Dropping the Other Shoe

If your commercial real estate is foreclosed, what is your personal exposure?

There was optimism that the real estate market was making a comeback and then – experts said it was looking really bad for commercial property owners and getting worse. This doesn’t sit well with you when you realize that the vacancies in your 100 unit apartment building have soared upwards from 5% to 15%.

It’s no small wonder then that you have also been forking over more money every month to make the mortgage payments on both the first and second mortgages. One night while reviewing the dismal situation, you decide to quit throwing good money after bad and make a resolution to let the lender take the property in foreclosure.

Being a smart businessperson you make a call to a lawyer first to ask what your personal liability is if the first or second lender forecloses on the property. Your lawyer gives you the “it depends” answer and you’re thinking you’d rather have a straight answer instead. The straight answer only comes when she has the history of the loans in question.

When you bought the building, it was financed with a loan from your local bank with the second one provided by the building’s seller. Three years after the purchase, you refinanced loan number one for a better interest rate. The seller who held loan number two agreed to subordinate his loan to the new first loan so long as the principal of the first wasn’t greater and the interest rate was lower than the original loan.

While doing that was a smart move, the property currently can’t support either the first or the seller’s carry-back second loan. The straight answer from you lawyer, based on those facts, is that you could be personally liable to the lender holding the first trust deed but not the second. That revelation startles you and you discover that it is because the current first was securing a loan that was not used to buy the property – it was a refinance situation.

On the other hand, the seller carry-back second was used to buy the property and the refinance and subordination to the new first did not change the nature of what the seller originally financed with his second. As such, the law would not change the rule that as a purchase money loan, you had no personal liability.

In a 1991 case, Thompson v Allert (1991) 233 Cal. App. 3d 1462, the facts were quite similar to what we have discussed to this point. In that case the court outlined that the subordination to a new loan for the same amount at the same or lower interest didn’t alter the purchase money character of the loan. Under the California Code of Civil Procedure §580b, the holder of the second isn’t entitled to get a personal judgment against our apartment owner in this story – even if the first forecloses before the second and wipes out the second. Put another way, the second becomes worthless, leaving the holders with no ability to recover any of the unpaid loan amount.

By comparison, Wright V Johnston (1988) 206 Cal. App. 3d 333 provides a contrasting situation where the seller subordinated their loan to a new loan that was for a significantly greater amount then the original first trust deed so as to remove it from the borrower protections of California Code of Civil Procedure §580b. In other words, it lost its purchase money character by virtue of the changed nature of the financing risk with the refinance. Other situations which could trigger a seller carry-back losing its purchase money character are increased interest rates, balloon payments not in original first, and substantial cash-out loans.

If you’re knee deep in a commercial, industrial or multi-residential real estate property and thinking about letting it go to foreclosure, seek legal advice well in advance of letting the property go into default. This is an extremely complicated area of law where mistakes can be costly, and the need to think through the consequences of a default strategy is crucial to obtain the best possible result. At least that’s what this lawyer thinks.

Roni Balint writes for the Law Office of Alan M. Insul. The content contained within this feature is not intended as legal advice and does not constitute an attorney-client relationship. To learn more, contact Los Angeles business attorney and California corporate lawyer, Alan M. Insul by visiting Insullaw.com.

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