Real estate professionals that have been in the industry for more than a few years know that interest rates and property values are cyclical. The current point in the cycle is marked by rising interest rates, (Federal Reserve has hiked its benchmark rate an aggregate of 4.5% since March 2022), inflation, and stagnating, or in some instances, decreasing property values. In times such as these, it can be challenging to extend financing based on property value due to actual or possible loan to value ratios exceeding requirements or risk tolerances. One option is to require additional real property as collateral for the loan. Unfortunately, not all borrowers own additional real property, or if they do, there may not be sufficient value to meet a lender’s requirements. Fortunately, there is an alternative to passing on the loan. Require the pledge of personal property assets.
What are Personal Property Assets?
Essentially, “personal property” includes any asset that is not real estate, and is divided into two categories, tangible, and intangible.
Tangible personal property includes physical objects, including inventory (including packaging, manuals, and instructions), merchandise, raw materials, work in process, equipment, machinery, tools, office equipment, supplies, furnishings, and fixtures.
Intangible personal property are all other types of personal property that are not physical objects, including stocks, bonds, retirement accounts. business records, deposit accounts, inventions, intellectual property, designs, patents, patent applications, trademarks, trademark applications, trademark registrations, service marks, service mark applications, service mark registrations, trade names, goodwill, technology, knowhow, confidential information, trade secrets, customer lists, supplier lists, copyrights, copyright applications, copyright registrations, licenses, permits, franchises, tax refund claims, and any letters of credit, guarantee claims, and security interests.
Why Require Personal Property Assets as Collateral?
In addition to supplementing the value of the real property collateral in order meet loan-to-value and other underwriting requirements, typical reasons that a lender will require personal property assets to be pledged as collateral, are:
- Business Assets. The borrower, or an affiliate, is operating a business at the real property collateral and the lender wants to ensure that in the event of foreclosure, those business assets will remain at and tied to the real property. If the tangible business assets utilized in hospitality (i.e., hotels, restaurants, etc.), gas stations, assisted living, cannabis, and other similar industries remain at the real property and are subject to sale, the value of the real property can increase, or at least stabilize, since an on-going business venture is often much more valuable than starting from scratch. Tangible assets utilized in operating the business are not the only desirable personal property collateral related to a business borrower. In some instances, there could be a franchise operating at the real property, so it is in a lender’s best interest to keep the flag in place. Some other business assets that can be taken include, insurance policies, contracts with third parties, accounts receivable, merchant accounts, and bank accounts.
- Construction. In order to ensure that a construction project is completed, a lender should consider obtaining collateral assignments of construction and construction related contracts, plans, and permits. By taking collateral assignments these types of personal property, a lender can step into the shoes of the borrower and developer and complete the construction, so the value of the real property can be maximized. A half-finished construction project often severely limits the value of the real property collateral, thereby forcing the Lender to complete construction to try to save its investment.
- Discourage Borrower from Cutting Losses and Walking Away from the Real Property. Sometimes, as a result of thorough underwriting, a lender will determine that a borrower lacks a history of servicing this type of debt, or has a history of cutting bait and running when circumstances are less than ideal (i.e., borrower is an entity, sponsor is about to file BK, and borrower determines that solely based on economics, the best decision for borrower is to strip the property and or business of all of its assets and walk away). A lender can protect itself from such a borrower by requiring that borrower pledge the following as collateral: all ownership interests in borrower or its affiliate(s), accounts receivable, and deposit accounts. Obtaining a collateral interest in the items mentioned above, will facilitate the appointment of a receiver to operate the real property, as well as obtain writs of attachment and other pre-foreclosure relief.
How to Take a Collateral Interest in Personal Property?
In general, Article 9 of the Uniform Commercial Code (“UCC”) governs secured transactions involving personal property and has been adopted in every state. Article provides that there are two steps involved in the creation of a personal property collateral interest, “attachment” and “perfection.”
“Attachment” is the moment at which a security interest is created in the collateral. For the security interest to attach in the collateral, (a) value must be given for the security interest, (b) the pledging party has rights in the collateral, and (c) the pledging party enters into a security agreement. In the instance of a mortgage loan where the lender is requiring additional personal property collateral, the loan itself is the value given. The security agreement should be included in the loan documents along with the promissory note, loan agreement, and mortgage or deed of trust.
The critical aspect of attachment is ensuring that the pledging party actual has an interest in the personal property being pledged. A common mistake occurs where a lender believes it is taking a collateral interest in the assets of the business that is operating at the subject property by having the borrower sign a collateral security agreement, but the business is actually being operated by a tenant or affiliate of the borrower. In the aforementioned instance, the business assets are not the property of the borrower, so no security interest would attach to them.
“Perfection” gives priority in the security interest to lender over all other parties. Thus attachment, creates the security interest between lender and borrower, while perfection applies to other creditors, bankruptcy trustees, and other parties that are obtaining an interest in the personal property collateral. By way of example, attachment occurs when a borrower executes a mortgage and funds are disbursed, but perfection does not occur until the mortgage is recorded.
Perfection can be accomplished by (i) filing a financing statement (UCC-1) with the appropriate government office; (ii) taking possession of the personal property collateral; (iii) controlling the personal property collateral; or (iv) taking a purchase money security interest in consumer goods.
If a secured party fails to perfect its security interest, another creditor could do so in the future and still have priority. A lender that fails to properly perfect its security interest still may assert its security interest against the borrower or pledgor.
Foreclosing on Personal Property Collateral
Article 9 of the UCC describes the process by which a lender may foreclose on personal property collateral following an event of default. Under Article 9, following a default, a lender may sell, lease, license, or otherwise dispose of any or all the collateral covered by the security agreement. The only limitation of what a lender may do is that its actions must be reasonable. Therefore, a lender may resort to self-help to recover personal property security, so long as the actions are reasonable and do not disturb the peace. In most instances, ten days’ notice of sale is deemed reasonable.
While Article 9 provides for a simple and fast foreclosure option, the ease and speed of an Article 9 sale will depend on the following factors:
- Level of cooperation from the pledging party. If the pledging party refuses to cooperate, obtaining and taking control of collateral could be difficult.
- Ability to possess or control the collateral could impact perfection of the security interest, as well as conduct a sale.
- Creditors with priority.
While the above items will make foreclosure of the collateral extremely difficult, a secured party still may enforce its rights by foreclosing judicially and obtaining assistance from the courts with determining the rights in the personal property collateral and forcing the turnover collateral to lender.
Effectively Adding Personal Property Security
Until the real estate cycle moves to a place where real property values are back on the rise, lenders can utilize personal property collateral as a method to decrease the risk associated with real estate loans with less than ideal loan to value ratios. Anyone interested in requiring personal property collateral should consult with a professional that is versed in the creation, attachment, perfection, and enforcement of security interests in personal property.
The transactional team at Geraci LLP is well-versed in providing loan documents and counsel in regard to real estate-backed loans. Contact us today with your lending questions.