Solving Complex Problems in Real Estate Loan Transactions: Examples (1 through 5)
By Dan Harkey
Business & Financial Consultant
cell 949-533-8315 email [email protected]
?Evaluating real estate loan transactions?by mortgage brokers/lenders who fund loans with private party lenders/investors requires understanding real estate principles, regulatory compliance, legal issues, securities, and best underwriting practices. A time-sensitive process of technical “prove-up of material facts” and “solving various complex problems” is generally necessary. The process also requires a skeptical inquiry by loan underwriters about the facts presented for the proposed loan. Presented facts may not be what they were represented to be. ?Sometimes borrowers and a few of their mortgage brokers have been known to stretch the truth.
In many cases, it is advised that broker/lenders walk away from purposed transactions and cancel any the active files where there are intentional misrepresentations, withholding material facts, or the transaction is overly problematic with the potential of future servicing problems.
Below are ten examples of complex issues:
1)?Husband intentionally did not disclose to his wife that he intended to obtain a loan and encumber their owner-occupied family home. The property was jointly in the name of the husband and wife as tenants-in-common. Deceiving one’s wife has its consequences, rarely good! Many lonely days and lonely nights will be forthcoming!
Borrowers mortgage broker comments to the broker/lender:
“My client wants to borrow a second trust deed on my single-family owner-occupied home to start an iron fabrication business for custom homes. He fabricates entries, gates, decorative railing, and handrails. He also does custom orders. ?He has owned his owner-occupied property for a long time and has plenty of equity,”
The borrower’s mortgage broker requested the application documents for his borrower to fill out, including loan application, credit authorization, and disclosures. ?Upon receiving the application back from the borrower, the borrower’s mortgage broker noticed that there was no signature from the wife. When questioning the borrower, it was apparent that the husband had failed to disclose his intention to encumber the property to the wife. She did not know of a potential loan or of her husband’s desire to use and using the property as collateral. He intentionally withheld the information from his wife, his broker, and the lender.
The experienced mortgage broker/lender responded:
“Both the borrowers’ will be required to agree to the terms and conditions of the proposed loan. Both will be required to approve and sign all the related documents. Upon notifying the wife that her husband intended to borrow money, using her home as collateral, she objected to the entire process. She refused to allow any encumbrance on the subject property. This transaction is referred to as “DOA”, dead on arrival. Borrower’s mortgage broker did not make an adequate inquiry of with his borrowers. As a few brokers do, he merely skated over the top and took the husband/borrower’s directive.
A Spouse may not sell, convey, or encumber a property in California without the consent of the other tenant in common, in this case the spouse. ?The non-consenting spouse has a right to void the transaction, but only with a court order.” The wife may petition the court to void the unauthorized transaction.
Reference material:
I have not addressed the subject of consumer purpose vs. business purpose lending and whether it was appropriate to encumber this couple’s single-family owner-occupied property to start a metal fabrication business. ?That is an entirely different issue that needs to be evaluated. I have referenced an article that I wrote on the subject at the end.
2) Borrower (husband) is going through a divorce proceeding. Husband desires to obtain a loan secured by the couple’s owner-occupied residence. The husband represented good communication and mutual understanding between he and his spouse.?(Of course, that is precisely why they are getting a divorce!)
?Borrowers mortgage broker comments to the broker/lender:
“The husband and wife are going through a divorce, and I’m sure that she will cooperate. She will sign whatever documents are necessary. The husband told me so. They are getting along pretty good.”
The experienced broker/lender responds:
“Yes, that may be true, that the wife will cooperate. But, before we go through all the work (sometimes referred to as spinning our wheels) to process and fund this loan, we will need a written verification from the wife or her attorney that she will cooperate in signing the proper documents for this transaction to be completed.
Is there a pending settlement agreement? Is there a completed proforma settlement agreement where she has agreed to quit-claim her interest in the security property as part of the settlement? Once a petition for dissolving the marriage is filed, typically, no further action to sell or refinance for community property is possible without a court order.
A court petition to dissolve a marriage imposes a legally mandated stay requiring court approval to complete any sale of a property or any loan transaction. The “stay” means that the parties may not take any action with the intent to encumber or sell a property without court approval. Suppose a property settlement has not been approved by a court. ?In that case, neither party has the authority to take any action, such as financing or selling any of the mutually owned assets.?A title insurer will also require a court order or court-approved settlement agreement as a condition to provide title insurance coverage.”
3) Super complex, big, hairy, and audacious proposed loan transaction with too many facts that were withheld.?And the transaction has too many moving parts to verify fully.
Borrowers mortgage broker comments to the broker/lender:
“My client needs a loan to pay various judgments, liens, and tax obligations.?He has a ton of equity in his real estate and is probably worth more than 10-20 million dollars. He would not ever default! I will obtain an application for your review.”
Experienced mortgage broker/lender:
A couple of weeks later, after a due diligence period by the lender’s underwriting department, the broker/lender responds.
·??As a proposed lender doing due diligence on this transaction, we have run a background search on the borrower, the borrower’s operating company, and checked court records regarding all the litigation, defaults, civil judgments, and county, state, and federal tax liens.
