GPSolo Magazine - March 2005
Real Estate Law
When Wrap-Around Mortgages Return: The Time To Plan Is Now
With interest rates near historic lows and lenders clamoring to make loans secured by quality commercial real estate, now is the time for investors to lock in attractive loan rates for extended periods, if possible, and to make sure they have the flexibility to keep those rates when economic conditions and future needs change. Now is the time for borrowers to negotiate provisions in their commercial real estate mortgages that allow them to leverage current low interest rates to their advantage when interest rates rise. Here’s how.
Consider the following hypothetical facts. The investor acquires investment property for $2 million. The investor obtains a $1.5 million loan (75 percent loan to value) with a fixed interest rate of 6.25 percent amortized and payable over 20 years, secured by a first mortgage on the property. Five years into the future, interest rates on the first mortgage loans have risen to 9.5 percent. Interest rates on loans secured by second-position mortgages are 10.5 percent to 11 percent. Because of built-in rental increases under existing leases, the property has appreciated in value to $2.2 million. Perhaps the tax shelter benefits of the property to the investor have diminished because the investor used segregated cost accounting to accelerate cost recovery in the early years of the investment, so the investor has decided to sell. The sales price is $2.2 million. The investor could simply sell the property to a willing buyer who would be responsible for obtaining its own financing. Or, if the mortgage is assumable, the buyer could, if it chose to do so and the seller agrees, pay the original investor an amount equal to the investor’s equity in the property and assume or take subject to the mortgage obligation with its low 6.25 percent interest rate for the balance of the loan term.
But assume at the time of obtaining the original mortgage the investor was able to negotiate a mortgage that did not include a due-on-sale clause and did not prohibit additional debt secured by the property. In this case, the investor has two additional choices if the buyer wishes to leverage the property by financing 75 percent of the purchase price.
Option One: The investor can offer to hold a standard second mortgage in the amount of $371,293.37 at an agreed-upon rate close to market rates for second mortgage loans, amortized over an agreed-upon period, and the buyer can assume or take subject to the existing first mortgage bearing interest at 6.25 percent. The buyer would get the benefit of the lower interest rate on the first mortgage but would pay a l0.5 percent market rate of interest on the second mortgage.
Option Two: The investor might offer a wrap-around mortgage for the entire amount being financed ($1.65 million) at a below-market interest rate for a first mortgage loan with interest of 9 percent on the entire amount, amortized over 20 years with a 15-year balloon.
If Option One is chosen, the investor receives at closing the sum of $550,000 in cash and will “hold paper” for $371,293.37 secured by a second mortgage, earning 10.5 percent interest per year, generating a monthly payment of $3,706.92, and a final balloon payment of $172,463.73 in 15 years. The effective yield to the investor would be 10.5 percent.
If Option Two is chosen, the investor receives at closing the sum of $550,000 in cash and will “hold paper” for $1.65 million bearing interest of 9 percent (desirable to the buyer because it is 0.5 percent less than market and results in a monthly payment of only $14,845.48, an amount of $534.68 per month less than available at the hypothetical current market rate of 9.5 percent). Of the $1.65 million held by the investor, only $371,293.37 represents funds actually “loaned” by the investor, which is the balance of equity the investor would have received if the property had been sold outright, without the need for the investor to provide any financing.
At first glance, it may seem that these funds will earn interest at only 9 percent instead of 10.5 percent available under Option One, but consider further: Through use of a wrap-around mortgage, the investor would also earn a 2.75 percent return on funds of the original lender because of the spread between the 6.25 percent interest rate on the first mortgage loan and the 9 percent interest rate on the wrap-around mortgage loan. Because the mortgage wraps around the original first mortgage loan, the balance of the wrap-around mortgage amount, $1,278,706.63, represents funds actually advanced by (and remaining unpaid to) the original first mortgage lender. The effective yield on funds actually invested by the wrap-around investor would improve to 14.32 percent.
Consequently, the monthly payment received on the wrap-around mortgage would be $14,845.48. After payment of the underlying monthly payment of $10,963.92 due on the existing first mortgage, the net amount retained from the wrap-around mortgage payment during the life of the underlying first mortgage is $3,881.56 (compared to only $3,706.92 under Option One). More significantly, at the end of 15 years, when the underlying first mortgage has been fully amortized and paid off, the balloon payment receivable under the wrap-around mortgage proposed in Option Two would be $715,156.77 ($542,693.04 greater than in Option One). In fact, the investor would receive nearly double the amount originally loaned because of accumulated interest from negative amortization.
Under Option Two, both the investor and the buyer benefit, and the original lender continues to receive the rate of return originally contracted for under the first mortgage.
Potential legal advantages and documentation. In addition to the yield enhancement benefits enjoyed by the wrap-around lender, another advantage of a wrap-around mortgage as compared to a simple second mortgage is that the collateral priority of a wrap-around mortgage may, over time, migrate to a collateral priority on par with the first mortgage.
For the most part, a wrap-around mortgage should mirror the provisions of the senior mortgage around which it wraps, with a pass-through to the mortgagor of virtually all mortgagor covenants. An essential element of a wrap-around mortgage, however, is that it must require the borrower to make all payments to the wrap- around mortgagee, who will, in turn, be obligated to pay the senior mortgagee. The wrap-around mortgage and related documentation must not permit the mortgagor to pay the first mortgagee directly. It is this arrangement that, legally, may enhance the wrap-around mortgagee’s collateral position.
The wrap-around mortgage and supporting documentation should include covenants of subrogation to establish the clear intent of the parties that subrogation to the lien of the senior loan is to occur with each payment by the wrap-around mortgagee to the senior lender. By including specific language to this effect, the doctrine of conventional subrogation may be sufficient to achieve this result.
Some commentators have raised the additional issue of whether future payments by a wrap-around mortgagee to a senior lender enjoy priority over liens filed after the date of recording a wrap-around mortgage but before the date of payment of future installments to the senior lender. The prevailing view is that this issue is adequately resolved through conventional subrogation and through the rule of tacking, which provides that a mortgagee who pays a prior encumbrance is entitled to include such amount in the indebtedness secured by the lien of its mortgage.
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- This article is an abridged and edited version of one that originally appeared on page 42 of Probate & Property, July/August 2004 (18:4).
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Real Property: Environmental Aspects of Real Estate and Commercial Transactions; Land Surveys: A Guide for Lawyers and Other Professionals, 2d ed.; Accessibility Under the Americans with Disabilities Act and Other Laws; A Practical Guide to Commercial Real Estate Transactions: From Contract to Closing; Land Use Regulation: A Legal Analysis and Practical Application of Land Use Law, 2d ed.; Synthetic Lease Financing.