When a borrower owes multiple creditors — for example, if a real estate investor takes out a loan to buy a property and then another loan to pay for construction on that property, and both loans are secured by the same collateral — one lender has the right to be paid first.
In California, the default lien priority is chronological based on the date the deed of trust is recorded, so the first loan a borrower takes out has the right to be paid first. If foreclosure becomes necessary, the proceeds from the foreclosure sale would be applied to completely satisfy the first lien before being applied to any subordinate lien(s). Therefore, the lien priority is key to whether a lender will be able to realize any return from its collateral.
Despite the importance of lien priority, scenarios often arise in real estate when lenders agree to change their lien priority. This is often the case for lenders who finance a purchase and later agree to subordinate their loan to a construction loan so the borrower can make improvements to the property, ultimately boosting the chances that both loans will be repaid in full. When such a situation arises, lenders depend on loan subordination agreements to alter normal priority rules and manage increased risk associated with taking a junior debt position.
Here are three quick things to know about subordination agreements:
Subordination agreements may be included in existing deeds of trust or may be outlined in an independent contract.
In situations where two deeds of trust are being recorded concurrently, the lien priority is typically handled by instructing the title company as to which security instrument will be recorded first. If the deed of trust being subordinated has already been recorded, then the subordination must be handled through an independent contract.
Lenders can execute what are referred to as executory subordination agreements.
Executory subordination agreements are essentially a promise to enter into a subordination agreement in the future if another loan enters the picture, like a construction loan. Because executory subordination agreements are merely promises to negotiate a future agreement, they should be written in detailed terms. Specifications should include maximum principal amount, interest rate, loan purpose, allowable fees, and payment, among others. And even if an executory subordination agreement is drafted precisely, the party relying on it should understand that there is still a chance the subordinating lender could refuse to cooperate in the future, at which point the only recourse would be an action for breach of contract.
When a property has more than two liens, lenders may face issues related to circuity of priorities.
This occurs if a primary lienholder subordinates to a junior lienholder, but there were other lienholders in line between them. The issue becomes a complex dilemma of priorities. California resolves this by using partial subordination to leave intervening liens in a neutral position and changing only the priority of the lenders entering into the agreement.
Loan subordination is a common and useful tool in real estate lending, particularly for commercial real estate, home equity loans, and lines of credit.
