Lenders take on several risks when issuing mortgages. Due to the complexity of the real estate market, property transfers, liens, and other financial issues can arise at a moment’s notice. Instead of leaving their financial interests to chance, they can use a subordination clause in real estate to ensure that their repayment rights take priority over other agreements.
The article below discusses what you should know about subordination clauses in real estate:
What Is A Subordination Clause In Real Estate?
Subordination clauses in real estate, also called dependent clauses, are contractual agreements used to indicate that current debt claims will take precedent over others made in the future. In effect, subordination is the action of one party yielding deferring priority to another party. They’re primarily used within the context of mortgage notes and commercial real estate agreements.
Real Estate Subordination Clause Meaning
Real estate subordination clauses generally refer to the liens that are placed on a property. They assign a chronological priority to one party that then trickles down to the next in line. You can adjust a lien’s priority by requiring that borrowers and lessees sign a subordination clause with your other agreements.
Subordination Clause Examples
Subordination clauses are complicated. There are state and federal regulations that govern their use. They can also be very powerful when used correctly, which is why you should always seek legal advice before incorporating them into your strategy.
Let’s take a look at subordination clause examples to help you better understand how they work:
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Subordination Clause in Mortgage Note
Subordination clauses in mortgage notes set the conditions around your mortgage agreement that states the lender’s lien takes priority over any other property liens. The most vital thing to remember is that if the borrow defaults on the mortgage, the first lienholder receives repayment first.
In most cases, the first priority generally originates from the primary lender. Here’s an example of how subordination clauses in mortgage notes work for a better understanding:
- John decides to buy a house
- John’s bank agrees to lend him the money to purchase a home on the condition that they take repayment priority
- John’s bank uses a subordination clause to secure its rights
- In three years, John defaults on several credit cards
- John’s credit card companies successfully pursue a civil claim against him for repayment
- The civil court issues a lien on John’s house
- John must repay his lien to the lender before repaying creditors pursuant to the subordination clause
Subordination Clause in Commercial Real Estate Lease Agreement
Subordination clauses in commercial real estate lease agreements set the priority of the lease versus the mortgage. If the commercial property owner defaults on their mortgage, the tenant will undoubtedly face severe business disruptions as a result. If the lease is subordinate and second to the mortgage, then a lender has the right to evict the tenant at will.
Here’s an example of subordination clauses to solidify your understanding:
- ABC Company rents a property from XYZ Corporation
- At the time of the lease, XYZ Corporation included a subordination clause in the lease that states it’s second in priority over the mortgage
- XYZ Corporation is still making mortgage payments to its bank
- After one year, XYZ Corporation defaults on the mortgage, and the bank repossesses the property
- Since the lease is a second priority, the bank terminates the lease
- ABC Company must now find a new location
Keep in mind that it’s generally in the lender’s best interest to continue leasing commercial properties. Doing so allows them to collect money on an otherwise vacant, unmortgaged property. However, lenders may not have the resources to engage in this type of relationship, so outcomes may vary.
Who Benefits From A Subordination Clause in Real Estate?
The party that primarily benefits from a subordination clause in real estate is the lender. However, if you decide to pursue a second mortgage, then the subordination clause prioritizes the first lender’s repayment and contract rights.
The most common application of subordination clauses is when refinancing a property. Refinancing occurs when the original loan is paid in full, and a new loan provider structures the agreement under a new interest rate. Instead of leaving the new lender at the priority’s list end, they can use subordination clauses to ensure that they are first in line for repayment.
As such, the claim holder must agree to them before the refinancing process can begin.
Other Important Real Estate Clauses
A subordination clause is just one of the many terms that you will find in real estate contracts, including purchase agreements , purchase and sale agreements , real estate purchase agreements , and land contracts . A complete real estate contract generally contains other provisions designed to protect the rights of the lender, borrower, and insurer.
From subrogation clauses to release clauses, other important real estate clauses may include the following:
Subrogation Clause
Subrogation clauses give one party the right to pursue another party’s claim. They generally pertain to insurance companies within the context of real estate. With a subrogation clause, insurers are free to pursue a third party if they caused property losses, such as a fire or water damage, while still paying for the property on a mortgage note.
Acceleration Clause
Acceleration clauses permit lenders to speed up a mortgage’s repayment when the terms and conditions go unmet. They outline the triggering events, such as non-payment, bankruptcy filings, and unauthorized property transfers, and the remedies by which the lender has to demand acceleration. Lenders must send a letter to mortgage holders when the acceleration clause is triggered.
Alienation Clause
Alienation clauses, also called due-on-sale clauses, require that the mortgage noteholder repay the full balance with interest before a property is transferred to another buyer. They describe the terms and conditions associated with contractual obligations by the borrower and their release. Lenders primarily benefit from alienation clauses since it prevents unapproved property ownership transfers.
Defeasance Clause
Defeasance clauses are provisions that state the mortgage borrower will receive the property title or deed of trust upon satisfying contractual obligations. They generally summarize the finalization of the mortgage and how secured collateral will be handled. Most states don’t require you to include a defeasance clause for it to be legitimate.
Prepayment Clause
Prepayment clauses authorize the lender to penalize a borrow for significantly paying down their mortgage within the first five years of the transaction. These clauses primarily benefit lenders since it offers some form of interest income protection. They must also explicitly disclose prepayment penalties when the borrower is closing on the mortgage.
Release Clause
Release clauses are the terms and conditions if the mortgage holder pays off a proportional amount of the mortgage. They can also be used in brokerage transactions if a release is required after accepting a specific offer. The release clause is what gives the lender full legal rights over a property, including foreclosure, financial, and insurance rights.
Get Legal Help with Real Estate Subordination Clauses
Real estate subordination clauses and the laws surrounding them are complicated. There are several considerations and nuances that you should consider with a legal professional. If you need legal help with subordination clauses in real estate, speak with real estate lawyers for advice and guidance. Post a project now on ContractsCounsel.
