WHEN WRAP-AROUND MORTGAGES RETURN - The Time To Plan is NOW!
This article was written in September 2003. The predicted rise in interest rates is occuring and is expected to continue for the foreseeable future. Interest in Wrap-Around Mortgages has increaed dramatically in the past year. For this reason, I am recirculating this article for those wishing to learn more about this topic.
For the complete article, with all footnotes and citations, please feel free to request a copy via email.
Enjoy!
WHEN "WRAP-AROUND MORTGAGES" RETURN*
*The Time to Plan is NOW
With interest rates near historic lows, commercial real estate is being financed at rates few believed possible only a short time ago. The commercial real estate loan market is extraordinarily competitive. Lenders are scrambling to find borrowers, and are willing to be flexible to attract borrowers with fiscally sound commercial real estate projects. Forward thinking Investors and Developers will use this time wisely to negotiate loan terms enabling them to take advantage of today's low interest rates when interest rates rise.
WHERE ARE WE NOW? (September 2003)
For over two years – especially since September 11, 2001 - we have watched interest rates decline. It has not always been steady. Rates have occasionally inched up 10, 20 or 30 basis points for a few weeks at a time but, generally, the trend has been downward. In mid-June 2003, interest rates were at their lowest levels in over 40 years. Although the economy is showing signs of recovery, analysts predict interest rates to remain historically low until after the 2004 presidential elections.
With this trend of falling interest rates it is easy to see how some investors have become complacent. As interest rates have fallen, commercial real estate values have risen due to investor willingness to accept lower yields. With traditional optimistic blindness, a significant number of investors seem to believe the current low interest rates, or even lower rates, are here to stay. Many are "taking advantage" by financing projects with floating or adjustable rate mortgages tied to the prime rate, LIBOR or other indexed rates.
The combination of lower yield expectations and higher annual cash flows (with ballooning debt coverage ratios as interest rates have dropped) has raised concerns by some, including the FDIC, that commercial real estate values and performance may be distorted in the current economic climate. A concern is that some commercial real estate loans and investments financed with "typical" underwriting ratios may be at risk when interest rates rise
Fortunately, to mitigate this risk, some borrowers and some lenders are opting to lock in fixed rates for longer periods of time. Lenders, to attract borrowers and to protect against the risk of a further decline in interest rates; and Borrowers, to protect against the risk of rising interest rates. Borrowers may pay a slightly higher yield to lock-in a fixed rate over an extended term, but in the current climate of historically low rates and lender competition for borrowers, long term fixed rates remain attractive.
Since interest rate increases are not likely to be any more predictable or steady than their recent decline, and because lenders can hedge their interest rate bets by matching long term loans to annuity contracts, long term Certificates of Deposit or other long term investments, lenders are likely, for the foreseeable future, to be flexible and negotiable on some loan terms – especially if the terms do not directly affect their agreed upon yield or impair their collateral.
PLANNING FOR RISING RATES
With interest rates at near historic lows, and lenders clamoring to make loans secured by quality commercial real estate, NOW is the time to plan for the future. 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.
INVESTORS: Now is the time to negotiate provisions in your commercial real estate mortgage to allow you to leverage current low interest rates to your advantage when interest rates rise. Here's how:
Leveraging Low Interest Rates
In one respect, the value of locking in low interest rates for extended periods when interest rates are likely to rise is obvious. If you knew today that interest rates were rising and that in the foreseeable future interest rates were going to be 7.5%, 8.5%, 9.5% or higher, who wouldn't lock in today's low interest rates if they could? That is not really the issue. That concept is self-evident.
But what if, for example, you lock in a low interest rate today for the next 10, 20 or 30 years - interest rates rise significantly, and then, say 5 or 6 years from now, you wish to sell your investment?
Assuming pre-payment of your loan is allowed , one solution is to simply sell the property. In this case, you would receive your equity and would be free to reinvest at then prevailing returns. Unless you have a "portable mortgage" allowing transfer to a new project, you would promptly loose any future benefit of your long-term low interest rate because the project would be gone and, most likely, the mortgage paid off.
If the mortgage is "assumable", you may gain some advantage by being able to negotiate a higher sale price for the project because the assuming buyer will be able to benefit from your lower rate. An obvious problem with this scenario is that, if the project has appreciated substantially, the amount of the down-payment the buyer may be required to produce to pay the equity between the purchase price and the remaining loan balance may be prohibitive to most buyers, thereby reducing demand for your property and creating downward pressure to lower the price.
