What is a Note Hypothecation?

 Real property owners’ usually sell to buyers’ who finance with a bank or institutional lender. The bank/lender records these documents at a municipal records office, referred to as a deed of trust or mortgage create a security interest in the property. The recorded instruments become a matter of public record, the property owner has fee title to the real property and the bank/lender has a security interest.

Assume that a long-time property owner decides to sell his/her property. In the negotiation the buyer and the seller decide that rather than a seller cash-out, the seller should carry back a first trust deed as part of the purchase. The seller will become the lender for the new purchaser/owner. At the closing the seller will sign a grant deed granting the title ownership to the new purchaser. The new purchaser will sign a promissory note which constitutes a promise to pay and a security instrument known as a deed of trust, or mortgage. The deed or mortgage will be recorded and become a matter of public record.

Real property can usually be sold if a seller wants to sell, and a buyer want to buy at a negotiated price and terms. If a seller becomes the lender at the close of the transaction, he/she will exchange real property for a security instrument(s), a promissory note and deed of trust. The promissory note, and related deed of trust, are considered personal rather than real property. The seller who becomes the lender will take possession of the security instruments. The seller will collect and enjoy monthly payments or financial benefits until maturity as provided for by agreement.

Sometimes, a seller will finance the sale because they are unable to obtain a buyer who will pay cash or is otherwise unable to get institutional financing. In other cases, the reason for this type of transaction may be part of a tax deferred strategy known as an installment sale. Capital gains taxes may be deferred or spread out over the life of the loan. The seller will pay capital gains taxes on the principal portion received annually, and ordinary passive income taxes on the interest portion. Obviously, this strategy requires counsel of a competent enrolled agent, or CPA.

The seller, now lender who owns the carryback paper has 3 options.

1)    Keep the paper and enjoy the cash flow until maturity.

2)    Sell the paper on the open market, usually at a discount to free up capital. Another unrelated investor may find value in purchasing the note and deed of trust or mortgage to create a stream of cash flow. If the note and trust deed holder of the paper sells, he/she would endorse the promissory note an assignment of deed of trust to the new purchaser. The assignment would be recorded, and the new party would then own the note and deed of trust.

3)    The third option is for the note holder, who would be to borrow a portion or percentage of the principal balance from another lender/investor and endorse the note and assign deed of trust or mortgage as collateral for the loan. This process is commonly referred to in the industry as a note hypothecation. The seller/owner of the note becomes the borrower (pledgor) and the new investor becomes the lender/investor-(pledgee). In practice the original note holder retains ownership but is required to give up physical possession to the new lender/ investor, or the investor’s loan servicer, subject to the terms and conditions of a pledge agreement.

The required documentation for a note hypothecation are as follows.

1)    Pledge agreement.

2)    Secured promissory note.

3)    Assignment of the promissory note and deed of trust.

4)    Offset statement & estoppel certificate.

5)    Uniform Commercial Code filing.

Each of the above documents has a unique purpose.

1.    Pledge agreement states the terms and conditions of the loan to be secured by the assignment of the note and deed of trust, loan payments, due dates, advancement of cost and expenses, provisions for default and foreclosure, servicing rights, and the method of re-conveying the paper back to the original note holder, now borrower (assignee), when the loan payoff is satisfied. The pledge agreement may have a series of representations and warranties by the pledgor. A loan servicer is responsible to collect the payment from property owner, use those proceeds to pay the investor/pledgee, and then to send any overage, to the pledgor. An important distinction is that if the lender forecloses on the property owner customary real property foreclosure law prevails. If the pledgee were to foreclose on the pledgor to perfect ownership of the promissory note and deed of trust, this is a matter of personal-property, and falls under laws of the uniform commercial code. The foreclosure process on personal-property transaction is much quicker and easier than real property.

2.    A secured promissory-written agreement and promise to pay from the pledgor to the pledgee.

3.    Assignment of note and deed of. The assignor becomes obligated to the assignee, pursuant to a certain secured promissory note, transfers, assigns, pledges, conveys, hypothecates, and delivers to the assignee, all the rights, powers, and privileges of the assignor. Once the loan obligation has been satisfied the pledgee will reconvey title back to the pledgor, or original note holder.

4.    An offset statement by the property owner will be signed. This document memorializes the declaration of facts relating to the property owner’s loan obligation, including outstanding principal amount, interest rate, payment schedule, payment history, due date, and any other agreements between the parties.  This document is also referred to as an estoppel certificate.

5.    Some lenders file what if referred to as a UCC filing which constitutes notice to the public that a security interest is held in a specified personal property asset, in this case is the underlying promissory note and deed of trust. UCC-1’s is/are filed with the Secretary of State. Upon satisfaction of the debt, the debtor would file a UCC-3 termination statement.

What are the benefits to the parties?

1.    The new property owner agrees to cooperate in such a transaction as part of their original documentation.

2.    Seller was originally motivated to carry back paper and earn a cash flow, and in most cases enjoy a deferred tax incentive.

3.    At some future datetime, the seller, now the note holder discovers that they need to free up cash for some reason. They own a valuable asset that can be hypothecated or used as collateral for the loan.

4.    A new Investor has money to invest. He/she agrees to invest a sum of money and become the endorsee on the note and assignee deed of trust. The investor expectation is to earn good market rates for trust deeds, but usually at a lower loan to value.

Dan Harkey

Business and Private Money Finance Consultant

Bus. 949 521 7115

Cell 949 533 8315

[email protected]

This article is intended for educational purposes only and is not a solicitation.