Early in my whole loan trading career, an investor once offered to fund a partnership that would purchase second position
liens, also known as second mortgages, secured by commercial real estate. The
investor promised to pledge a substantial amount of capital, if I was able to
assemble a portfolio of target assets. Understanding the risk/reward profile of
such an investment and desiring to deliver for what seemed to be a potential
source of new business, I quickly began to work on finding commercial seconds
to underwrite and select. After a few days on the phone with a number of
commercial lenders, real estate debt funds and large financial institutions, I
began to realize that commercial real estate second mortgages were not easy to
find. Finally, after a few weeks of searching, I informed the investor that I
was unable to find any asset worth purchasing that met his mandate.
Nearly ten years later, I now understand why the second
mortgage, an established method of financing in the world of residential
finance, is so infrequently used in commercial real estate. To state it
plainly, the property-income focus of commercial real estate, makes commercial
seconds more of a liability than an asset. It is this income focus that leads
most commercial lenders to emphasize property performance over the
qualifications of the borrower. As a result, most commercial financing is offered
with no recourse to the buyer upon default, giving the lender as much control
over a distressed asset as possible and incentivizing the owner of a distressed
property to “walk away” when there are no more options. In order to maintain as
much control over the property as possible, most commercial real estate lenders
will insist that they be on the only creditor of the property and that the
property be structured in such a way that it is remote from the bankruptcy of
the borrower. These goals are typically accomplished by establishing a holding
entity for the property to be financed, placing the borrower in the equity
position of the entity and making the lender a creditor of the entity, secured
by its largest asset.
Once you understand the motivations of a commercial lender,
the reasons for the unpopularity of second liens in commercial real estate
become clear. Second position liens allow for a party other than the lender to
have a claim to property in the event of default. This claim is superior to the
rights of everyone except for the first mortgage lender. Although, the second
mortgage holder could not foreclose on the first position lien holder, it is in
an advantageous position for a number of reasons. The most powerful of these
reasons is that the second position lender typically has lent a fraction of the
capital that the first position lender has. As a result, a second position
lender has gained a claim to a valuable property for a minimal investment.
Moreover, the second position lender has the right to foreclose upon default and take
possession of the property without having to assume the liabilities of the former
owner. The ability of the holder of the second mortgage holder to clear all other
junior liens and wipe out most owner-created liability troubles first position
lenders, as it incentivizes foreclosures, leaving the first position lender
with a new owner of the property that is subject to the first position lien on
the property, but not to the terms of the mortgage. The freely transferable
nature of second mortgages only exacerbates this potential situation. In the
end, the first position will likely have to foreclose or at least threaten to
do so upon the default of the second mortgage, an outcome that is far from
desirable.
In order to comply with commercial real estate financing
practice of having only one mortgage on the property, most secondary financing
is conducted by pledging or selling the equity in the entity to willing
lenders. These types of financing are called mezzanine or mezz financing. The
mezzanine lender is in a less enviable position than the second mortgage
holder, in that a mezz lender only has the right to foreclose on the equity of
the entity in the event of a default. Foreclosing on the equity would simply
put the mezz lender “in the shoes” of the defaulted borrower, subject to all of
the legal claims against it, including the mortgage on the property. As a
result, in practice, most mezz lenders do not take any action to protect their
investment upon default of their debt or the potential default of the property.
Doing so would only place upon the lender a liability far in excess of the
amount that it lent to the borrower.
The title of this post, however, suggests a comparison. This
begs the question—why, then are second mortgages used in residential real
estate? Well, first, they aren’t frequently used any more. Since the market
crash of 2008 and the subsequent legal and regulatory reforms, the once common
practice of using a second mortgage to either make up for a lack of funds or to
avoid PMI, called piggybacking, has nearly disappeared. Secondly, residential
lending is less property based and more borrower focused. The income of most
residential properties is typically not substantial enough to attract the
attention of a second mortgage holder, so the incentive to foreclose the second
mortgage is not as great. Additionally, the Uniform Commercial Code and most
state foreclosure and lien laws give the first position lien holder the right
to pursue the borrower for satisfaction of the debt, with the second mortgage
holder receiving nothing until the first lien is satisfied. As a result, the
first mortgage lender is less concerned with the actions of the second mortgage
holder.
Well, those are my thoughts on the matter. Please feel free
to comment below.
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