donald j. weidner1 appraisals: three basic indications of (or ways of approaching) value (text p....

Donald J. Weidner1

Appraisals: Three Basic Indications of (or ways of approaching) Value (Text p. 387)

1. Sales Comparison Approach (recent sales of comparable properties)

• Also known as “Market Data” Approach• The approach is less valid if there is an

inactive market or if the property is unique

2. Replacement Cost• Cost of replacing a building (and the land

under it) minus depreciation charges on the building

Donald J. Weidner2

Appraisals: Three Basic Indications of Value (cont’d)

3. Capitalized Value of the Income a Property Generates

Reconciliation is the process of relating these three factors (recent sales, replacement cost and capitalized value of income) to determine a value-- it does not simply average them. A reconciliation may select one factor as the most important.

Ultimately, valuation is a matter of definition and of judgment. Written appraisals of commercial properties can be voluminous.

Three Ways of Looking at the Value of Property Through the Cash it Generates

1. Extraordinarily rudimentary: estimate a value by multiplying the gross rent receipts by some factor.

2. Somewhat more refined: estimate a value of the property by applying a capitalization rate to its current net operating income.

3. More refined: estimate net operating income for each year well into the future and reduce each of those receipts to its present value.

Donald J. Weidner3

Donald J. Weidner4

Sales Price of Comparable Properties

Gross Rental Revenues of Comparable Properties

= Multiplier

Method # 1: Use a GROSS MULTIPLIER to Derive A Value from Gross Rentals

Assume a Recent Sale of Comparable

Property:

12 Million Sales Price

2 Million Gross Rental Revenue

= 6 [Gross Multiplier]

Applying this rough method, a comparable property with only $600,000 of

Gross Rent receipts would therefore have a $3,600,000 value (six times gross rent receipts)

($600,000 X 6 = $3,600,000)

Method #2: Determine the Capital Value of the Current Net Operating Income

A. Determine Current Net Operating IncomeBegin by considering an owner’s net cash flow from a

property she currently owns that is encumbered by financing.

Net cash flow is simply the sum of all cash receipts from operations minus all cash spent (ignoring any capital improvements), including debt service.

As we shall discuss more fully (and which will become painfully simple to you), to derive taxable income or loss from net cash flow, simply start with net cash flow, then subtract the depreciation deduction and add back in amount that was paid to amortize debt.

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NCF versus NOI Or, stated as a formula:Net Cash Flow=Rent Receipts–Real Estate Taxes–

Maintenance Expense– Insurance–(Principal + Interest)

Assume you are a buyer valuing a property and you don’t yet know how you will finance your acquisition. You might want to ignore the debt service the owner has been paying and first look at the Net Operating Income from the property.

Net Operating Income is NCF apart from the current owner’s debt service (principal and interest).

NOI = Rent Receipts – Real Estate Taxes – Maintenance Expense– Insurance

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B. Apply a Capitalization Rate to the current net operating income to determine a value for the property

Basic idea: x 8% = $1,000 per year

is how much an investor will pay for the right to receive $1,000 per year if the investor will insist on an 8% return on his or her investment.

In this example, is $12,500

A. If I expects an 8% cash return [stated in fractions]

The price

x 8/100 return = $150,000

Divide each side of the equation by 8/100

( x 8/100) x 100/8 = 150,000 x 100/8 = $1,875,000

B. If I expects a 12% cash return [stated in decimals]

.12 return = $150,000The price

x

Divide each side of the equation by .12

x .12/.12 = $150,000/.12 = $1,250,000

1)

2) 2)

1)

How Much Will Investor Pay for a Building with a $150,000 Net Operating Income?

This is NOT a course that requires you to make complicated calculations. On the other hand, you need to understand ways business people consider transactions. So let’s restate this all another way.

Capitalizing Value of NOIA. Another Look at Net Operating Income. Another way of looking at Net Operating Income (NOI) is as the amount of cash flow that is available to service your acquisition debt.B. Another Look at the Capitalization Rate.•How much would you pay for an annual NOI of a certain amount? The answer depends on the rate of return you expect on your investment in a particular asset. That expected rate of return is your capitalization rate, for example, 5%.•To determine value, divide the net operating income by the Cap Rate you select, for example:

– NOI of $300,000 = $6,000,000 Value– Cap Rate of .05

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Capitalizing Value of NOI• Many of us who come to law school are

uncomfortable using numbers at all, much less dividing by decimals (by the .05 Cap Rate). The following statement avoids dividing by decimals. – The assumption still is that NOI is $300,000 and the Cap

Rate is .05—• The buyer expects a 5% return on an investment in this particular

property.

NOI x. 100 = Value Cap. Rate300,000 X. 100 = $6,000,000 5

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Capitalized Value of NOI (cont’d)• This simply substitutes multiplication coupled

with a more simple division.• Suppose you expect a greater return on your

investment, say, 8% rather than 5%. How much would you pay for that same $300,000 NOI?

• $300,000 x. 100 = $3,750,000 8The basic point: the higher the rate of return you

expect, the less you will pay for the income stream (the NOI).