Are there other solutions?
Consider the following hypothetical facts:
Today: Investor acquires an office building, strip shopping center, single use building, or other typical investment property (the "Property") for $2,000,000. Investor obtains a loan for $1,500,000 [75% loan to value] with a fixed interest rate of 6.25 % amortized and payable over 20 years, secured by a first Mortgage on the property.
Five years later: Now, project yourself five years into the future: Interest rates on first mortgage loans have risen to 9.5%. Interest rates on loans secured by second position mortgages are, perhaps, 10.5% to 11%. Because of built-in rental increases under existing leases, the Property has appreciated in value to, say, $2,200,000. Perhaps the tax shelter benefits of the Property to the Investor have diminished somewhat because the Investor used segregated cost accounting to accelerate cost recovery in the early years of the investment, so Investor has decided to sell. The sale price is $2,200,000.
Case No.1. Investor could simply sell the property to a willing buyer (the "Buyer") who would be responsible for obtaining its own financing. Under a typical scenario, the Buyer will obtain a mortgage loan for 75% of the value of the property at current market interest rates. Under the hypothetical facts given, the Buyer will invest equity of $550,000 (25% of the purchase price) and will obtain a first mortgage loan in the amount of $1,650,000 (75% of value) at a current interest rate of 9.5% amortized over 20 years, with a 15 year balloon payment . The Buyer's monthly payment would be $15,380.16. The balloon payment due in 15 years would be $732,323.88. The original Investor would "cash-out" at the time of funding this loan and the original first Mortgage loan would be paid off.
Case No. 2. If the Mortgage is "assumable" (or, at least, not "due-on-sale ), 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% interest rate for the balance of 15 years. If this were to occur exactly 5 years after the original investment, the Mortgage balance would be $1,278,706.63, requiring the Buyer to invest $921,293.37 as its equity to acquire the Property and receive the benefit of the lower interest rate. An investor may be willing to do this, if it has the funds available and is willing to make a 42% cash outlay for an investment property to achieve a below market interest rate. Investor preferences, however, typically favor a lower down payment.
Case No. 3. 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% of the purchase price.
Option 1: 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 (perhaps, 10.5%), amortized over an agreed upon period (say, 20 years with a 15 year balloon) and buyer can assume or take subject to the existing first Mortgage bearing interest at 6.25%. In this case, the Buyer would get the benefit of the lower interest rate on the first Mortgage, while paying a 10.5% market rate of interest on the second mortgage; or
Option 2: the Investor might offer the Buyer a "wrap-around mortgage" for the entire amount being financed ($1,650,000) at a below market interest rate for a first mortgage loan with interest of, say, 9% on the entire amount, amortized over 20 years with a 15 year balloon.
If Option 1 is chosen, the Investor will receive 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% 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%.
If Option 2 is chosen, the Investor will receive at closing the sum of $550,000 in cash, and will "hold paper" for $1,650,000 bearing interest of 9% (desirable to Buyer because it is .5% less than market, and results in a monthly payment of only $14,845.48, an amount $534.68 per month less than available at the hypothetical current market rate of 9.5%). Of the $1,650,000 held by Investor, only $371,293.37 represents funds actually "loaned" by Investor .
At first glance, it may seem that these funds will earn interest at only 9% instead of 10.5% available under Option 1, but consider further: Through use of a wrap-around mortgage, the Investor would also earn a 2.75% return on funds of the original lender because of the spread between the 6.25% interest rate on the first mortgage loan and the 9% interest rate on the wrap-around mortgage loan. Since 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 (remaining unpaid to) the original first mortgage lender.
As a consequence, 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, (in this case, $174.64 per month more than the monthly payment receivable under Option 1, above, with only a second mortgage position. 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 2 would be $715,156.77 ($542,693.04 greater than in Option 1 - and, in fact, nearly double the amount originally loaned, due to accumulated interest from negative amortization), generating an effective overall yield on Investors actual cash investment of $371,293.37 at a rate of 14.32% per annum compounded monthly during the life of the loan.
Under Option 2, 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.
