Solving Problems in Real Estate Loan Transactions Part I?Real-Life Examples (1 through 5)
Dan Harkey
Educator and Private Money Real Estate Lending Consultant | 30,000 + connections
Introduction:
Real estate lending has a sequential process from the consumer’s consideration for a loan to a loan closing.?Prospecting, locating a prospective borrower, evaluating the feasibility, borrower’s commitment to obtaining the loan with “subject to conditions,” loan processing, loan underwriting, and eventually closing the loan transaction follows a?“natural and orderly pattern.”?The natural and orderly pattern will break down not because of the orderly system but because some borrowers and a few brokers obstruct and gain an advantage for self-benefit.
The process may have multiple breakdowns like an escrow officer or loan processor getting the flu and delaying the process.??Obstructions, as opposed to breakdowns, may be out of ignorance or, more frequently, out of?“cunning and deceitful actions to achieve one’s goals.”
The natural order and manufactured obstacles are much like all in society.?Disruptions and obstacles are not always harmful but are born to some degree resulting in improving society and humanity.?
Lending business operations would improve immensely if mortgage brokers could rely on borrowers to be forthright in providing the requested material data and truthful disclosures about their loan requests.?But in 2023, loan brokers can only occasionally rely on receiving accurate or correct information.
The business has become a jungle of illusions, lies, and deceptions by some borrowers.?Only in some cases, of course, but too many for comfort.?Many borrowers have become sophisticated enough only to give drabbles, or works of fiction, of the requested information.?Therein lie the admirable skills of loan processors and underwriters to ferret out the facts to gain an accurate picture of the material elements in the transaction.
?America has replaced the culture of honesty and consideration for others with “win at all costs.”?Common courtesies, rules, ethics, and mutual respect are “cast to the wind.” All in life possesses a “natural order of things and events” based upon a set of expectations from criteria perceived as universally valid.?Self-interest is suitable to a degree but also can disrupt the order.?When the leadership becomes absorbed in self-interest, constantly disrupts the natural order through manipulations and propaganda, and no longer represents its people, so goes the governed.
Many institutional banks are ceasing to make loans, and borrowers must resort to private money lenders as an intermediate solution (1 to 5 years) until banks begin lending again.?When they do, we can expect banks to be significantly stricter on underwriting requirements and no longer make marginal credit or close-to-hard-money loans.
Loan brokers will no longer be able to make a healthy living with overly inflated confidence in easy pickings. They must “forage in the forest” for good loans with an assured complex underwriting process to follow.
Institutional banks got “walloped” by the realization that most are essentially insolvent.?They are desperately trying to bail themselves out, out of sight of the public, by pulling back and not making loans.?Many are insolvent because of too many risky loans with excess risks and too much capital invested in super-low-yielding U.S. treasuries.?As interest rates rose, low-yielding treasury investments became a form of “toxic assets” because sellers (banks) would take massive losses.
Most banks invested large sums of depositor funds in long-term government bonds and U.S. Treasury notes.?The bonds were purchased when interest rates were near zero.?Their average yields are 1.78%. As interest rates began to rise, banks were stuck with a portfolio of low rates.?The banks had instant unrealized-value losseswhen interest rates rose from near zero to 3.5% to 5%.?Their unrealized portfolio losses eventually make banks insolvent, which triggers the regulators to step in.
If banks sell their underperforming portfolios and toxic assets, that will wipe out their net worth.?Only through dumping the financial losses on the backs of the taxpayer are the banks and the federal reserve able to be bailed out.?The price tag is one trillion dollars.
There are additional economic headwinds on the horizon. An estimated six million-plus residential renters defaulted (mid-2023) in paying rent, or 15% of the total.?Lease tenants in the U.S. commercial sector are under severe pressure because retail sales are plummeting.?Commercial office owners’ debt cost is up 40% to 50%, and a seismic $16 billion in loans will mature this year and next.?An estimated 330 million square feet of prime U.S. office space is vacant because of hybrid work, economic uncertainty, and rampant layoffs.?Phony government statistics cannot put lipstick on this pig, although they will try.?These estimates will surely rise as interest rates rise, cash flows are squeezed, CAP rates go up, and we will slide into a recession.?I believe that stresses in the market provide an opportunity for the private money lending sector.