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Eyeballing Capitalized Value of NOI (cont’d)

• Very simply (and rounded slightly)For 1% cap rate, the multiplier is:100 [100/1] x. $300,000 NOI = $30,000,000For 2% cap rate, the multiplier is 50 [100/2] x. $300,000 NOI = $15,000,000For 3% cap rate, the multiplier is 33.33 [100/3] x. $300,000 NOI = $ 9,999,000For 4% cap rate, the multiplier is 25 [100/4] x. $300,000 NOI = $ 7,500,000For 5% cap rate, the multiplier is 20 [100/5] x. $300,000 NOI = $ 6,000,000For 6% cap rate, the multiplier is 16.67 [100/6] x. $300,000 NOI = $ 5,001,000

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Why do so many domestic sellers like certain foreign investors? Because many of them are interested primarily in safety of principal rather than in a high return. Therefore, they may be more likely to settle for a lower return and hence pay more for the property.

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Method #3: Reduce the Future Stream of NOIs to their Present Value

Values property by A) estimating the net operating income for each year into the future; and b) discounting those future flows of cash to their present value. Discounting is the obverse of compound interest.

How much would you pay to purchase a 10-year position as landlord the right to receive $1,000 yr. rent for 10 years? The answer depends upon the rate of return you insist on.

1 .833 x $1,000 = 8332 .694 x $1,000 = 6943 .5794 .4825 .4026 .3357 .2798 .2339 .19410 .162 x $1,000 = 162 $4,193

HYPO: What is the total present value of the right to receive $1,000 in cash at the end of each of the next ten years? If the investor insists on a 20% rate of return? Because the 10, $1,000 payments are spread over the next 10 years, their total present value is the sum of the present value of each of the future payments. That Is:

936 Second Ave. L.P. v. Second Corporate Dev. Co., Inc.

(Text p. 681)

• Long-term net lease of three adjoining buildings with mixed residential and retail spaces.

• Lessee had option to renew for two, 20-year terms.• Renewal rent was to be 7% of the “value of the

demised premises.”– “Demised” is here and generally synonymous

with “leased”• Value was defined to include “the value of both the

land and the buildings.”

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936 Second Ave. (cont’d)• More specifically, the lease defined “value

of the demised premises” to mean– “the value of the demised premises together

with all buildings and improvements thereon including any and all additions and improvements erected by Tenant.”

• Issue: Should the lease itself be taken into account in determining the “value of the demised premises?”– The lease was silent on the point.

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936 Second Ave. (cont’d)

• Lessor’s appraiser said value was $ 7.1 million.– Lessor’s appraiser, in effect, treated the real property to be “free

and clear” of the lease.• Lessor’s appraiser employed both the comparable sales and income

capitalization approaches

• Lessee’s appraiser said value was $ 3.4 million.– Lessee’s appraisal is lower because Lessee’s appraiser

considered the effect of the net lease itself on the value of the premises.

– The Lessee’s appraiser treated the lease itself as an encumbrance.

• Lessee’s appraiser used only the income capitalization method.

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936 Second Ave. (cont’d)

• N.Y.Ct.App. reversed two lower courts and held that the lease itself must be considered in determining the “value” of the demised property.

• Cites Plaza Hotel: “the market value . . . is the amount which one desiring but not compelled to purchaser will pay under ordinary conditions to a seller who desires but is not compelled to sell.”– Standard definition of fair market value

• The “highest and best use” of the property is also a standard referent.

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936 Second Ave. (cont’d)• Unless the lease provides otherwise, appraisers generally

consider highest and best use, but they “necessarily must examine any restrictions . . . that may impact the highest and best use for which the property may be utilized.”– Then: “valuations of land must take into consideration all

encumbrances thereon, including reasonable restrictions as to its use, unless there is a clear provision to the contrary.”

– “Special attention must be given to limitations on ownership rights, which include easements, encroachments, leases and the disposition of air or subsurface rights and an appraiser must ‘analyze all of the economic benefits or disadvantages created by the lease.’”

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PLAZAOWNS THE BUILDINGBUILDING

LAND½

PLAZA½

HOTEL

CP

Operating

Agreement

SUBLEASE OF ½ FEE INTEREST

LEASE OF ½ FEE INTEREST

LEASE

Plaza Hotel Associates340 N.Y.S.2d 796 (N. Y. Sup. 1973)

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Plaza Hotel Facts• Lease provided for rent to increase to 3% of

the “value” of “all of the land,” exclusive of the building and improvements.

• It also provided that, if LL and T could not agree on value, appraisers would determine value.

• An appraisal valued the land alone at $28,000,000.

• Tenant sued to set appraisal aside on ground that it was too high because it was based on the assumption that the land was vacant and available for its highest and best use.

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Plaza Hotel Highlights• Court set aside the appraiser’s valuation, stating

that the appraiser “erroneously valued the land as available for its highest and best use, and not as already encumbered by the long term lease which restricts the use of the land to hotel purposes only.”

• Consider: since the fee and the building on it were separately owned, the fee could be sold separately. Hence, it is possible to ask: how much would someone pay for the fee.– How would you value the fee? Discount the cash flow?

• Having set aside the appraiser’s determination of value, the court undertook to determine value.

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Plaza Hotel Highlights• The court distinguished price from

value:– “Price is determined by short term factors

and by the caprices of the market.” – “Value . . . is dependent upon long term

factors and is directly related to the intrinsic worth of the property that resists the impact of temporary and abnormal conditions.”• “[V]alue, even more than price, is a

matter of judgment.”

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More from Plaza Hotel

• “The concept of a fluid market such as that existing in regard to corporate securities, where one sale can indicate the value at the time, is just not true with respect to real estate.”

