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.