Loan Out Your Equity (Not Your Cash)

Carey Dodson · 2016-04-11T14:01:56-07:00

Do any of my BP colleagues have experience or more info on a concept that I will refer to as equity loans with equity partners? This would be where Investor A owns equity in a property or several properties and allows Investor B to use that equity as collateral for a note.I’ve heard of this concept before but haven’t really seen a good case study on it nor am I sure what it is called. A few challenges I could see are as follows: 1)Investor A needs to have assurance that if their property sells that the cloud placed on it by Investor B can be easily remedied. One example may be that the notes placed by Investor B have subordination and substitution clauses that allow them to be placed in a junior lien position or moved to a different property when Investor A’s property goes to market.2)Investor B needs to have assurance that Investor A is not interested in placing the subject property on the market within the terms he needs.3)Consideration for Investor A – If the note(s) held by Investor B has a term greater than a term that Investor A is willing to go, how should an agreement be structured? And what is a reasonable amount of dollars for allowing your property to be used as collateral?I can see the incentive for Investor A earning a premium for allowing their property to be used as collateral. I can also see the incentive for Investor B having a place to park their notes during a time where their equity may be running low or tied up on a fix and flip. But I suspect there are considerations such as those mentioned above and others I haven’t thought of.

Dion DePaoliPro Member

Real Estate Broker · Northwest Indiana, IN · Member since 2011 · 2k+ posts · 2k+ votes

10y

This scheme will not work.

Only an owner can pledge property as security for a loan. In the example here, Investor B doesn't own the property so they can not give a mortgage to any lender. Borrowers GIVE mortgages or deeds of trust to lenders. The mortgage or deed of trust secures the note.

Investor A would have to add Investor B to title to the property in order for the property to be pledged in any manner by Investor B. This means as joint tenants Investor B now owns 50% of the property or as tenants in common Investor B is now X% owner. Investor A would have to foreclose Investor B's interest out of the collateral property when push comes to shove. If any sale of the property takes place Investor B would have claims to the equity since he is vested in title for the same.

In the eyes of the Lender, Investor B is meaningless in this equation. Investor A is the only one who can offer security and would be the only one dealt with for a loan secured by real property.

Investor A could mortgage his property and pull cash out and offer that to Investor B under agreeable terms. That is probably the shortest path to accomplish the goal here. All parties being present and things being equal.

There are no case studies because this scheme doesn't exist.

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Carey Dodson

OP

Real Estate Investor · Chelsea, AL · Member since 2013 · 32 posts · 4 votes

10y

Excellent points @Dion DePaoli. One point of clarity that I failed to mention in my original post is that the notes are pre-existing with other property currently serving as collateral. Should the collateralized property sale, the notes contain substitution of collateral and subordination clauses which would allow the Payor to move the note to other property with equal or greater equity as the property that is currently serving as collateral. So there really isn't a new Lender coming into play here other than Investor A who would be lending the equity. (Perhaps a better term would be allowing their property to be used as collateral). Does that make better sense?

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Dion DePaoliPro Member

Real Estate Broker · Northwest Indiana, IN · Member since 2011 · 2k+ posts · 2k+ votes

10y

@Carey Dodson

As I gently implied, it is best to leave this whole thing alone. You are not fully understanding the mechanics at work. I get it and understand what you are trying to describe and I am suggesting based on my deeper knowledge of the matter that you leave this alone.

Collateral substitution is set aside for more complex commercial transactions. Commercial CMBS loans have defeasance clauses which allow for such things. Some portfolio loans can contain substitution clauses but again typically in commercial arenas not residential.

To not get too far into this here, substitution of collateral is not as simple as it sounds. There are risks involved from the Mortgagee standpoint involving the point in which the old collateral is released and the new collateral is encumbered. Further, the note which are originally secured call out that security specifically. Improper changes can cause defects with enforcement.

In residential loans the addition of any collateral interest is treated like a new loan. The term "substitution" in that setting is misleading. The note is not what drives the legality there, it is the actual security interest which was first established, then requested to be relieved to then be established elsewhere.

Again, while I love these types of conversations this is one where I think it is beyond the scope of the skill sets here in the forum. Substitution as you are understanding it is not the whole nor correct picture. Real property is not considered homogeneous. That is, one piece of real property is not the same or the equivalent to another piece. So substitutions in that sense are not "even" or "the same". Real property is non-homogeneous.

A Note does not subordinate or substitute nor does it contain any language as such. A note is not a security interest. A note does not have priority in title.

Further, Investor A is not a "lender". The lender is the entity who delivers cash and takes the lien. Investor A "gives" the lien. In order for the lien to be granted Investor A must also be obligated on the note as they must retain a right of redemption onto the security instrument.

Loans purposely do not contain these types of clauses as that would lead to the exact idea you are trying to skirt which is never paying the loan off and transferring the secured interest of the note to new property.

As I suggested, leave this alone. It is not going anywhere in the settings you are thinking.