• The lessee’s 3 appraisals of the land alone ranged from $8.5 million to $11.5 million.

• The lessor’s 3 appraisals of the land alone ranged from $33.3 million to $34.5 million.

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Plaza Hotel (cont’d)

• Plaza Hotel noted: – “In considering the opinions of the experts, the

court is not unmindful that ‘the appraisal of rental property necessarily involves the discretionary application of one or more accepted methods of computation’ and we must recognize that appraisers retained in litigated matters, within the limits of professional integrity, tend to adopt those formulae which favor their employer’s position.”

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A Different [Florida] View on “Free and Clear” Appraisal

• In Taylor v. Fusco Management, 593 So.2d 1045 (Fla. 1992), the issue was to determine value within the meaning of a tenant’s option to purchase contained in the lease.

• The lease was a 99-year lease. The price of the option to purchase, in the tenant’s view, was the present value of the rents (economically, a prepayment of the rent).– That is, the future cash cash flows discounted to their present

value• The court held for the landlord:

– “[T]he market value of leased property at the time a lessee exercises an option to purchase the property should be computed as if the property were unencumbered by the lease. Any intent to value the property otherwise should be clearly stated in the lease.”

– Correctly decided?

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Florida Statute on Balloon Mortgages(Supplement p. 39)

• Fla. Stat. sec. 697.05(2)(a)1 has its own definition of balloon mortgage.

• “Every mortgage in which the final payment or the principal balance due and payable upon maturity is greater than twice the amount of the regular monthly or periodic payment of the mortgage shall be deemed a balloon mortgage.”

Florida Statute on Balloon Mortgages(Cont’d)

• With certain exceptions, “there shall be printed or clearly stamped on such mortgage a legend in substantially the following form:– THIS IS A BALLOON MORTGAGE AND THE

FINAL PRINCIPAL PAYMENT OR THE PRINCIPAL BALANCE DUE UPON MATURITY IS $-----, TOGETHER WITH ACCRUED INTEREST, IF ANY, AND ALL ADVANCEMENTS MADE BY THE MORTGAGEE UNDER THE TERMS OF THIS MORTGAGE.”

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• The statute also has special provisions concerning “the case of any balloon mortgage securing the payment of an obligation the rate of interest on which is variable or is to be adjusted or renegotiated periodically, where the principal balance due on maturity cannot be calculated with any certainty.”

• Failure of a mortgagee to comply with these provisions “shall automatically extend the maturity date of such mortgage.”


• Note that the Florida Statute on Balloon Mortgages has several exceptions important for commercial real estate purposes:– “Any mortgage, the periodic payments on which are to

consist of interest payment only, with the entire original principal sum to be payable upon maturity;”

– “Any mortgage securing an extension of credit in excess of $500,000;” and

– “Any mortgage granted by a purchaser to a seller pursuant to a written agreement to buy and sell real property which provides that the final payment . . . will exceed the periodic payments thereon.”

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Provisions in Mortgages

• The typical “mortgage” transaction involves two separate documents:– 1. A note– 2. A mortgage.

• We have been considering some of the variables in notes.

• We now turn to take an even longer look at the variables among and within mortgages and mortgage substitutes.

• We’ll then take up more of the law of notes.

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DRAGNET CLAUSE IN MORTGAGE(Text p. 380)

• A dragnet clause in a mortgage uses a single property to secure the original debt and any other debt owed, or to be owed, by the mortgagor to the mortgagee.– The clause “drags” other debts into the

protection of the mortgage

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• Courts vary in approach to dragnet clauses • Some “interpret” dragnet clauses narrowly, holding,

ex., that dragnet clauses will only secure subsequent debts directly related to the property.

• Some “presume” that a future advances clause only covers advances of the same quality or relating to the same transaction, – perhaps unless the documentation concerning

the subsequent advance refers to the original mortgage as providing security.

DRAGNET CLAUSE IN MORTGAGE(Cont’d)

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State Bank of Albany v.Fioravanti(Text p. 381)

• 1966: Fee Owner executed $2,500 Note #1 and Mortgage #1 on Lot 1. – Mortgage #1 had a dragnet clause providing

that additional subsequent debt would be secured by the mortgage, but no more than $2,500.

– Lender recorded Mortgage #1.• 1973: Fee Owner executed $6,800 Note #2 &

Mortgage #2 on Lot 2 to same Lender. – No reference was made to Lot 1.

• Fee Owner conveyed Lot 1 to Grantee who assumed “the payment” of Mortgage #1 on Lot 1.

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Fioravanti (cont’d)• Fee Owner paid in full the 1966 Lot 1 Note #1 in

connection with which Mortgage #1 (with the dragnet clause) was issued and recorded on Lot 1.

• Fee Owner defaulted on the 1973 Note #2, causing Lender to foreclose Mortgage #2 on Lot 2. – Lender got a $3000 deficiency judgment in the

foreclosure of Mortgage #2.• Lender sued Grantee of Lot 1 to foreclose Mortgage

#1 on Lot 1 to recover $2,500 of the $3,000 deficiency from the foreclosure of Mortgage #2 on Lot 2.– Recall, the dragnet clause in Mortgage #1 had a

$2,500 limit on the additional debt that could be dragged in.