The loan brokerage business:
Mortgage brokers/lenders who fund loans with private-party lenders/investors require an understanding of 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 complexproblems” is necessary.?The method also requires a “skeptical inquiry” by loan underwriters about the material facts presented for the proposed loan.?Sometimes borrowers and a few mortgage brokers have been known to stretch the truth.?At least 80-90% of mortgage brokers are professional and desire to be good fiduciaries.
When brokers/lenders accept the risk of a proposed loan transaction with intentional misrepresentations, withheld material facts, or a transaction with complex and problematic issues, there will be increased future costly servicing problems in the future.
I have not discussed “business vs. consumer purpose” lending on single-family 1-4 owner-occupied dwellings.?Email me if you want a PDF of my article, and I will forward it.
Below are ten examples of complex issues:
1) Deceiving one’s wife has many dire consequences-failure to disclose to the wife- A husband intentionally did not disclose to his wife that he intended to obtain a loan and encumber their owner-occupied family home.?The property title is held jointly in the name of the husband and wife as tenants-in-common. Many lonely days and lonely nights will be forthcoming!?The husband may find himself singing or dreaming the lyrics of “Only the Lonely’” by Roy Orbison or “You’ll Lose a Good Thing.” songs by Barbara Lynn, an early rock classic.?Or “Wasted Days and Wasted Nights” by Freddy Fender.
The borrower’s mortgage broker made the following representations to the lender:?
“My client wants to borrow a second trust deed on the family 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 wife was never mentioned while discussing a potential loan.
The borrower’s mortgage broker requested the application documents for his borrower to fill out, including the loan application, credit authorization, and disclosures.?Upon receiving the application back from the borrower, the borrower’s mortgage broker noticed no signature from the wife.?When questioning the borrower, it was apparent that the husband intentionally failed to disclose his intention to encumber the property to the wife.?She did not know of a potential loan or her husband’s desire to use the property as collateral.?He intentionally withheld the information from his wife, broker, and lender.
The experienced and prudent mortgage broker/lender responded:
“Both husband and wife 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.”?After 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 was “DOA,” “dead on arrival.”
The borrower’s mortgage broker was negligent and violated their fiduciary responsibility.?The broker did not inquire adequately about his borrower’s intentions.?Some brokers would merely skate over the top and accept a borrower’s directive without critical inquiry.
A spouse may not sell, convey, or encumber a property in California without the other non-consenting spouse’s permission.?The wife may petition the court to void the unauthorized transaction.?The non-consenting spouse can revoke the transaction only with a court order. ?A lender could lose their lien position on the property and become an unsecured creditor.
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.?Email me if you want an article on the subject.
2)?Divorce proceedings during a loan process- The borrower (husband) is going through a divorce proceeding with soon to be ex-wife.?The husband desires a loan secured by the couple’s owner-occupied residence.?The husband states he has good communication and mutual understanding with the pending ex.?(That is precisely why they are getting a divorce!)
The borrower’s mortgage broker comments to the lender:?
“The husband and wife are going through a divorce, and I’m sure she will cooperate.?She will sign whatever documents are necessary.?The husband told me so.?They are getting along well.” Skeptically, “Yeah, everyone gets along with their soon-to-be ex-spouse.”
The experienced and prudent broker/lender responds:?
“Yes, that may be true, that the wife will cooperate. But, before we go through all the work (sometimes called spinning our wheels) to process and fund this loan, we need a written verification from the wife or her attorney that she will cooperate in signing the proper documents for this transaction.
Is there a pending settlement agreement in the divorce proceedings? Is there a completed proforma settlement agreement where the x-spouse has agreed to quit-claim their interest in the security property as part of the settlement??Once a petition is filed for dissolving the marriage, further action to sell or refinance community property is typically only possible with a court order.
A court petition to dissolve a marriage imposes a “legally mandated stay” requiring court approval to complete any property sale or loan transaction. The “stay” means that the parties may not act with the intent to encumber or sell a property without court approval. Suppose a court has not approved a property settlement.?In that case, neither party may act, such as financing or selling 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) A super complex and audacious proposed loan transaction where a borrower withholds many material facts. And the transaction has too many moving parts to verify each problem thoroughly.
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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 and prudent mortgage broker/lender:?