Wrap Option Available to Banks Also
In the foregoing examples, we have assumed that it is the Investor/"Seller" who is providing the financing and who will be the "wrap-around Mortgagee". This is not necessarily the case. There is no legal reason a Bank or other lender could not be the wrap-around Mortgagee under similar circumstances provided it is not prohibited by regulatory mandate or internal loan policies from securing loans through use of a "junior mortgage".
In this case, the transaction would be structured by having the Bank be the wrap-around lender. The Bank would advance to the Buyer the additional $371,293.37 needed to pay off the Seller, as a loan secured by a wrap-around mortgage. The Buyer would contribute $550,000 as 25% of the purchase price, the Bank would lend the Buyer an additional $371,293.37, taking back a wrap around mortgage for $1,650,000 (75% of the purchase price). At closing, the Investor/Seller would receive its entire equity of $921,293.37, and the original lender would continue to carry its first mortgage with a principal balance of $1,278,706.63 at 6.25% for the balance of 15 years.
Except for substitution of the Bank in place of the Investor as the wrap-around mortgagee, all other loan attributes remain the same: the Buyer gets the benefit of below market interest [9% instead of 9.5%]; the Seller receives all of its equity to invest or use as Seller determines appropriate; the original lender continues to receive the benefit of its contracted for fixed interest rate over the term of its loan; and the Bank, as wrap-around mortgagee, receives an effective interest yield of 14.32%. Everyone wins.
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 with 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-round 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 which, legally, may enhance the wrap-around mortgagee's collateral position.
Although not entirely clear from reported case law, at least one respected commentator has suggested that this migration of lien priority is a natural consequence of applicable subrogation law. Judicial interpretation of this proposition in the context of wrap-around mortgages, however, has been scant, and in most jurisdictions non-existent.
While this legal position appears sound in circumstances where the indebtedness secured by a superior lien is paid in full , its application to partial payments under a wrap-around mortgage with pro rata subrogation remains largely untested.
Still, building a case for preservation of this outcome is desirable. Accordingly, 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 inclusion of specific language to this effect, the doctrine of "conventional subrogation" may be sufficient to achieve this result.
From an underwriting standpoint, however, until this issue is definitively settled through judicial interpretation or otherwise, it is appropriate to analyze a proposed loan secured by a wrap-around mortgage as being a loan secured by a junior mortgage.
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 subsequent to the date of recording a wrap-around mortgage but prior to the date of payment of future installments to the senior lender. This issue is implicated because most wrap-around mortgages provide that the wrap-around mortgagee is required to pay the senior lender only to the extent of funds actually received from the wrap-around mortgagor, giving rise to the legal dichotomy between obligatory future advances and non-obligatory future advances .
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 (whether or not subrogation applies) is entitled to include such amount in the indebtedness secured by the lien of its mortgage.
Other covenants are useful or necessary to preserve the yield enhancement provided by use of a wrap-around mortgage. In particular, a covenant in the wrap-around mortgage that the underlying first mortgage may not be prepaid by the wrap-around mortgagor is essential, since it is the interest rate spread between the wrap-around mortgage and the underlying first mortgage that enhances the effective yield to the wrap-around mortgagee. Also, a cross-default provision in the wrap-around mortgage, providing that a default under the senior mortgage will constitute a material default under the wrap-around mortgage, is a useful protective covenant.
Proper documentation of a loan secured by a wrap-around mortgage loan is critical to maximize the potential benefits and afford the legal protections a wrap-around mortgage may provide.
Advanced Planning Is The Key
Wrap-around mortgages are useful legal devices that seldom arise except during periods of rising interest rates. When interest rates rise, wrap-around mortgages provide a legally sound tool for preserving the benefits of long-term low interest rate loans. Not only do they enable Investors and Banks to realize enhanced effective yields on commercial real estate loans, they can also make properties and loans more marketable by enabling the Buyer to pay a lower overall interest rate than may otherwise be generally available in the marketplace.
To take advantage of the benefits of a wrap-around mortgage when interest rates rise, the Investor/Borrower must plan now, while long-term interest rates are low, by negotiating loan terms that facilitate their use. Key among these provisions are elimination or limitation of the "due on sale" clause, and elimination or limitation of a negative borrowing covenant that prevents the property from securing other indebtedness. Similarly, all other provisions of the Mortgage loan must be carefully reviewed with an eye toward future use of a wrap-around mortgage to protect against unforeseen obstacles.