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Fioravanti (cont’d)• HELD: “payment of the 1966 note [secured by

Mortgage #1 on Lot 1] could not terminate the bank’s right to foreclose the mortgage [#1].” – To decide otherwise would defeat intent.

• TO EMPHASIZE: The note and mortgage are two separate instruments. One can survive the other.

• Dissent: Lender’s document did not specify that the Lot 1 Mortgage would survive the payment of the Lot 1 Note– Construe a document that is at best ambiguous

against the person that drafted it.

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Note 1 to Fioravanti• In Florida, dragnet clauses are construed

against the drafter. • In particular, pre-existing debt must be

specifically included (or they will be deemed excluded). – United Nat’l Bank v. Tellam, 644 So.2d 97 (FL

3d DCA 1994) (invalidated attempt to drag in pre-existing debt rather than future debt). Existing debts must be specified and future debts may not be dragged in if they were not anticipated at making of the Mortgage.

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Note 2 to Fioravanti (p. 416)

• The Restatement of Mortgages permits dragnet clauses only if

(a) the future debt is incurred in a transaction similar to the original mortgage; [or]

(b) the original mortgage described with adequate specificity the additional types of loans that will be secured by the mortgage; or

(c) the parties expressly agreed at the time of the future advance that it would be secured by the original mortgage.

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AFTER ACQUIRED PROPERTY CLAUSE(Text p. 381)

• Secures a single debt with a mortgage that purports to encumber both the property originally mortgaged and all future property the borrower will acquire.

• Attempts to bring future property under the mortgage rather than future debt.

• However, real estate lenders only get limited benefit from after acquired property clauses in mortgages.

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AFTER ACQUIRED PROPERTY (Cont’d)

• The reason: A mortgage with an After Acquired Property clause will be outside the chain of title of the after-acquired property.

• Subsequent purchasers or mortgagees of a second parcel will not find the After Acquired Property clause in the recorded chain of title of the second parcel. – Hence they will not be bound by that clause.

• The purpose of the recording acts is to allow buyers and lenders to rely on the instruments properly recorded in a particular parcel’s chain of title.

AFTER ACQUIRED PROPERTY (Cont’d)

• In sum: a subsequent purchaser (or mortgagee) of the second parcel will defeat the lender-mortgagee of the first parcel who is trying to rely on the After Acquired Property clause in the mortgage on the first parcel.– This is true whether a tract or a grantor-

grantee index is used.

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EVOLUTION OF PROTECTION OF MORTGAGORS(Text p. 337)

The “mortgage deed,”says the legal historian Maitland,“is one long suppressio veri and

suggestio falsi.”

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1) Defeasible fee enforced according to its terms

Stages in Evolution of Mortgage Law

Borrower LenderDeed

Fee simple subject to condition subsequent

Lender’s estate ends ONLY if borrower pays everything

off exactly on time.

2) Equity relieved Borrower in special circumstances3) Special circumstances were always found

• The equity of redemption came to be called an estate in land.

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Stages in Evolution of Mortgage Law (cont’d)

4. Lenders were permitted to strictly foreclose the borrower’s equity of redemption

• Lenders were permitted to end the borrower’s right to redeem the land from the mortgage

• Strict foreclosure decree states: pay up now or be barred (foreclosed) from asserting any interest in the future.

5. Lenders were required to foreclose by Judicial Sale (or, in some states today, other sale)

• The proceeds of a foreclosure sale are distributed:• First, to the lender, to pay what is due to the lender

(principal, interest and costs)• Second, any surplus is paid to the borrower.

• Thus, the lender gets what was promised to the lender, repayment, interest and no more.

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Stages in Evolution of Mortgage Law (cont’d)

6. Legislatures in roughly half the states supplement the equity of redemption and other judicial protections of borrowers with an additional Statutory Right of the Borrower to Redeem from a Foreclosure Sale

• In short, the mortgagor (and, often, a junior lienor) is permitted, for a specific period of time, to redeem “from the sale” by paying, to the foreclosure sale purchaser, the foreclosure sale price plus, in some cases, certain additional amounts.

• There are many approaches to the consequences of nullifying the foreclosure sale.

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Stages in Evolution of Mortgage Law (conclusion)

Where that leaves us.1. Leading Rule today: There may be no

contemporaneous (with the loan origination) waiver of the equity of redemption.

– No matter how clearly stated, understood and agreed to, a contemporaneous waiver of the equity of redemption is unenforceable.

2. However, in many states: Powers of sale, authorizing a sale out of court, whether they are contained in mortgages or in deeds of trust, are enforceable (and popular).

– In these states, the only two necessary steps to foreclose are notice and sale.

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THE PRACTICAL REALITY OF CHOICE OF SECURITY INTEREST

1) A Mortgage2) A Deed of Trust3) An Absolute Deed Standing by Itself4) An Absolute Deed with Collateral

(accompanying) Documents• Collateral documents such as a lease back or an

option to repurchase5) An Installment Land Contract

• Also called “contract for deed” or “bond for title”6) A Negative Pledge7) A Lease8) A Proprietary Lease in an Cooperative

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Sample Balloon Mortgage(Supplement p. 34)

• “This Mortgage Deed”• “Mortgagor hereby grants, bargains, sells,

conveys and confirms unto Mortgagee, in fee simple”

• Legal description of the land conveyed• Mortgagor covenants that it “is indefeasibly

seized of the Premises in fee simple and has full power and right to convey . . . And does hereby fully warrant title and will defend the same”

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Sample Balloon Mortgage(Cont’d)

• “CONDITIONED, HOWEVER, that . . . If Mortgagor shall fully perform all the covenants, conditions and terms of this Mortgage, then these presents shall be void, otherwise to remain in full force and effect.”

