunter - NYTimes.com
PNC Real Estate Finance Company: Information from Answers.com
Land bank | Define Land bank at Dictionary.com
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Commercial Real Estate News
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Yes. David Lindahl and Ray Alcorn have excellent reference materials.
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[...] in that they usually have first claim to getting money back in the event of borrower defaults. An exception to this senior lien protection is if the borrowers declare bankruptcy in which case the…. Mezzanine debt typically carries higher interest rates on account of the increased risk taken by [...]
Charlie is right, what the market will bear is the “only” valuation of a house. Go to Detroit you’ll find lots of worthless property, because nobody will pay a dime for that junk. Everything else we buy tends to depreciate the moment we buy it, why not our house? Actually the house does too. But you are generally buying two things with your single purchase: the house structure itself, which is always depreciating like any other manufactured object; and the actual “real estate” which is the yard it is sitting on (only because it is generally impractical to separate the two things, to remove the house from the land). So if a neighborhood is slammed by recession and nobody’s making enough money to buy property, then the market stagnates and asking prices eventually have to fall to meet what the market will bear. Or other phenomenon such as deteriorating neighborhood.