Sale clause

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You also want to look at due-onsale clauses. If the senior lien has a due-on-sale clause and you are forced to foreclose, the senior lienholder can call the loan due and payable in full. This is because after foreclosure the former property owner has alienated, or gone out of title. You should therefore try to get the senior lienholder to sign a non-acceleration letter to prevent this from happening. It is your best protection because it protects you in obtaining the property through foreclosure if you keep the senior position lien(s) current. If you resell, the senior lienholder still has the right to accelerate his or her loan unless he or she approves the new buyer. This non-acceleration letter buys you time to resell the property and allows the senior lienholder to avoid foreclosure. It therefore creates a win-win situation for you both. If you cannot obtain a non-acceleration letter make sure you have the capability of paying the senior lien in full. Senior liens that contain a “future advances” clause should be approached with great caution. This clause allows the lender to advance more money to the purchaser. If this occurs, your junior lien could be positioned behind a much larger amount of debt than previously thought, thus increasing your risk. Release clause. Release clauses present another risk to junior lienholders. A release clause allows the property owner to release or unencumber part of his or her property. This is common with land developers who need such releases so they can build and sell from portions of the property. Senior lienholders normally do not need the authorization of junior lienholders to release part of the property used as collateral on their lien. This means that your note may not be adequately secured. Even worse, because your consent usually is not needed for the release, you may not know that your note is under-collateralized until you need to sell your note or foreclose on the payer. A prepayment penalty clause in the senior lien will hinder the chances that the senior lien will be paid off early, thus also decreasing the chance that your junior lien is prepaid. This clause can decrease the value of your junior lien considerably. If the senior lien has unusual payment terms, such as a high interest rate or sporadic lump sum payments, the value of subordinate liens can suffer. If the property owner wanted to sell, it would be difficult to find a buyer who was willing to assume a lien with such unusual terms. Since the value of real estate is tied to its available financing, a property with unusual terms will be more difficult to sell. Consequently, all liens junior to the unusual lien will suffer in value.

If you own a junior lien, you should understand some basic principles regarding its market value. Determining the value of a junior lien involves comparing the size of the junior lien to that of any and all senior liens. The larger the junior lien is in comparison to any senior liens, the less risk there is to the note owner and hence the more that note is worth. Small junior liens behind large senior liens are heavily discounted, and investors who purchase them will often walk away if the payer defaults. In other words, investors will not even bother trying to foreclose; the cost is too great. Therefore, if you are going to create a junior lien, try to make it as large as you can and/or secure additional collateral for the lien. One way of accomplishing this would be to ask the property purchaser to obtain a small mortgage from a traditional lender. Offer to owner finance the larger, remaining balance so that your junior lien is larger than the traditional lender’s senior lien. Your junior lien will then be marketable due to its large size in comparison to the senior lien and can be sold for a decent price if the need ever arises. Should you ever need to foreclose, there are other benefits. The cost to foreclose will be less since the senior lien is smaller than your junior lien. A smaller senior lien means a smaller obligation (usually monthly), which you will be paying during the time it takes to foreclose and resell the property. In effect, it means the chances of your recovering your investment are greater. Remember that the owner’s equity in the property is your greatest protection. If the owner has little or no equity, and you hold a junior lien and have to foreclose, you may be lucky to recover any money after paying foreclosure costs, real estate commissions, possible back taxes, money spent fixing up the property, and the obligations of the senior lien(s) during the foreclosure period. If you owner finance a small junior lien, try to make it no less than 50 percent of all senior liens combined. A junior lien that is less than 50 percent of the senior liens will be discounted greatly. Let’s look at an example. For the purpose of this example, assume the following:

• You are selling a multifamily, 12-unit apartment complex.

• You have owned it for many years and own it free and clear with the exception of a small $75,000 lien.

• This $75,000 loan is assumable by a qualified purchaser.

• You are selling the building for $300,000.

• Your equity in the property is thus $225,000.

• The buyer is going to pay 10 percent or $30,000 as a down payment.

• The buyer can qualify at a local bank for a loan in the amount of $220,000.

• You have been asked to owner finance the remaining debt of $50,000.