·??What was represented as a few judgments, liens, and tax obligations has become an extremely complex underwriting exercise. A few turned out to be many. Not for the individual borrower but also for the company owned and operated by him.
·??There are three separate parties in the example:?a) The primary borrowers as individuals who own at least 15 pieces of real estate. b) A company owned by the borrower. c) A newly formed company started and operated by a related borrower party, which is not part of this loan request.
·?The borrower also has a business enterprise that has many judgments and liens, separate from the borrower as an individual.
·?It is true that this borrower has many pieces of prime real estate, and some are free and clear. The equity to borrow against appears to be more than adequate.
·?The borrower individually has about 2 million dollars of state and federal personal tax arrearages and judgments.
·?There are also multiple defaults on large pieces of leased business equipment that he has personally guaranteed. The borrower had a Lis Pendens recorded on numerous properties by lenders to had personal guarantees on the equipment from the borrower and were going after his real estate as a source of repayment. ???No new loans or conveyance is possible unless these obligations are satisfied.
·?The operating company owned by the borrower separately from the individual also has a separate 2 million dollars of civil judgments and liens.?The company has not been paying employment taxes to California for quite some time, almost two years.
·?The company has also defaulted on lease payments of multiple pieces of large equipment for which the borrower personally guaranteed.
·?The defaults of some equipment leases had personal guarantees; therefore, the judgment becomes a personal obligation of an estimated $500,000.
·?The borrower and the borrower’s lawyer argue that business debts cannot be attached to the borrower as an individual.
·?Borrower’s lawyer argues that a title insurer will insure these new real estate loans. That is a massively questionable proposition.
·?The borrower tends not to pay vendor service providers in his business resulting in litigation. There are multiple civil judgments against the company.
·??Another member of the borrower’s related parties has started a new company in the same line of business. Accounts have been moved, the physical facility’s operational buildings and the equipment used in the new business are the same. But even the new company continues to default on equipment payments.
·?It appears, although not verified, that the borrower is attempting to take his defaulting company with two million in defaulted debt into insolvency without ??declaring bankruptcy or paying creditors.
·???The new company would take over the business accounts and operate a functioning business enterprise with a projected profit. It appears that the intent is that all tax obligations, judgments, liens, and tax obligations remain in the old insolvent company.
·? All arrears in taxes, judgments, and liens of the old operating company would disappear in an insolvency
·? While one may consider this a brilliant estate planning scheme, this loan request should be declined by a lender for obvious reasons.
·?The broker/lender perceives that there will be future litigation since the new operating company continues to be defaulting on equipment leases, all of which have personal guarantees leading back to the borrowers as individuals.
4)?Borrower purchased the property subject to a first lien with no loan assumption being requested or obtained. ??The property title is now in the new owner’s/transferee’s name but is subject to a first lien in the prior owner’s (another party’s) name
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Borrowers mortgage broker comments to the broker/lender:
“My client needs to borrow some cash and will agree to place a second trust deed on their property. Five years ago, they purchased the property “subject-to” a first lien an institutional lender?made to the?prior?property owners. The loan reflects the borrowing party as the prior property owner, not the current owner. There has been significant equity build-up because the property has substantially increased in value.”
The experienced broker/lender responds:
“The problem is that there?may be?a due-on-sale or due-on-further encumbrance clause in the first trust deed.??The prior owner’s lender was never notified of the sale transfer because it was done with the intention of avoiding notice to the lender. ?The first trust deed lender retains the option of calling the loan due and payable upon transfer to the present owner when they discover the action. ?As interest rises, the first lien lender may become motivated to free up the capital to lend to another party at a higher rate.?
The Garn–St Germain?Depository Institutions Act of 1982, which became effective on October 15, 1982, provided for exemptions in which the lender cannot exercise the “due-on-transfer and due-on-encumbrance” provisions if the collateral property is a single-family, or a one-to-four, including co-ops, residential dwelling owner-occupied.
The specific provisions?can be?found in 12 U.S. Code?1701J-3. Therefore, if a due-on-transfer clause?is contained?in the first trust deed, the lender?may or may not be?prohibited from exercising the due-on provisions, depending upon the type of collateral property and the Exceptions.”
Exceptions to the Due on Sale Clause and Due on Further Encumbrance:
·?????Transfer to a spouse or children of the borrower.
·?????Transfer to a relative resulting from the death of the borrower.
·?????Transfer because of the death of a joint tenant or tenant by the entirety.
·?????Transfer to a trust where the borrower is the beneficiary, that does not relate to the transfer of occupancy rights.
In this example, broker/lenders representing private party investors will be required to assess their risk to move forward with a second loan. Many broker/lenders and their private party investors will agree to make this loan (junior lien) because they believe that the first trust deed first lender is prohibited from calling the loan due. The prohibition from calling the loan due and payable on transfer may or may not apply.
On any property other than residential single family and one-to-four units’ lenders still have an option of calling the loan due.
Part of the lender’s due diligence is ordering and reviewing a copy of the promissory note and deed of trust.?Additionally, the lender should order a beneficiary statement from the first trust deed lender or obtain 3 to 6 months of payment statements supplied by the borrower.