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Carey Dodson

OP

Real Estate Investor · Chelsea, AL · Member since 2013 · 32 posts · 4 votes

10y

@Dion DePaoli

I appreciate your cautious tone as it affirms that to enter such an agreement all parties need to be informed of the risk/reward scenario. I agree that referencing Investor A as a Lender is inaccurate. To take this a step further the existing notes are results of a private Seller-financed loan. The Sellers were flexible enough to allow the subordination and substitution. You are correct in that when a seller does agree to allow other property to substitute on the collateral a separate mortgage document is drafted where the original seller (dare I say lender) agrees again to the terms of the original note with a new property serving as collateral.

I do disagree with your assertion:

"Loans purposely do not contain these types of clauses as that would lead to the exact idea you are trying to skirt which is never paying the loan off and transferring the secured interest of the note to new property. "

If you have a 15-year mortgage note that a Seller has agreed to create and the underlying property is being refinanced within a 2-year period of that note's creation, to collateralize the note with another property - how does this equate to never paying of the loan? If the Seller were flexible enough to agree to the note and their only other option is to accept a discounted pay-off, why wouldn't they agree to the same terms where the only change would be property that is serving as collateral?

Caution should prevail. All parties (Investor A, Investor B & original Seller) should be privy to the transaction. To not move forward and leave it alone may indeed be the best option depending on the intent of the parties, quality of the collateral and legality of the agreements.

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Dion DePaoliPro Member

Real Estate Broker · Northwest Indiana, IN · Member since 2011 · 2k+ posts · 2k+ votes

10y

@Carey Dodson

I can't tell you I am shocked this half baked idea is coming from the mystical world of Seller Finance. That place likes to scare reality into a corner. Most of what you have here are irrational ideas based on an improper understanding of a whole bunch of stuff. It is a train wreck really.

If a loan is made on a 15 year term it doesn't have a balloon in 2 years forcing a refinance or any other action to satisfy debt. So which is it...a 15 year loan or a 2 year loan? There is no such thing as both. In addition, a Mortgagee can not force a specific action by the Borrower and owner of the property, be it refinance, sale or otherwise.

When a Seller of real property finances the sale of real property by taking back a loan, the Buyer takes title to the property from the Seller and the Buyer gives the Seller a mortgage. The Buyer is the vested property owner not the Seller.

I have no idea what you mean with "..to collateralize the note with a different property..." Why are we even considering the need of different collateral? Did the Buyer buy the wrong property? If the property was good enough to buy initially with seller finance, why is it not sufficient to continue to secure the same loan made?

How on earth did you go from a Seller who is "flexible" (read as willing) to finance the sale of their property to a Seller who has no options and has to take a discounted payoff? Further, a discounted pay-off of what, the note?

Why isn't the Mortgagee simply foreclosing the Borrower for not paying? The Mortgagee doesn't have to discount anything. They need to use the remedies provided in the security instrument.

Further, if you are the Seller turned Mortgagee and you are willing to subordinate instead of getting paid off you had better have a plan for getting paid off now that you lost your equity priority. To just subordinate for the heck of it is, well......stupid.

The final paragraph were you attempt to deliver some words of wisdom is all just garbage. This idea is all wacked out. It boarders on incoherent even. I do want to point out, in that paragraph at the end we have three parties now: Investor A, Investor B and Seller - my gosh, this is a train wreck....

We have a Seller who sells his property with financing to Investor A. So to be clear, Seller is Seller. Investor A is Buyer.

What the heck is Investor B doing here?

Investor B has no interest in the real property, he is neither the Seller/Mortgagee nor the Buyer/Borrower.

I have no idea who you heard all this non-sense from but it is 100% just that... complete and utter non-sense. That is not me being cautious. That is not me misunderstanding things here. I assure you, I understand this asset class very well. Take this idea behind the tool shed and shot it, light it on fire and bury it dead. It is going no where.

Ironically, this is an illustration on why first liens do not come standard with a subordination clause or substitution clause. Someone would come up with a half baked idea like this and make a mess of things. So at least, we worked in an example of why not to allow such things.

It seems, if I read between the lines here, that the underlying purpose is to somehow allow Investor B to use Investor A's property as collateral for a loan. The property Investor B does not own. The property which is already encumbered by the seller financed mortgage.

Let me be clear: THAT CAN NOT BE DONE....AT ALL

You can not give something as collateral that you do not own.

Maybe Investor B should stop trying to invent crazy ideas based on a lack of understanding of how any of this works and simply go find a Seller willing to finance a property on his own and leave Investor A to enjoy his property and the Original Seller to enjoy his interest income from the loan.

Also and finally, "Investor B" is not an investor if he doesn't actually invest in anything. He is just some weird spectator on the sidelines trying to covet somebody else's property.

1 Reply

Stephen D.

Investor · Lake Zurich, IL · Member since 2012 · 53 posts · 12 votes

10y

@Dion DePaoli There must be a way I can vote 1000 times for your latest post :)

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Loan Out Your Equity (Not Your Cash)

Loan Out Your Equity (Not Your Cash)

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