In this scenario, your owner financed junior lien of $50,000 would equal 23 percent of the senior lien ($50,000 divided by $220,000). This is less than the recommended 50 percent. If you ever wanted to sell your junior lien, it would be discounted heavily because the senior lien is so large. If you ever chose to foreclose, you would have to pay the monthly payments of the senior lien. In some states the foreclosure process can be very slow and hence very expensive. Overall, this scenario is risky for you because you are being asked to create a junior lien that is positioned behind a large senior lien. Due to this risk, the junior lien you are being asked to create is virtually worthless if you ever needed to sell it for cash. A better way to structure the deal would be to ask the buyer to assume the $75,000 first-position loan that is currently on the property. Ask the buyer to obtain a second position mortgage in the amount of $95,000 and offer to owner finance the remaining $100,000. Even though this scenario places you in third position, behind the existing first and the new second, you have created a note that is much more valuable. Remember, the value of a junior lien involves comparing the size of that junior lien to the senior liens. In this example, your third-position note in the amount of $100,000, is positioned behind a combined total debt of $170,000 ($75,000 first-position lien and the new $95,000 lien).

It is thus 59 percent of the first and second liens combined ($100,000 divided by $170,000). As mentioned previously, if you hold a junior lien you should try to make it no less than 50 percent of all senior liens combined. Therefore, this third-position lien has much more value than the second-position lien the property purchaser originally proposed. Thus, if you needed to sell all or part of your third-position lien for cash today, you could do so without a heavy discount. Additionally, it means that if you needed to foreclose, you could do so less expensively and therefore have a greater chance of recovering your investment. Junior liens are more risky than senior liens and hence are generally worth less than senior liens. Foreclosures can be very expensive. You will need to pay the obligations of all senior liens in order to protect your interest while you initiate foreclosure, unless you have the funds to pay off the senior liens. Remember that the owner’s equity in the property is your greatest protection. The larger the junior lien is in comparison to any senior liens, the less risk there is to the note owner and hence the more the note is worth. Try to make your junior lien no less than 50 percent of all senior liens combined. A junior lien that is less than 50 percent of all senior liens will be discounted greatly. It is never advisable to create a junior lien behind a senior lien that prohibits junior liens. You want your junior lien to be paid off before the balloon payment of any senior lien is due. You should obtain a loan status report for any senior lien to be sure it is current. Keeping track of payments made on senior liens can be difficult. One way of protecting yourself is to require the purchaser send you cancelled receipts of monthly payments made on all senior liens, or receipts of payments made. Place this requirement into your contract with the purchaser. Failure to supply you with such proof of payment may be considered evidence of default. Servicing notice of default to the grantor may be difficult if the grantor’s address is unknown. You may require the grantor designate a local agent for such service. Negative amortization can quickly decrease the protective equity you have as a junior lienholder. If the senior lien has a due-on-sale clause and you are forced to foreclose, the senior lienholder can call the loan due and payable in full. You should therefore try to get any senior lienholder to sign a non-acceleration letter to prevent this from happening. Be wary of senior liens that contain a “future advances” clause. Release clauses present another risk to junior lienholders. A release clause allows the property owner to release or unencumber part of his or her property. This means that your note may not be adequately secured. Senior liens with prepayment penalties and senior liens with unusual terms are variables that will negatively affect junior liens.

Clarify the right to sue by adding an addendum or extra paragraph to your contract stating that you reserve the right to personally sue the purchaser(s) should default occur. Ideally, you should fully understand foreclosure laws in your state and be prepared to consult with a competent attorney if the need arises. States differ in the average amount of time it takes for a foreclosure to conclude; thus the potential costs of foreclosure can differ dramatically from state to state. Understanding the foreclosure laws in your state will help you budget adequate cash reserves. This is particularly important if you are a junior lienholder. You may choose not to pay off the amount you owe on your property at the time you sell. This is called underlying debt, often referred to as a “wrap.” In this scenario, the money you pay on your underlying financing is superior to the money owed to you by the new sale. This is because the underlying financing was put into place before the financing from the new sale. If you choose to keep the underlying financing in place, make sure the new, inferior financing’s monthly payment is at least 25 percent greater than the payment you will continue to make. This gives you a little breathing space.