Commercial Loans and Fun Blog

Why Commercial Second Mortgages Are So Rare - Part II - Due-On-Encumbrance Clauses

Posted by George Blackburne on Thu, Aug 15, 2013

Yesterday I explained that the most important reason why commercial second mortgages are so rare these days is because all of the commercial second mortgage lenders got wiped out in the commercial real estate depression of 1987 to 1991.  Today I will explain a number of legal barriers facing commercial lenders wishing to make commercial second mortgages.

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Most modern commercial mortgages contain a due-on-encumbrance clause.  This means that if the borrower places any junior financing on the property, the underlying first mortgage lender has the right to declare the borrower in default and to accelerate his loan; i.e., demand that the borrower immediately repay the loan in full.

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It gets worse.  Most modern commercial mortgages also contain a provision whereby any alienation of title without the first mortgage lender's permission is grounds to accelerate the mortgage.  Alienation of title means the transfer of any legal or equitable ownership right in the property.  In this context the word "alienation" means "to make foreign" or "to send away".  When you alienate your wife's affection by yelling at her, you send her love for you to a foreign planet.

Okay, let's not forget where we are.  We are talking about the legal obstacles to making commercial second mortgages.  Placing a second mortgage on a commercial property constitutes a form of alienation of title.  You better get the lender's permission first because further encumbering the property is grounds for accelerating the bank's first mortgage.

"Mr. Borrower, this is Bob Smith, the loan officer at the bank.  I see that you recently placed a $200,000 second mortgage on your apartment building.  It is my duty to tell you, Mr. Borrower, that because you did not first get our permission, you are now in default on our $3.4 million first mortgage.  We are hereby accelerating it.  Would you please pay off our entire $3.4 million commercial loan by 5:00 p.m. tomorrow?  If you fail to do so, we will be forced to start seizing your assets (like all of the cash in your checking and savings account).  Have a pleasant day."

Have a pleasant day?

Tomorrow we'll talk about prohibitions against mezzanine loans, preferred equity, and springing personal guarantees.

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Topics: due-on-encumbrance clause