• The mortgagor also covenants– To pay the principal and interest “according to

the terms of the Note and this Mortgage.”– To pay all taxes and assessments.– To keep the buildings and improvements

insured

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• The mortgagor also covenants to give the mortgagee– the right to spend money to cure defaults

by the mortgagor [ex., to pay real estate taxes if the mortgagor does not] and add the amount to the mortgage

– the right, on default, to declare the “whole of the indebtedness . . . due and payable” and proceed to foreclosure [the “acceleration” clause]


The mortgagor also covenants that–“all rents, profits, incomes . . . are hereby assigned and pledged as further security for payment of the indebtedness hereby secured with the right on the part of the Mortgagee at any time after default hereunder . . . to demand and receive the same and apply the same on the indebtedness hereby secured.”

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• The Mortgagor also covenants– “Receiver. In the event suit is instituted to

foreclose this Mortgage or enforce the payment of the Note . . . Mortgagee shall be entitled to the appointment of a receiver to take charge of the Premises, to collect the rents, issues and profits . . . and to . . . care for the premises, and such appointment shall be . . . as a matter of right to the Mortgagee.”


The mortgagor also covenants•“Subordination. This mortgage” shall be “subject and subordinate to the lien of any and all institutional mortgages that may now or hereafter affect the premises,” provide they are in connection with the property and not more than $500,000.

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Deed of Trust• From Klem v. Washington Mutual, 2013

Wash. LEXIS 151 (Feb. 28, 2013):– A deed of trust . . . Is a statutorily blessed “three-

party transaction in which land is conveyed by a borrower, the ‘grantor,” to a ‘trustee,’ who holds title in trust for a lender, the ‘beneficiary,’ as security for credit or a loan the lender has given the borrower.”

– If the trustee acts only at the direction of the beneficiary, then the trustee is a mere agent of the beneficiary and a deed of trust no longer embodies a three party transaction.

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C. Phillip Johnson Full Gospel Ministries, Inc. v. Investors Financial Services, LLC

(Text p. 339)• Church purchased land and building on credit.• Gave Lender three documents:

1. A Note 2. A Deed of Trust with

a) an acceleration clause and b) a Power of Sale

3. A Deed in Lieu of Foreclosure (DLFC) with language ofa) absolute conveyance, with b) permission to record it, and c) declaring a present defaultd) reciting consideration of cancellation of existing indebtednesse) Yet DLFC was accompanied by a “disclosure statement” that

the DLFC would be put in escrow until default.

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Full Gospel Ministries (cont’d)• 7 months later, borrower defaulted on the note.• Lender, without pursuing foreclosure, recorded

the DLFC with the land titles.• Borrower argued that there was no consideration

given when the DLFC was executed. Lender disagreed, saying the DLFC was part of the package. And, it was under seal.

• Held on appeal: the DLFC, executed at loan origination, is a mortgage. Therefore, it must be foreclosed as a mortgage and there is no need to address whether there was consideration for it.

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Full Gospel Ministries (cont’d)

• Court defines issue: “Is a deed in lieu of foreclosure, executed as a precondition to originating a loan, before any default in the loan, valid under Maryland law, to support conveyance of marketable title upon default, but without foreclosure, in light of the borrower’s equity of redemption.”

• Held: no, it is not valid: “it clogs the equity of redemption.”

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Full Gospel Ministries (cont’d)• A loan “workout” after default is a different

matter:– “After a mortgagor defaults on a note, she may

legitimately contract with the noteholder to execute a conveyance, in exchange for adequate consideration, so long as there is no overreaching.”

– “After a mortgagor defaults, she may negotiate a ‘short sale’ to avoid a deficiency judgment, i.e., further indebtedness persisting even after the proceeds from a . . . sale have been distributed.”

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Full Gospel Ministries (cont’d)

• The statute in Full Gospel Ministries says substance trumps form:– “Every deed which by any other writing

appears to have been intended only as security for payment of an indebtedness or performance of an obligation, though expressed as an absolute grant, is considered a mortgage.”

• Similar to the Florida Statute we shall see shortly.

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Mortgage Substitute Hypo # 1

Deed Absolute with Collateral

Documents

HYPO # 1

Alleged Borrower Alleged LenderSale

2 year option to repurchase

Borrower Permits 2 years to pass without exercising option

What Kind of Evidence Might Borrower Want to Introduce to Establish that the Sale Coupled with an Option to

Purchase Was Intended and Should Be Treated As a Mortgage?

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Factors to Consider whether there is an “Equitable Mortgage”

(See Text p. 348)[1] “Side agreements providing for reconveyance will

readily be connected to the deed to support a finding that the deed and agreement formed a single security transaction.” A written agreement is not essential.

Other relevant facts are:[2]declarations of the grantee; [3] the relations subsisting between the parties at the

time the deed was executed; [4] the retention by the grantor . . . of possession . . . and [5] the exercise of dominion and control over it in

making improvements and repairs, [6] paying taxes, [7] the value of the property compared with the

consideration actually paid.

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Equitable Mortgage(Text pp. 349)

• The “putative deed will probably have been recorded.”