With proper planning and effective negotiation at the time of obtaining a low interest long-term loan secured by investment real estate, a wrap-around mortgage may provide a unique opportunity to profit when interest rates rise.
R. Kymn Harp
For the complete article, with all footnotes and citations, please feel free to request a copy via email.
Enjoy!
WHEN "WRAP-AROUND MORTGAGES" RETURN*
*The Time to Plan is NOW
With interest rates near historic lows, commercial real estate is being financed at rates few believed possible only a short time ago. The commercial real estate loan market is extraordinarily competitive. Lenders are scrambling to find borrowers, and are willing to be flexible to attract borrowers with fiscally sound commercial real estate projects. Forward thinking Investors and Developers will use this time wisely to negotiate loan terms enabling them to take advantage of today's low interest rates when interest rates rise.
WHERE ARE WE NOW? (September 2003)
For over two years – especially since September 11, 2001 - we have watched interest rates decline. It has not always been steady. Rates have occasionally inched up 10, 20 or 30 basis points for a few weeks at a time but, generally, the trend has been downward. In mid-June 2003, interest rates were at their lowest levels in over 40 years. Although the economy is showing signs of recovery, analysts predict interest rates to remain historically low until after the 2004 presidential elections.
With this trend of falling interest rates it is easy to see how some investors have become complacent. As interest rates have fallen, commercial real estate values have risen due to investor willingness to accept lower yields. With traditional optimistic blindness, a significant number of investors seem to believe the current low interest rates, or even lower rates, are here to stay. Many are "taking advantage" by financing projects with floating or adjustable rate mortgages tied to the prime rate, LIBOR or other indexed rates.
The combination of lower yield expectations and higher annual cash flows (with ballooning debt coverage ratios as interest rates have dropped) has raised concerns by some, including the FDIC, that commercial real estate values and performance may be distorted in the current economic climate. A concern is that some commercial real estate loans and investments financed with "typical" underwriting ratios may be at risk when interest rates rise
Fortunately, to mitigate this risk, some borrowers and some lenders are opting to lock in fixed rates for longer periods of time. Lenders, to attract borrowers and to protect against the risk of a further decline in interest rates; and Borrowers, to protect against the risk of rising interest rates. Borrowers may pay a slightly higher yield to lock-in a fixed rate over an extended term, but in the current climate of historically low rates and lender competition for borrowers, long term fixed rates remain attractive.
Since interest rate increases are not likely to be any more predictable or steady than their recent decline, and because lenders can hedge their interest rate bets by matching long term loans to annuity contracts, long term Certificates of Deposit or other long term investments, lenders are likely, for the foreseeable future, to be flexible and negotiable on some loan terms – especially if the terms do not directly affect their agreed upon yield or impair their collateral.
PLANNING FOR RISING RATES
With interest rates at near historic lows, and lenders clamoring to make loans secured by quality commercial real estate, NOW is the time to plan for the future. 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.
INVESTORS: Now is the time to negotiate provisions in your commercial real estate mortgage to allow you to leverage current low interest rates to your advantage when interest rates rise. Here's how:
Leveraging Low Interest Rates
In one respect, the value of locking in low interest rates for extended periods when interest rates are likely to rise is obvious. If you knew today that interest rates were rising and that in the foreseeable future interest rates were going to be 7.5%, 8.5%, 9.5% or higher, who wouldn't lock in today's low interest rates if they could? That is not really the issue. That concept is self-evident.
But what if, for example, you lock in a low interest rate today for the next 10, 20 or 30 years - interest rates rise significantly, and then, say 5 or 6 years from now, you wish to sell your investment?
Assuming pre-payment of your loan is allowed , one solution is to simply sell the property. In this case, you would receive your equity and would be free to reinvest at then prevailing returns. Unless you have a "portable mortgage" allowing transfer to a new project, you would promptly loose any future benefit of your long-term low interest rate because the project would be gone and, most likely, the mortgage paid off.
If the mortgage is "assumable", you may gain some advantage by being able to negotiate a higher sale price for the project because the assuming buyer will be able to benefit from your lower rate. An obvious problem with this scenario is that, if the project has appreciated substantially, the amount of the down-payment the buyer may be required to produce to pay the equity between the purchase price and the remaining loan balance may be prohibitive to most buyers, thereby reducing demand for your property and creating downward pressure to lower the price.
Are there other solutions?
