If you have been asked to subordinate and if you are fully aware of (and understand) the risks and facts and you still are not comfortable, then you could ask the borrower for sufficient additional cash resulting in a reduction of the amount you have been asked to subordinate. Also, one could require sufficient additional real estate collateral (instead of cash) to further protect your remaining interests being subordinated.
Often times a buyer without a lot of money to put down on a property will be willing to pay more for a particular piece of property where the seller will agree to offer subordination, because it will enable him to offer the construction lender first position without having to pay cash for the land he wishes to build on. A knowledgeable buyer might be attracted to a property where a seller would agree to subordinate his equity to that buyers construction lender. A seller who agrees to subordinate his equity would In effect be giving that buyer the sellers equity to use as collateral for obtaining construction financing.
The request for the use of subordination isn't always restricted to the sale of vacant land or new home building, however, and does occur within many types of real estate transaction. Any type of equity position can be subordinated. For example, a motivated seller could allow property that he owns free and clear to be pledged as collateral for a construction loan to a buyer's lender. The seller carries his equity as a second at close of escrow behind the buyers new construction first loan because the buyer's construction lender requires a first position for his new construction loan that will also be placed on the property. I've even seen a bank agree to subordinate a one million dollar first loan they held to eleven privately funded new first position construction loans that I brokered.
Not to dwell on the topic too much longer but suppose for example I sold you one acre parcel of land for $50,000.00 with nothing down and carried a $50,000.00 first trust deed loan for you. You probably wouldn't be able to obtain a construction loan very easily in second position especially when also having no equity in the property. Now if you could have convinced me to subordinate my $50,000 first loan, you would then be free to offer any construction lender first position. Subordinating my interest (into second position) would allow you and your lender to use my valuable land equity as though it were your own. But watch out! Assuming for a moment that I did agree to subordinate my land equity for your new construction lender in the amount of $50,000.00 what do we have? Yikes! A $50,000.00 lot with a $50,000.00 first construction loan, and a $50,000.00 second land loan on it. This obviously would be the time to require additional cash and or real estate collateral to protect my interests from winding up being secured by blue sky! With sufficient additional cash and or real estate collateral my situation could have been well enough secured and the buyer is equally happy as he put his deal together with a lot less cash than usual, possibly no cash and 100% financing. All is well if you required enough additional collateral. For example he gave you a first on another home he owns out right worth $100K. You're protected and he got 100% financing, didn't he? 100% financing is neither illegal or immoral. After all, every veteran in the U.S. is eligible for a no down 100% V.A. loan if he can qualify because the government guarantees repayment of V.A. loans to the lenders that fund them (like another form of the above additional collateral).
What if I decide to sell to you as described above and subordinate for you, but instead you take the construction loan proceeds and instead of improving the property (by building a nice home there, greatly increasing my collateral to more than cover both loans), you skip town? Now I've got nothing because I gave my equity position to you to give to your lender. One year after escrow closes what if then subsequently the construction lender in first position then has to foreclose and take back the lot (I could have taken the lot back, but what good is a $50,000 lot with a $50,000 construction loan on it, before or ahead of mine?)
When would subordination ever be good for anyone? Well, believe it or
not, as much as one out of every two or three loans I've brokered in the
private construction lending business on average will entail some amount
of subordination on the sellers part. If misused, subordination can be
a lethal mistake for a seller however, with knowledgeable buyers and sellers
and sufficient cash and or additional collateral to protect a subordinator
it can oftentimes be a wonderful tool. (like a "piece of rope" or a "double
edged sword"!
It is very important to see to it that the loan funds from the construction
loan will be used to improve the property. If there is even the slightest
chance that they might not, then anyone subordinating in that situation
had better adjust the cash and or additional he requires upward as if the
borrower had no construction lon and never will improve the property from
your equity stand point. Just suppose for a moment that you could be guaranteed
through the use of a voucher system or a reliable draw system that the
borrower will must improve the property. In that case you may want
to give some consideration to a portion of the future proposed improvements.
As well as asking for additional cash and or additional real estate collateral
to protect his interests a subordinator should require the borrower be
on a voucher system or a draw system that says that the buyer has to use
each draw release to improve the property at each stage or the balance
of all construction money will be applied back on his loan and taken away
from him. If that can be obtained then a subordinator should not count
on any future improvement to the property as a part of the security for
his interests subordinated. If a subordinator has required sufficient cash
and or additional collateral, and has verified that a voucher or draw system
will be in place he is still not done yet. At this point if I were agreeing
to subordinate I would look very close at the loan I am going to be "subordinating
to. When is it due? Does it have a balloon? What's the interest rate and
monthly payment amount? Will a potential rental income cover the debt service
should after all this I still be forced to foreclose to protect my interest
and take over the responsibility of the new construction loan myself ??
If the const' loan has a balloon payment is it so big that I could never
begin to handle it financially if I had to take the property back? And,
if I have to take this project back when it's only half done, can I phone
up some subcontractors to finish the job, and will the balance of the construction
funds be adequate to finish? The agreement to subordinate could be made
with a condition giving me the right to approve or even set limits on the
loan amount, interest rate, and terms of that new loan I am to be taking
a back seat to.
One last point. Banks spend a lot of time checking borrowers assets,
incomes, savings account balances, car loans, verifications and loads of
other not so relevant information when you consider that if a borrower
of theirs tomorrow turns to the bottle, gets cancer, goes broke, loses
his job and falls behind, none of that above stated information will matter
more than the remaining real estate equity securing their loan. In a foreclosure
situation as the lender you don't get his spous' income, his car, sailboat,
savings account, or anything else but the property. So, in my opinion
if you ever plan to be a lender or a subordinator it would make good sense
to educate yourself as much as you can about the collateral. If the collateral
offered in any real estate transaction isn't sufficient to protect ones
interests, one should require sufficient additional collateral or simply
refuse the offer.