• A bona fide purchaser from the grantee will generally be allowed to rely on the record.– Therefore, an unscrupulous grantee-lender may sell or

encumber the title as soon possible, leaving the grantor-borrower with limited rights.

– However, a subsequent grantee with notice is bound by the equitable mortgage characterization.

– See, ex., Fla. Stat. 697.01(2).• Deeds absolute are also often used by grantors

trying to hide assets from other creditors.

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Mortgage Substitute Hypo # 2

1) If Lender #2 records a mortgage, will it be the first mortgage?

2) Would Lender #1 be able to get an injunction to prevent borrower from making an outright conveyance?

• Tahoe: “Specific performance of the covenant against encumbrances might create an invalid restraint against alienation.”

3) Would it be easier for Lender #1 to enjoin Borrower from giving a mortgage to Lender #2?

• Tahoe: “Under these circumstances, enforcement as an equitable mortgage, which permits the property to be conveyed subject to the lien, is the only alternative to invalidation of the instrument.”

HYPO #2

Lender #2

Definite Borrower Definite Lender #1Loan

Note

Negative pledge [“Agreement not to transfer or encumber property”]

RecordsBorrower

Applies for loan

Insists on 1M

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Enforceability of Due-on-Sale & Due-on-Encumbrance Clauses (Text p. 433)

• Prior to 1982, due-on-sale clauses were frequently invalidated by the courts as unreasonable restraints on alienation.

• Several state legislatures imposed restrictions on the enforceability of due-on-sale clauses--commonly prohibiting enforcing them in residential mortgages unless the mortgagee could establish that a transfer would impair mortgage security.

• The majority judicial approach held due-on-sale clauses were enforceable (presumption of enforceability) unless the borrower could show the lender engaged in unconscionable conduct.

• The minority judicial approach generally held due-on-sale clauses enforceable only if (presumption against enforceability) the mortgagee established reasonableness by showing that the transfer would result in security impairment or an increased risk of default.

• Due-on-encumbrance clauses were rarely litigated and the few reported cases permitted enforcement of the clause only when shown reasonably necessary to protect the lender’s security.

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Enforceability of Due-on-Sale & Due-on-Encumbrance Clauses (Cont’d)

• The enforcement of due-on-sale clauses by lenders enabled them to force repayment of lower-than-market interest rate loans during periods of rising interest rates upon the sale of the property by the mortgagor.

• Judicial and state legislative restrictions on the enforceability of due-on-sale clauses imposed severe economic burdens on depository institutions during a period of high inflation.

• In response, to protect the lenders, Congress passed the Garn-St. Germain Depository Institutions Act of 1982. 12 U.S.C. § 1701j-3.

• Garn-St. Germain preempts state laws that restrict due-on-sale clauses, and makes these clauses generally enforceable. 12 U.S.C. § 1701j-3(b)(1).

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Due-on-Sale & Due-on-Encumbrance Clauses (Cont’d)• Garn-St. Germain covers any “person or

government agency making a real property loan.” 12 U.S.C. § 1701j-3(a)(2).

• Due-on-sale clauses are defined broadly as any “contract provision which authorizes a lender, at its option, to declare due and payable sums secured by the lender's security instrument if all or any part of the property, or an interest therein, securing the real property loan is sold or transferred without the lender's prior written consent.” 12 U.S.C. § 1701j-3(a)(1) (emphasis added).– Thus, the Act defines due on sale clauses to

include due-on-encumbrance clauses.

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Enforceability of Due-on-Sale & Due-on-Encumbrance Clauses (Cont’d)

• Garn-St.-Germain, as a general rule, says that due on sale clauses and due on encumbrance clauses are enforceable.– However, they are not enforceable in a certain limited

number of situations involving residences.• See12 U.S.C. § 1701j-3(d)(2-9) (Text p. 473).

– The biggest exception is, that in the case of a single family residence, a due on encumbrance clause is not enforceable.

• For example, an acceleration clause triggered by a subsequent home equity loan is unenforceable.

Prepayment Privileges and Penalties(Text p. 474-475)

• Absent a specific provision in a note governing prepayment, the borrower is generally not entitled to prepay whenever the borrower likes– The rationale is that the lender has bargained for a specific debt service

schedule

• However, a minority of jurisdictions disagree.– In some, statute provides for a right to prepay unless the note provides

to the contrary. • See F.S. 697.06, providing for a right to prepay if the note is “silent” on the matter.

– Some caselaw presumes a right to prepay

• The Office of Thrift Supervision has returned some of this area to the states.

• Consistent with Fannie Mae and Freddie Mac forms that permit prepayment without penalty

• However, Federal law still prevents a due-on-sale clause from triggering a penalty in limited residential situations

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Florida Statute: Substance Not Form Determines Whether Mortgage Exists

• Fla. Stat. sec. 697.01(1) (Similar to the Balloon Mortgage provision at Supp. 36):

• “All conveyances, obligations conditioned or defeasible, bills of sale or other instruments of writing conveying or selling property, either real or personal, for the purpose or with the intention of securing the repayment of money, whether such instrument be from the debtor to the creditor or from the debtor to some third person in trust for the creditor, shall be deemed and held mortgages, and shall be subject to the same rules of foreclosure and to the same regulations, restraints and forms as are prescribed in relation to mortgages.”