Consider the following hypothetical facts:
Today: Investor acquires an office building, strip shopping center, single use building, or other typical investment property (the "Property") for $2,000,000. Investor obtains a loan for $1,500,000 [75% loan to value] with a fixed interest rate of 6.25 % amortized and payable over 20 years, secured by a first Mortgage on the property.
Five years later: Now, project yourself five years into the future: Interest rates on first mortgage loans have risen to 9.5%. Interest rates on loans secured by second position mortgages are, perhaps, 10.5% to 11%. Because of built-in rental increases under existing leases, the Property has appreciated in value to, say, $2,200,000. Perhaps the tax shelter benefits of the Property to the Investor have diminished somewhat because the Investor used segregated cost accounting to accelerate cost recovery in the early years of the investment, so Investor has decided to sell. The sale price is $2,200,000.
Case No.1. Investor could simply sell the property to a willing buyer (the "Buyer") who would be responsible for obtaining its own financing. Under a typical scenario, the Buyer will obtain a mortgage loan for 75% of the value of the property at current market interest rates. Under the hypothetical facts given, the Buyer will invest equity of $550,000 (25% of the purchase price) and will obtain a first mortgage loan in the amount of $1,650,000 (75% of value) at a current interest rate of 9.5% amortized over 20 years, with a 15 year balloon payment . The Buyer's monthly payment would be $15,380.16. The balloon payment due in 15 years would be $732,323.88. The original Investor would "cash-out" at the time of funding this loan and the original first Mortgage loan would be paid off.
Case No. 2. If the Mortgage is "assumable" (or, at least, not "due-on-sale ), 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% interest rate for the balance of 15 years. If this were to occur exactly 5 years after the original investment, the Mortgage balance would be $1,278,706.63, requiring the Buyer to invest $921,293.37 as its equity to acquire the Property and receive the benefit of the lower interest rate. An investor may be willing to do this, if it has the funds available and is willing to make a 42% cash outlay for an investment property to achieve a below market interest rate. Investor preferences, however, typically favor a lower down payment.
Case No. 3. 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% of the purchase price.
Option 1: 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 (perhaps, 10.5%), amortized over an agreed upon period (say, 20 years with a 15 year balloon) and buyer can assume or take subject to the existing first Mortgage bearing interest at 6.25%. In this case, the Buyer would get the benefit of the lower interest rate on the first Mortgage, while paying a 10.5% market rate of interest on the second mortgage; or
Option 2: the Investor might offer the Buyer a "wrap-around mortgage" for the entire amount being financed ($1,650,000) at a below market interest rate for a first mortgage loan with interest of, say, 9% on the entire amount, amortized over 20 years with a 15 year balloon.
If Option 1 is chosen, the Investor will receive 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% 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%.
If Option 2 is chosen, the Investor will receive at closing the sum of $550,000 in cash, and will "hold paper" for $1,650,000 bearing interest of 9% (desirable to Buyer because it is .5% less than market, and results in a monthly payment of only $14,845.48, an amount $534.68 per month less than available at the hypothetical current market rate of 9.5%). Of the $1,650,000 held by Investor, only $371,293.37 represents funds actually "loaned" by Investor .
At first glance, it may seem that these funds will earn interest at only 9% instead of 10.5% available under Option 1, but consider further: Through use of a wrap-around mortgage, the Investor would also earn a 2.75% return on funds of the original lender because of the spread between the 6.25% interest rate on the first mortgage loan and the 9% interest rate on the wrap-around mortgage loan. Since 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 (remaining unpaid to) the original first mortgage lender.
As a consequence, 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, (in this case, $174.64 per month more than the monthly payment receivable under Option 1, above, with only a second mortgage position. 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 2 would be $715,156.77 ($542,693.04 greater than in Option 1 - and, in fact, nearly double the amount originally loaned, due to accumulated interest from negative amortization), generating an effective overall yield on Investors actual cash investment of $371,293.37 at a rate of 14.32% per annum compounded monthly during the life of the loan.
Under Option 2, 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.
Wrap Option Available to Banks Also
In the foregoing examples, we have assumed that it is the Investor/"Seller" who is providing the financing and who will be the "wrap-around Mortgagee". This is not necessarily the case. There is no legal reason a Bank or other lender could not be the wrap-around Mortgagee under similar circumstances provided it is not prohibited by regulatory mandate or internal loan policies from securing loans through use of a "junior mortgage".
