Real Estate Capital Basics – Subordinate Loans
Subordinated Debt is defined as a loan with a lower repayment of priority to any other outstanding debt encumbering a property. Often times, a property may be encumbered by multiple loans with legal priority determining how these loans are classified including secured (e.g., first mortgage, second mortgage) and unsecured (e.g., mezzanine) debt. Such loans are dependent upon the senior debt for classification as to temporary or permanent term as subordinate debt must be retired on or before the maturity date of senior debt.
Leveraging any lucrative senior financing, subordinate debt provides additional funds for a multitude of reasons including funding further physical improvements, tax-free loan proceeds, increased leverage yields and replacement of more costly equity.
Subordinated debt instruments are attractive investment vehicles because higher yields are exchanged for assuming subordinate lien positions in both principal and interest. Funding sources include banks, credit companies, thrifts, Wall Street (securitizations), private capital, and to a lesser extent, life insurance companies and pension funds.
The most popular subordinate debt vehicles include second mortgages, mezzanine debt and wraparound mortgages.
Second Mortgage
The Second Mortgage is the simplest and most common form of subordinate financing. Also known as a Junior Mortgage, this form of funding is structured as a recorded lien encumbering real property and obviously is subordinate to a senior lien position. In rare instances with larger and more complicated financings, a Second Mortgage can also be a third lien (or lower) lien structured for repayment within the term of the senior debt. Second mortgages use various payment formats including fixed rate, variable rate, participating, convertible and preferred equity.
Mezzanine Debt
In practical terms, mezzanine debt is (“mezz”) nearly identical to a second mortgage except for lien positioning. Mezzanine debt is unrecorded debt; instead, is an equity obligation. The mezz noteholder has a principal position in the ownership structure. Mezz debt is often structured as preferred equity. Mezz notes are especially very popular lien formats in securitized loans which usually prohibit secondary liens.. In the event of default, the mezz lender assumes the primary equity ownership role and may choose to cure the first lien as a principal protection mechanism. Since the loans are unrecorded against the property, higher yields are required to compensate for repayment risk dynamics.
Wraparound Mortgage
The Wraparound Mortgage is lesser known subordinate debt program that was popular during the 1980s when extremely high interest rates were commonplace. Wraparound mortgages were popular with borrowers having attractive first mortgages in place at below market rates which were unprofitable to disturb.
Also known as a “blanket” mortgage, the Wraparound Mortgage is a financing technique “wrapping” a favorable, lower-rate first mortgage with additional funding proceeds to form a new loan. The Wraparound Mortgage combines the existing loan balance with freshly generated proceeds into a “new” loan with a revised interest rate blending the original rate and a yield premium for the added funds. The Wrap lender structures the revised loan and a below-market interest rate on the face amount of the wrapped loan priced below current market rate on a new first mortgage, taking advantage of the undisturbed and competitively priced first mortgage remaining in place.
While Wraparound Mortgages are similar to other subordinate debt instruments for tapping into additional funds, a number of features distinguish this form of financing from typical subordinate debt. The total proceeds – both existing and newly advanced – are shown as the “face” amount in all loan documentation. A special agreement between senior and Wrap lender covers debt service payment responsibilities and discusses cure provisions in the event of default. A promissory note and a lien is filed like any other form of secured debt, as well.
Wraparound Mortgages are still popular for a variety of reasons. When interest rates are high, borrowers will try to protect properties encumbered by below-market senior debt. Funding sources are simultaneously eager to “wrap” a first mortgage loan at higher yields premiums and other terms that take advantage of the underlying debt.
Negotiating a wraparound mortgage favorable to all parties requires understanding the key issues of the funding structure including first mortgage restrictions, prepayment penalties, the wraparound coupon rate and overall yield as well as how much additional funds to advance. Numerous wraparound mortgage vehicles exist including the most popular shown below which are differentiated by timeline:
Equal-Term Wraparound Mortgage: When the term of the wraparound mortgage and underlying senior debt have the same term, the result is an Equal-Term wraparound mortgage. The Equal-Term wraparound mortgage is the most popular program, offering additional funds while minimizing principal repayment overhang risk.
Extended-Term Wraparound Mortgage: When the loan term of the additional wraparound proceeds funds exceeds the senior debt term, the lender is providing an extended-term wraparound mortgage. Generally speaking, when the wraparound mortgage has a longer term than the underlying debt, the borrower enjoys reduced mortgage payments and the lender a corresponding lower yield. Most important of all, the extended-term wraparound mortgage is riskier to the funding source because the additional funds are exposed over a longer period of time than the primary mortgage, creating a greater refinance risk.
Reduced-Term Wraparound Mortgage: The opposite of an extended-term wrap loan, the reduced-term wraparound mortgage is prepaid sooner than the underlying senior debt. Since the term is shorter than the senior debt, the payments and amortization schedule will typically lead to higher debt service payments.