Florida Statute: Substance Not Form Determines Whether Mortgage Exists (cont’d)• Is a negative pledge within Fla. Stat. 697.01(1)?

– Is it a conveyance?– Is it a writing selling property?

• Reflecting the general rule, Fla. Stat. 697.01(2) provides:

“Provided, however, that no such conveyance shall be deemed or held to be a mortgage, as against a bona fide purchaser or mortgagee, for value without notice, holding under the grantee.”

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Installment Land Contracts as Mortgage Substitutes

H & L Land Co. v. Warner, 258 So.2d 293 (Fla. 2d DCA 1972):• “An installment land sale contract, or so-called contract for

deed, evidences a sale of the land and an obligation of the seller to convey and of the purchaser to pay the purchase price in installments . . . and is essentially a security instrument taking the place of a purchase money mortgage.– “The doctrine of equitable conversion is established in

Florida. * * * if a land sale contract is specifically enforceable, and is free of equitable imperfections, the vendee becomes the equitable owner of the land and the vendor holds legal title as security for the vendee’s performance.”

• “[A]n installment land sale contract is in essence a mortgage, and pursuant to Fla.Stat. s 697.01, F.S.A., the safeguards for the debtor and the remedies for the creditor are the same as those between a mortgagor and mortgagee.”

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Three Basic Theories of Mortgages

1. Title. Mortgage passes title at outset.2. Lien. Mortgage is nothing but a lien.3. Intermediate. Mortgage is a lien at the

outset, but passes title upon default.• In general, the theories have low predictive

value.• However, the theories have some predictive

value on issues concerning the lender’s right to rents after default and prior to consummation of foreclosure proceedings.

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Commercial Mortgage Variations• Call provision: permits lender to call in the note for complete

repayment at specified intervals before the loan has been fully amortized.

• Participation: gives lender a share in property’s income and/or appreciation in value.

• Convertible mortgage: analogous to a convertible bond—provides that the lender’s interest as a creditor can be converted into an equity interest. – Ex., “a fixed rate loan that entitles the lender at a specified

point to convert the unamortized portion of the loan (say, 70% of the property’s initial value) into an equity interest (again 70%) in the property. Frequently, a convertible mortgage will give the lender the right to buy out the mortgagor’s remaining equity interest (here 30%) at a predetermined price or at a price calculated on the basis of a predetermined formula.”

• Personal liability: most loans on income-producing property have been nonrecourse.

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USURY VARIABLES

• Variations Among State Usury Laws– Range in rates– Range in penalties– Range in what is deemed to constitute

interest– Range in exemptions

• Because of the above variations, do not assume that the usury case law of one state is persuasive in other states.

Congressional Curbs on Usury Limits

• In 1979 and 1980, Congress preempted state constitutions and laws imposing usury limits on first lien residential mortgage loans used to acquire property– But authorizing states a limited opportunity to impose

such limits• Text (p. 380) states that at least 15 states (not including Florida) have

reimposed such limits on first mortgage loans.

• In short: “State usury limits still govern real estate lending arrangements other than first lien residential loans.” Text (p. 380).

• See Fla. Stat. Ch. 687

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NV One, LLC v. Potomac Realty Capital, LLC(Text p. 570)

• Plaintiff LLC sought a loan to rehabilitate and renovate a former post office– Plaintiff LLC signed a $1.8 million note– In addition, two individual plaintiffs “personally

guaranteed the loan.”• Interest was accruing on the full face amount of

the loan– More than half of the face amount was stated

to have been put in escrow– But no money was put in escrow or set aside

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NV One, LLC v. Potomac Realty Capital, LLC (cont’d)

• In short, when interest charged was computed on the basis of the limited amount of money actually disbursed, rather than on the basis of the full face amount of the note, the interest charged clearly exceeded the state’s statutory usury limit. – This loan fell outside the limited exception in the

statute for certain commercial loans that are 1. in excess of a certain amount; and 2. not secured by a principal residence; and 3. which are certified by a CPA as being capable of being repaid

• The loan was otherwise qualified but there had been no prior certification by a CPA

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• Issue: Did the usury savings clause in the loan documents validate an otherwise usurious contract?– “It is the intent of Maker [of the note] and Payee

[of the note] to conform strictly to the usury . . . laws . . . and . . . in no contingency or event whatsoever . . . shall the amount paid or agreed to be paid . . . exceed the amount permissible”

– Any excess amounts actually paid are to be treated as overpayments and refunded.

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• “If lenders could circumvent the maximum interest rate by including a boilerplate usury savings clause, lenders could charge excessive rates without recourse.”– Lenders would be incentivized to charge excessive

interest rates because the worst that could happen to them was the receipt of the maximum permissible interest

• The burden of compliance should be on the lender– who is a repeat player in a better position to assure

compliance– Even if both parties are sophisticated business entities

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FOUR ELEMENTS THAT MUST BE MET BEFORE A LOAN CAN BE CONSIDERED USURIOUS (Text p. 580):

1) An agreement to lend money2) Interest in excess of that allowed by statute3) An absolute, not contingent, obligation to repay the

principal4) An intent to violate the usury lawsNOTE: Intent, #4, is usually presumed if the other 3 elements

are shown.NOTE: An absolute obligation to repay, #3, is difficult to avoid

without defeating the lender’s business objectives.NOTE: There has been considerable federal preemption of

usury limits in residential mortgages (since Pres. Carter).