In this case, the transaction would be structured by having the Bank be the wrap-around lender. The Bank would advance to the Buyer the additional $371,293.37 needed to pay off the Seller, as a loan secured by a wrap-around mortgage. The Buyer would contribute $550,000 as 25% of the purchase price, the Bank would lend the Buyer an additional $371,293.37, taking back a wrap around mortgage for $1,650,000 (75% of the purchase price). At closing, the Investor/Seller would receive its entire equity of $921,293.37, and the original lender would continue to carry its first mortgage with a principal balance of $1,278,706.63 at 6.25% for the balance of 15 years.
Except for substitution of the Bank in place of the Investor as the wrap-around mortgagee, all other loan attributes remain the same: the Buyer gets the benefit of below market interest [9% instead of 9.5%]; the Seller receives all of its equity to invest or use as Seller determines appropriate; the original lender continues to receive the benefit of its contracted for fixed interest rate over the term of its loan; and the Bank, as wrap-around mortgagee, receives an effective interest yield of 14.32%. Everyone wins.
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 with 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-round 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 which, legally, may enhance the wrap-around mortgagee's collateral position.
Although not entirely clear from reported case law, at least one respected commentator has suggested that this migration of lien priority is a natural consequence of applicable subrogation law. Judicial interpretation of this proposition in the context of wrap-around mortgages, however, has been scant, and in most jurisdictions non-existent.
While this legal position appears sound in circumstances where the indebtedness secured by a superior lien is paid in full , its application to partial payments under a wrap-around mortgage with pro rata subrogation remains largely untested.
Still, building a case for preservation of this outcome is desirable. Accordingly, 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 inclusion of specific language to this effect, the doctrine of "conventional subrogation" may be sufficient to achieve this result.
From an underwriting standpoint, however, until this issue is definitively settled through judicial interpretation or otherwise, it is appropriate to analyze a proposed loan secured by a wrap-around mortgage as being a loan secured by a junior mortgage.
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 subsequent to the date of recording a wrap-around mortgage but prior to the date of payment of future installments to the senior lender. This issue is implicated because most wrap-around mortgages provide that the wrap-around mortgagee is required to pay the senior lender only to the extent of funds actually received from the wrap-around mortgagor, giving rise to the legal dichotomy between obligatory future advances and non-obligatory future advances .
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 (whether or not subrogation applies) is entitled to include such amount in the indebtedness secured by the lien of its mortgage.
Other covenants are useful or necessary to preserve the yield enhancement provided by use of a wrap-around mortgage. In particular, a covenant in the wrap-around mortgage that the underlying first mortgage may not be prepaid by the wrap-around mortgagor is essential, since it is the interest rate spread between the wrap-around mortgage and the underlying first mortgage that enhances the effective yield to the wrap-around mortgagee. Also, a cross-default provision in the wrap-around mortgage, providing that a default under the senior mortgage will constitute a material default under the wrap-around mortgage, is a useful protective covenant.
Proper documentation of a loan secured by a wrap-around mortgage loan is critical to maximize the potential benefits and afford the legal protections a wrap-around mortgage may provide.
Advanced Planning Is The Key
Wrap-around mortgages are useful legal devices that seldom arise except during periods of rising interest rates. When interest rates rise, wrap-around mortgages provide a legally sound tool for preserving the benefits of long-term low interest rate loans. Not only do they enable Investors and Banks to realize enhanced effective yields on commercial real estate loans, they can also make properties and loans more marketable by enabling the Buyer to pay a lower overall interest rate than may otherwise be generally available in the marketplace.
To take advantage of the benefits of a wrap-around mortgage when interest rates rise, the Investor/Borrower must plan now, while long-term interest rates are low, by negotiating loan terms that facilitate their use. Key among these provisions are elimination or limitation of the "due on sale" clause, and elimination or limitation of a negative borrowing covenant that prevents the property from securing other indebtedness. Similarly, all other provisions of the Mortgage loan must be carefully reviewed with an eye toward future use of a wrap-around mortgage to protect against unforeseen obstacles.
With proper planning and effective negotiation at the time of obtaining a low interest long-term loan secured by investment real estate, a wrap-around mortgage may provide a unique opportunity to profit when interest rates rise.
R. Kymn Harp
posted by R Kymn Harp | 10:18 AM
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