Pop Quiz:
- (A) Yes, under all circumstances.
- (B) No. Subordination is always safe.
- (C) If a person knows exactly what the terms are of the loan they are subordinating to and fully understands their risks and knows exactly how all of the proceeds of any loan they are subordinating to will be disbursed to improve that property, then sometimes if they can make it profitable enough to themselves to off set some unavoidable risk, it can be beneficial to all parties. (So long as there is sufficient equity to protect their investment).
2. If a person blindly subordinates their interests away to another
without any understanding, forethought or investigation into the consequences,
what is likely to happen?
- (A) The property will be improved.
- (B) The property will not be improved.
- (C) They will have to take the property back in foreclosure.
- (D) They could lose their entire investment.
3. If I agree to sell my Real Estate to you today for 50 percent
down and at the same time, I agree to carry the balance of the purchase
price on the note and deed of trust and subordinate to a new 50 percent
first for you, how much would your down payment be?
- (A) Zero
- (B) 10 percent.
- (C) 50 percent.
4. A careful or knowledgeable seller could in effect make a building
lot that he may be offering for sale possibly even sell faster or appear
attractive to prospective buyers who have a little less cash to work with
by offering to subordinate to construction financing if a few conditions
can be met.
- (A) Yes.
- (B) No.
5. It is possible to:
- (A) Subordinate prior to a close of escrow.
- (B) Subordinate upon a close of escrow.
- (C) Subordinate after a close of escrow.
- (D) All of the above.
6. Subordination only happens on vacant land transactions and never
occurs where improved property is involved.
- True or false?
7. Subordination could benefit a buyer enough that he might:
- (A) Be willing to pay a little more money for the property.
- (B) Put up additional real estate equity as collateral.
- (C) Buy a particular property sooner.
- (D) All of the above.
8. If someone subordinates away their real estate equity interests
blindly, what could happen?
- (A) They could wind up with no real estate equity securing their junior loan.
- (B) The buyer could have 125 percent financing and cash back (in his pocket) at the close of escrow.
- (C) They may not benefit by foreclosing.
- (D) All of the above.
9. Subordination can be a safe and useful tool for a buyer as well
as a seller if:
- (A) The subordinators risks are understood and compensated for with sufficient additional cash down and or sufficient additional collateral.
- (B) If both parties are aware of their risks and fully aware of all details as to what might be required of them in order to protect each of their interests at steak.
- (C) If both parties in a sale transaction can mutually, intelligently, and carefully come to an agreement to purchase that includes subordination to construction financing it could be to both their benefit.
- (D) If a seller who is subordinating is confident that all money from the loan he is subordinating to can only be used to improve the subject property (because of a proven draw or voucher system). And that the loan that he has agreed to subordinate to is a loan that he himself can realistically handle the financial responsibility of should he be forced to foreclose in order to protect his remaining interest.
- (E) None of the above.
10. You can only subordinate equity in real estate and not the equity
in a note secured by real estate.
- True or false?
11. If you are the seller of a property on "A" Street, and you sell
it to me, and you subordinate to construction financing, and I only manage
to get the house halfway built before I subsequently decide to walk away,
will you then be "on the hook" for that construction loan if you want to
foreclose on your junior loan inorder to protect your interests?
- (A) Yes, if you want to foreclose and take the property back in order to protect your remaining interest.
- (B) No, never. You can't legally foreclose.
- (C) You can finish the property yourself without foreclosing and be guaranteed a big profit.
12. If you subordinate your interests as the seller in a sale transaction
and the new construction loan you subordinated to is due in one year and
your second loan is due in 5 years; and 6 mo. later the borrower loses
the property to you in foreclosure, you will:
- (A) Have to come up with the money to pay the new construction loan off in 6 mo. unless you can extend or refinance it.
- (B) If you foreclose on your junior loan before the new construction loan is due you would own the property and could then use the subject property as collateral in a effort to obtain a new first necessary to pay off the construction loan.
- (C) Possibly lose all of your investment if you are unable to take over the responsibility of the senior construction loan ahead of your loan should they foreclose.
- (D) All the above.
13. If you still wish to subordinate and feel that you fully understand
the risks, but want just a little more security, you could:
- (A) Ask that the amount of your equity being subordinated be reduced by asking for more cash as a down payment or future principal payment from the buyer prior to me subordinating
- (B) Ask for sufficient additional real estate equity to be provided by the buyer/ borrower as additional collateral for your loan.
- (C) Demand a higher purchase price for your real estate.
- (D) Require a sufficient reduction the amount of the loan you are being asked to subordinate to.
- (E) Ask for any and all of the above.
14. Is 100% financing either illegal or immoral?
- (A) No. The government to some degree even guarantees100% loans to veterans.
- (B) Yes.
- (A) Any transaction where a party is allowed to skim a sellers equity by financing more than 100% of his purchase price against that sellers equity and sometimes even pocketing the excess proceeds at close of escrow with no intention of repaying the loan(s).
- (B) A rebate incentive on buying a new car.
No Peekin' At The Answers till you're done!
Answers to pop quiz questions:
- 1) C
2) D
3) A
4) A
5) D
6) False
7) D
8) D
9) A,B,C,D
10) False
11) A
12) D
13) E
14) A
15) A
