A hypothecation is defined, at least in the context of commercial real estate finance, as a loan secured, not by a piece of commercial real estate, but rather by a mortgage note owned by the borrower, which is itself secured by a piece of commercial real estate. In short, its a loan to a guy who owns a mortgage note. He pledges his mortgage note receivable for a smaller loan.
It is normally far-far better for a note holder to hypothecate his mortgage note rather than to sell it at a huge discount. Normally when an investor sells a mortgage note, he is forced to take an enormous haircut (loss). If he simply borrows against his mortgage note receivable (hypothecates it), he can pay back the hypothecation loan and regain title to the full value of his mortgage note. An example will make this much more clear.
Once upon a time Billy Whiteshoes (he wears plaid pants and a matching white belt) owned an 80-unit apartment building in Naples, Florida free and clear. He was 68-years-old, and it was finally time for his bride of 55 years and him to retire. He sold his apartment building for $4.2 million and carried back, for tax reasons, a $3,700,000 first mortgage at 6% interest for 20 years, a wonderful return considering that banks are only paying 0.50% for deposits right now.
Sadly his beloved bride is snatched by an alligator while feeding the ducks in a pond near their Florida retirement community. Billy Whiteshoes is devastated and realizes that life is short. He resolves to live his last remaining years with gusto. That's when he meets Lola La Boom-Boom, a 42-year-old retired stripper, working as a bartender in a nearby watering hole. It's love at first sight (of Billy's assets). Lola convinces Billy to take her on an expensive cruise and to buy her an enormous diamond engagement ring ($120,000).
Needing $150,000 in cash for the rock and the cruise, Billy contacts a mortgage note broker, who offers him just $2,250,000 for his $3.7 million first mortgage note. "This is a 20-year mortgage, Billy, and while 6% may sound like a great yield today, in five years it may be well below market. Then my investors will be stuck with a below-market yield for 15 more years. In any case, we buy our mortgage notes discounted to yield at least 13%." Outraged, Billy calls a half-dozen more mortgage note brokers, but the offers he receives are all about the same.
Billy is inflamed with desire for Lola, but he is not a complete idiot. He keeps calling commercial mortgage brokers, until he reaches a subscriber to George's blog. "You know, Billy," the wise commercial mortgage broker explains, "there is another way. I can arrange for a $170,000 loan, secured by your first mortgage note receivable. You don't have to sell the note at a discount. You can just borrow against it. This is a private money lender, so you are going to pay 12.9% and 4 points, plus my loan brokerage commission. But when you pay off this hypothecation loan, you'll still own the entire $3.7 million first mortgage note. Your cash flow from his mortgage note receivable is large, so I recommend that you triple up on your monthly payments. Billy, you would be an idiot to sell your $3.7 million note for just $2.25 million!"
My private money commercial mortgage company, Blackburne & Sons, will hypothecate commercial first mortgage notes.
How much can you borrow against a commercial first mortgage note? For how much can you hypothecate it? Most lenders (there are very few of us) who hypothecate commercial first mortgage notes will lend up to 80% of the discounted present value of the note. Without trying to teach a whole college-level course in business finance, most hypothecation lenders will discount the monthly payments and the balloon payment back to present value. Blackburne and Sons will use a discount rate of 13%, the yield required by our private investors. Since we charge a 4-point loan origination fee on hypothecations, we would use as our value of the note 96% of its discounted present value. Just like we are not going to lend 100% of the value of a property, we will lend up to 80% of the value of that note (to us).
So how do you package a hypothecation loan? If you are a commercial mortgage broker, what documents do you ask for? One of our newer loan officers recently ran across a hypothecation loan request, and our brilliant EVP, Angelica Gardner, sent this to him:
Good Morning, (New Loan Officer),
I received your voicemail message regarding a hypothecation loan. I figured it would be better to send you the details so you can review (the deal) first, then we can discuss details or questions.
First, the definition of a hypothecation: The established practice of a borrower pledging an asset as collateral for a loan, while retaining ownership of the assets and enjoying the benefits therefrom. With a hypothecation, the lender has the right to seize the asset if the borrower cannot service the loan as stipulated by the terms in the loan agreement.
Below is a list of the documents that I would want to see. It is unlikely that you will be able to gather all of the documents listed below, but try to get as many of them as possible.
- Color photos of the property.
- Copy of Promissory Note and Mortgage*
- Original title insurance policy (or fresh prelim)*
- Something showing the payment history*
- Closing statement from when note was created*
- Financial statement on the maker/borrower (when the note was created)
- Credit report on the maker/borrower (when the note was created)
- Two years’ tax returns on the maker/borrower (when the note was created)
- Appraisal - an old one is very helpful and a new one is blissful
- Rent roll and/or commercial leases (when the note was created)
- Current financial statement of the Maker (hypothecation borrower), current credit report on the Maker, last two years tax returns on the Maker, current Rent Roll, current commercial leases.
* Very, very important.
Find out early who has possession of the original Promissory Note and Mortgage. It is legally impossible to properly assign a note and mortgage to the assignee (buyer of, or lender against, the discounted commercial loan) without delivering the original promissory note. In fact, if the assignee (buyer of, or lender against, a discounted commercial loan) fails to take physical delivery of the original promissory note, and if the assignor (the seller of, or borrower against, the discounted commercial loan) later files Chapter 7 bankruptcy, the promissory note becomes the asset of the bankruptcy estate! (In real life) the intended assignee is completely wiped out.
Another important note: We will require that the underlying borrower makes his payments directly to us. We want to always make sure that the payment on our loan is covered by the payments from the underlying borrower. Please let me know if you have any questions.
Angelica D. Gardner
Executive Vice President