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Sometimes, a second mortgage may be nonforeclosable. In this instance, the lender cannot foreclose upon the mortgage and gets additional security, such as an assignment of the ownership interests. In the event of default, although the investor cannot foreclose the mortgage, it can foreclose on the ownership interest and take over the ownership of the borrowing entity, subject to the liens and whatever problems exist. The security is not as good, the perceived risk increases and the required rate of return increases.
Many investors prefer the nonforeclosable second mortgage to loan structures such as assignment-of-ownership interests without a mortgage, however. This is because they are deemed secured creditors in the event of bankruptcy and have better protection in the event of hazardous-waste issues or construction loans so the lien is in front of any mechanics liens.
Issues may arise between lenders when a borrower seeks a mezzanine loan. Mezzanine lenders typically require an agreement from the first mortgagee or senior lender that gives them notice of any default, in addition to the right to cure the defaults the borrower has under the senior lender's documents and to work out their problems with the borrower.
Mezzanine lenders generally can foreclose upon the borrower and terminate the borrower's interest. If they foreclose out the borrower's interest, they often must get the senior lender's consent to sell it to a new borrower before it forecloses. Many senior lenders don't want to allow the mezzanine lender to foreclose out the borrower's interest when construction is taking place, however.
Another issue that can come up is the senior lender's request that the mezzanine lender "stand still" for a period of time. Many senior lenders want the mezzanine lender to grant them the right to vote their interest during a borrower bankruptcy. Although mezzanine lenders in corporate transactions often agree to the obligation to stand still, it rarely occurs in real estate transactions.
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Various other issues exist with mezzanine lending.
For instance, brokers also must let borrowers know that a typical mezzanine transaction also requires they share with the lender their operation's cash flow, which often has a cap on the return. Some lenders have large exit fees in addition to or in lieu of the sharing in excess cash flow, but all excess cash flow goes to interest or amortization.
Despite mezzanine loans' high cost and varying legal issues, many borrowers who need to get their deals done often can use them to fill a financing gap. Mortgage brokers who understand how this financing type works and develop solid relationships with mezzanine lenders can best determine whether their clients would benefit.
is managing director of Whitestone Realty Capital LLC, a real estate investment banker and developer. WRC is developing 24 multifamily projects, six mixed-use projects and four resort-hotel projects. Zukerman is of counsel to Warshaw Burstein Cohen Schlesinger and Kuh LLP (www.wbcsk.com), practicing real estate law in New York City, and also is an adjunct professor at New York University's Schack Institute of Real Estate. Reach him at (212) 984-7836. Visit www.whitestonerealty.com.
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