There may be multiple written clauses in the note and deed of trust that increase the risks.?The note is the promise to pay.?The deed of trust is a legal instrument which is used to create a security interest in real property, although the legal title is transferred to a third-party trustee.?The trustee holds title on behalf of the lender/beneficiaries.
One problematic clause in the deed of trust is an alienation clause or a due-on encumbrance clause. Another problematic clause would be a negative-amortization adjustable-rate mortgage where the principal balance increases with each payment. ?When the principal balance increases, it erodes the protective equity creating unwanted risks for the second trust deed investor.
Another problematic issue is when there are clauses in the deed of trust that both parties agree to such as additional advances or other deferred payments modifications. ??Additional advances and deferred payments would mean that the principal balance would increase, eroding the protective equity.
Government-mandated COVID payment deferrals created additional risk for junior liens on subject-to and non-subject-to transactions. State and Federal mandates allowed tenants who merely claimed that they were affected by COVID could stop paying rent or only pay a fraction of their rent. These deferrals resulted in millions of property owners going into default with their lenders. All those arrearages of payments were added to the first trust deed balance, which reduced the protective equity and reduced the safety cushion of the junior liens.
An estimated 30-40 million-plus renters/lessees, including commercial lessees in the U.S., who were, and may still be, in arrears or are having great difficulty coming up with the money to pay their monthly obligations. There were, and still are, an estimated 30-40 million property owners who were in payment arrears or having difficulty because they were not receiving rental or lease income necessary to pay the debt service on their property loans.?Millions of these folks were, and still are, not paying or just barely starting to pay their arrearages of rents and house payments again. Of course, this crisis transferred stress and potential losses to the broker/lenders and their private party investors who made junior loans. At his time (the beginning of 2022), the fall-out is getting worse.
Other problematic clauses that need to be addressed as to how they affect the risks of a second lien. Only diligent underwriters will read the note and deed of trust and obtain a beneficiary statement completely to address these issues. The broker/lender who is an agent of the private party lenders may request a review of this transaction and the prior purchase transaction by a lawyer to ensure compliance and correct decisions.
5)???Borrower failed to mention he and his wife are in a Chapter 13 bankruptcy. Borrower thought by having a court-approved plan, all his problems were solved, and there would be no issue in obtaining a loan. ???
Borrowers mortgage broker comments to the broker/lender:
“My client is in Chapter 13, an individual re-organizational bankruptcy filing. Under a Chapter 13 bankruptcy, it called a wage earner’s plan.?It enables individuals with income to develop a plan to repay all or part of their debts. Debtors may propose a repayment plan and make installments over three to five years.
There is an agreed payment plan, and they are current on their payments. ??They approached me with a request to obtain a second trust deed loan secured by their primary residence. ?The purpose is to purchase a walk-in laundromat which should increase their monthly income.”
The experienced broker/lender responds:
“A coin-operated washing machine and dryer venue is a great retail business.?Does your client have a confirmed payment plan approved by the bankruptcy court, which outlines how they intend to repay creditors? The confirmation order should be reviewed to determine whether a purchase of a business enterprise requires court approval.
The lender will need to evaluate the borrower’s creditworthiness and determine if the court approved a discharge of a portion of the debts. A discharged debt constitutes forgiveness, but specified debts may survive the bankruptcy, including criminal restitution, domestic support obligations, and student loans. Discharging debts may also have tax consequences.
The lender will need a copy of the bankruptcy court filing and the payment plan. We also need to review the borrower’s financial statement to verify that there is adequate cash flow to make monthly payments.”
Summary for examples (1 through 5).
Mortgage brokers on both sides of the transaction may well be licensed professionals. The borrower’s broker works on behalf of the borrower to obtain required information, verify facts, and overcome obstacles. ?Full disclosure is assumed, not hidden, or treated as an avoidance game. Sometimes too many facts are conveniently avoided or intentionally withheld.
Understanding how to analyze complex underwriting issues can make or break a transaction.
There are dozens of complex issues that arise in new proposed loan transactions. ?Make sure that you work with knowledgeable and experienced mortgage brokers who can understand the complexities and solving the problems.
Supporting articles written by Dan Harkey intended to help interested parties gain knowledge of private party real estate lending.
?Any of these articles will be forwarded upon request.
Business vs. Consumer Purpose Lending.
1)???Solving Complex Problems in Real Estate Loan Transactions-examples. (5 through 10).
2)???Property Insurance coverages During Inflationary Times.
3)???Private Money Real Estate Loans-An Overview of Good Reasons.
4)???An Overview of Private Money Lending & Trust Deed Investments.
5)???The Capitalization Approach to Income Property Valuation.
This article is intended for educational purposes only and is not a solicitation.
? Dan Harkey. This material’s unauthorized use or duplication without express and written permission from this author or owner is strictly prohibited. Excerpts and links to the articles may be used in marketing efforts, provided that full and clear credit is given to Dan Harkey. The credit displayed when you forward any article must include Dan Harkey, Business & Finance consultant. You are not authorized to modify the content or the articles title.
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