A couple of weeks later, after a due diligence period by the lender’s underwriting department, the broker/lender responds to the borrower’s agent.
4)?The borrower purchased the property subject to a first lien without the lender’s knowledge or a formal bank loan assumption. 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 with a previous lender.?The transaction is called a “subject to” without lender approval.?
Borrowers mortgage broker comments to the broker./lender: “My client wants 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?made to the??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 and prudent mortgage broker/lender responds:?“The problem is that there??a “due-on-sale” or “due-on-furtherencumbrance” clause in the first trust deed relating to the prior owner.?The first trust deed lender can call the loan due and payable upon transfer to the present owner when they discover the violation of the covenants of the loan documents. There was no notification to the prior owner’s lender of the transfer. The first trust deed lender was Intentionally deceived by not being informed to avoid the due-on-sale clause.
Intentionally deceiving a federal-related lender has dire negative consequences. 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 first lender may call the loan due and payable and trigger a default.?
The Garn-St Germain?Depository Institutions Act of 1982.?The law became effective on October 15, 1982, provided 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 provision?is in 12 U.S. Code?1701J-3.?Therefore, if a first trust deed contains a due-on-transfer clause, 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:
In this example, brokers/lenders representing private-party investors will assess the risk of moving forward with a second loan. Many brokers/lenders and their private party investors will agree to make this loan (junior lien) because the first trust deed lender is prohibited from calling the loan due. The prohibition from calling the loan due and payable on transfer may or may not apply—technical stuff that requires a lawyer to determine the outcome.
Lenders can still call the loan due on any property “other than” residential single-family and one-to-four units.
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.
Multiple written clauses in the note and deed of trust may increase the risks.The promissory message is the promise to pay.The deed of trust is a legal instrument used to create a security interest in real property. The legal title is transferred to a third-party trustee.The trustee holds the title on behalf of the lender/beneficiaries.
One problematic clause in the deed of trust is an “alienation clause” or an “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 area for improvement is when there are clauses in the deed of trust that both parties agree to, such as additional advances or modification of other deferred payments. Further refinements and deferred payments would mean the principal balance would increase, eroding the protective equity.
The lender should review other problematic clauses in the loan documents relating to the risks of a second lien. Diligent underwriters will read the note and deed of trust and obtain recent payment and beneficiary statements to address these issues. The broker/lender, an agent of the private party lenders, may request a lawyer’s review of this transaction and the prior purchase transaction to ensure compliance and correct decisions.
5)?Borrower failed to tell the lender that he and his wife are in Chapter 11, 13, or 7 bankruptcy. ?The borrower thought that having a court-approved plan would solve all his problems and obtaining a loan would be no issue.????
Borrowers mortgage broker comments to the broker/lender:?“My client is in Chapter 13, an individual re-organizational bankruptcy filing.?Under Chapter 13 bankruptcy, it is 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.
Is there an agreed payment plan? Are the borrowers current on their payments??They approached me to request a second trust deed loan secured by their primary residence. The purpose is to purchase a walk-in laundromat, increasing their monthly income.”
The experienced and prudent mortgage 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 court confirmation order should be reviewed to determine whether a purchase of a business enterprise requires court approval.
The lender must 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 bankruptcy, including criminal restitution, domestic support obligations, and student loans.?Discharging debts may also have extreme federal and state tax consequences.
The lender will need a copy of the bankruptcy court filing and the payment plan. We must also review the borrower’s financial statement to verify adequate cash flow to make monthly payments.”
The above concludes Part I.?Part II is scheduled for publication in two weeks.
Part II will contain Real-Life Examples of the following.
6)?Loaning on bootlegged apartment units.
7)?Making loans on properties with a need for maintenance and upkeep.
8)?Making loans on small strip/convenience neighborhood retail centers with mom-and-pop tenants.
9)?Making loans on owner-occupied commercial buildings with separate non-related tenants.?The owner operates a business under an S-corporation and owns the building as trustee of a family trust.
10)?Family trust of an elderly transfer’s trustee responsibilities to his sons as co-trustees.?The sons and co-trustees want to borrow and encumber the property.
Let me know if you want a PDF of part II emailed.
Part II also contains the summary for part I and II.
Thank you,
Dan Harkey.