Commercial Loans and Fun Blog

Scary Things Can Happen When You Make a Loan Against a Commercial Loan

My mentor - the man who taught me commercial real estate finance years ago - is the wise, old veteran, Bill Owens, of Owens Financial Group. "So, Bill," I asked today, "please tell me some horror stories about hypothecation loans."

You will recall from my earlier blog article that a hypothecation loan is a loan secured by a mortgage loan. The easiest way to understand what we're talking about here is to imagine a cranky old investor who owns a 36-unit apartment building free and clear. The cranky old investor sells his apartment building for $1 million, and he carries back an $800,000 first mortgage at 7% interest for seven years. It's a good deal for the investor because he couldn't earn 7% on his $800,000 in sales proceeds if he deposited the cash in the bank.

Now let's scroll forward three years. The 72-year-old old investor meets 37-year-old Blondie the Bimbo in a bar. Blondie wants a new car, a diamond necklace, and a vacation to the Bahamas. The investor needs cash. So he trots down to Blackburne and Brown and pledges his $800,000 first mortgage receivable to us as collateral for a $600,000 loan. Blackburne & Brown is comfortable with the loan because if the old man doesn't make his payments, we'll simply execute (think of it as a fast foreclosure) on his $800,000 note and mortgage. Our $600,000 investment would then be secured by a $1 million dollar apartment building.

Blackburne and Brown made several hypothecation loans last year, and we are hungry to make more. But I was nervous. I didn't know the pitfalls of hypothecations, so I asked Bill Owens, "Bill, please tell me some horror stories about hypothecation loans."

"Okay, George, try this one. A guy owns an $80,000 first mortgage note against a $100,000 house. You make a $60,000 hypothecation loan against it, evidenced by a promissory note and hypothecation (pledge) agreement against the mortgage. Then the borrower goes bankrupt, and the bankruptcy court rules that because you only had a collateral assignment of the mortgage, rather than a mortgage against the actual real estate, you are an unsecured creditor. Such a ruling, in real life, means that you will be probably completely wiped out by the bankruptcy!"

"So what should I have done, Bill?" I asked.

"You should have a taken an absolute assignment of the mortgage. Now you can still give the borrower a buy-back agreement that says he can buy back the mortgage if he makes all of his loan payments, but it is critical to take an absolute assignment of the mortgage, as opposed to a collateral assignment."

"Please tell me another horror story, Bill."

"Okay, suppose you execute (foreclose) on a $60,000 note and mortgage, secured by a $100,000 house. Then you notify the underlying borrower - the owner of the house - to start making monthly payments to you. He replies that he doesn't owe any payments for another year because he prepaid them to the original mortgage holder, in return for a discount."

"So what should I have done, Bill?"

"You should have gotten a combination Waiver of Offset and Beneficiary Statement, signed by both the mortgage holder and the underlying borrower. (A Waiver of Offset is a statement by the underlying borrower that he doesn't have any claims against the mortgage holder - such as prepaid payments.) These would act as an estoppel against any claim by the underlying borrower that he owes less than what the mortgage holder claims."

I, George, also remember that whenever you make a hypothecation loan that you should take possession of the original note and be sure to record your absolute assignment of the mortgage note.

I spoke again with Bill and he confirmed that I make a hypothecation loan that I should notify the underlying borrower that the mortgage holder has assigned the note to me and inform him that he should make all future payments directly to me.

A Hypothecation is a Loan Against a Commercial Loan

Suppose a wealthy commercial real estate investor owns a commercial building free and clear. A potential buyer makes a good offer on the commercial building, subject to obtaining a new commercial mortgage loan at 7% from his bank for 75% of the purchase price. The wealthy commercial property owner accepts the offer.

Unfortunately the commercial lending world is in turmoil right now. Banks are afraid to make new commercial loans for more than around 62% loan-to-value. The bank turns down our borrower's 75% LTV commercial loan application, and the deal looks like it is going to fall apart.

Then the commercial real estate broker has an idea. He convinces the wealthy owner to carry back a commercial loan for 75% of the purchase price at 7% interest. After all, the wealthy investor owns the commercial building free and clear. The buyer puts down 25% of the purchase price in cash, and the deal closes.

Now let's scroll forward four years. The stock market has tanked, and the wealthy investor is not so wealthy anymore. He has lost 70% of his stock investments, and now he desperately needs cash to fix up an empty office building that he owns.

He takes his $750,000 first mortgage note that he owns to a number of commercial mortgage companies that specialize in discounting commercial notes. (By the way, if you ever want to sell a commercial note at a discount, please call me, George Blackburne, at 574-360-2486.)

Because his commercial loan has a 27-year remaining term and the note rate is only 7%, he learns that he will have to discount it by close to 28 points in order to sell it. He would have to give up over $200,000 if he tried to sell his note at a discount; and he really only needs the money for about 18 months. He is going to use the money to pay for the tenant improvements on his vacant office building. Once the new tenants move in, he'll be able to easily refinance the building and pull out lots of dough.

The investor therefore calls his clever commercial real estate broker, and the broker tells him to just hypothecate his first mortgage note. A hypothecation is a loan secured by a mortgage receivable. It's a loan secured by a loan.  In this case, the investor will be pledging his $750,000 first mortgage note as security for a new hypothecation loan of $500,000.

The advantage of hypothecation loan, compared to selling a mortgage receivable at a discount, is that the investor won't have to discount his perfectly performing first mortgage note by over $200,000. He'll just pay a modest 3 point loan fee on the new, smaller $500,000 loan. The interest rate on the hypothecation, typically around 12%, is admittedly higher than what a bank would charge for a new commercial loan, but banks are not really lending right now. In addition, our investor really only needs to borrow the money for about 18 months, until his new tenants move into his vacant office building and he refinances the building. It's far better to pay 12% on $500,000 for 18 months than to suffer a $200,000+ discount if he tries to sell his commercial loan.

If you own a commercial first mortgage note that you would like to either hypothecate or sell, please call me, George Blackburne, at 574-360-2486.