Usury Avoidance

• Text at 580:– “The more common efforts at usury avoidance include

a sale and repurchase characterization; discounts from the face value of the note; prepayment penalties; brokerage or placement fees; late fees; inspection fees; standby or commitment fees if the lender is funding a permanent loan; requirements that the borrower deposit part of the loan proceeds in an interest-free account with the lender; sale-leaseback arrangements; and equity “kickers” such as a percentage of the borrower’s gross or net income earned from the security.”

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Interest Contingency Rule• Assume a loan is risky. A rational investor will expect a

greater return on risky investments.– How might a loan be structured if the lender wants more

a greater return than the “interest” that would be allowed under an applicable usury limit?

• The casebook suggests one possible solution: provide the lender a share of the profit on the sale of an asset, even if that share of profits ultimately pushes the lender’s total return above the usury level.

• This type of solution is possible because of the interest contingency rule, which is a fundamental principle in the usury case law.

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Interest Contingency Rule (Cont’d)

• One statement of the interest contingency rule:– “[A] promise to give the lender a greater profit than

the highest permissible rate of interest upon occurrence of a condition, is not usurious if the return promised on failure of the condition is materially less than the amount or debt with the highest permissible rate of interest.”

• Note: a lender whose “greater profit” is in the form of a share in profits as opposed to a share of gross receipts may risk partnership classification– Profit sharing is a strong indication of partnership

(but the Revised Uniform Partnership Act protects shared appreciation mortgagees)

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Interest Contingency Rule (Cont’d)• A second statement of the interest contingency rule

suggests that nonrecourse loans might be treated more favorably: – “in a loan the lender does not share in the profits of

the enterprise, nor does he run any risk of the loss of his capital other than that of the insolvency of the borrower, attendant upon all loans.”

– From Golden State Lanes v. Fox, involving a sale-leaseback

• A nonrecourse lender risks loss of capital even if the borrower is solvent– The mortgaged asset may simply have declined in value,

leaving the lender with no remedy against a solvent borrow for a foreclosure deficiency

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Corporate Borrower Exemption

• The most common statutory exemption from usury laws is for loans made to corporate borrowers.

• Text (p. 580): “The central question . . . concerns the extent to which, to qualify [for the corporate borrower exemption], a corporation must have a life and business purpose independent of usury avoidance.” – “New York and several other states take the view

that any corporation, even one formed exclusively for the purpose of avoiding usury limitations, qualifies for the corporate exemption.”

– Courts are split.• “Governing law” clauses are common in loan

agreements.

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Time Price Doctrine (to avoid usury)

• Is a Seller’s agreement to provide purchase money financing to his Buyer an “agreement to lend money” within the meaning of the usury law?– Stated differently, is a seller-provided purchase money

mortgage a loan subject to the usury law? • The “time-price” doctrine says that a seller has a right to

charge more for a sale on credit than for a cash sale.• What if the seller sells on credit at the cash price but

explicitly charges “interest” at a rate in excess of the maximum rate?– See Mandelino v. Fribourg (Text p. 581), saying a purchase

money mortgage is not a “loan” within the meaning of the usury statute.

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Heller Financial Inc. v. Lee(Text p. 581)

• Florida Limited Partnership with a Sole Corporate General Partner took out a senior loan and a junior loan to purchase an Orlando hotel. This case concerns the smaller loan, which was the junior loan.

• The $9,900,000 junior loan was made both to the Limited Partnership and to its sole corporate General Partner. The loan was secured by the equity interest in the limited partnership and by the equity interest in its General Partner.

• After the closing of the loans and hotel acquisition, an unrelated corporation managed the hotel.

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Heller Financial Inc. v. Lee (cont’d)• At issue was Section 11(b) in the Note, which made the

borrowers’ obligation to repay nonrecourse, subject to a carve-out:– “Subject to the provisions set forth below, no Maker

shall be personally liable to pay the Loan . . . and Holder agrees to look solely to the Assignments and any other collateral . . . pledged . . . to secure the loan. Notwithstanding the foregoing, each Maker (excluding Robert Ahnert), . . . shall be personally liable for . . . (b) repayment of the Loan and all other obligations of the maker under the loan Documents in the event of [any breach of certain covenants].”

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Heller Financial Inc. v. Lee (cont’d)

• The referenced covenants said that each borrower agreed not to permit the filing of any encumbrances on the Hotel other than those provided for in the senior loan documents.

• Approximately $821,212 in encumbrances were filed (4 tax liens and 2 mechanics liens).

• Issue: Do the Makers of the note become personally liable on the full $9,900,000 loan because they permitted less than a tenth of that amount ($821,212) in encumbrances to be filed?– Or are they only liable for the smaller amount?

• Held: the makers are liable for the full loan: “Section 11(b) is not a liquidated damages provision because it provides only for actual damages.”– Which the court said was payment of the unamortized

loan balance.

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Junction Bit & Tool Co. v. Village Apts., Inc.(Supp. p. 42)

• In an earlier case, the Supreme Court of Florida had said that an election to sue on a note at law acted as a bar to any subsequent suit for foreclosure of a mortgage executed as security for the note.

• Here, the Court reversed its earlier decision:• If the earlier judgment on the note leaves the

creditor unsatisfied– that unsatisfied judgment on the note was no

remedy and– hence, does not bar the remedy of foreclosure on

the mortgage.