What is a Subordination Agreement?
A subordination agreement is a type of agreement that is quite common in the world of finance and real estate. Here at Wolverine Title Agency, we often receive phone calls from lenders and developers looking for information on a sample subordination agreement, so we’re bringing you information on subordination agreements today.
The purpose of a subordination agreement is to alter the order of a lien or a debt. As we mentioned above, there are a couple of different ways that they are used: In commercial loans, lenders will often ask the property owner to subordinate their interest in the property to the lender’s interest . What subordination does, in this case, is lessen the ranking of the particular property owner’s title claim in favor of the lender. These deals are captured in subordination agreements.
Subordination agreements can also be used in constructing a new building. An owner takes out a construction loan from a lender, who will pay contractors and builders as work progresses in exchange for mechanics liens filed by the contractors, etc. These mechanics liens become the first priority on the property and a recorded subordination would subordinate those liens to the lender’s lien or mortgage.
Essential Components of a Subordination Agreement
The practice of securing a mortgage loan with a subordinate mortgage or other lien is commonplace throughout the United States. This is especially true for homeowners that refinance their home, obtaining a second mortgage or equity line of credit. In cases where one lender asks another to agree to subordinate its prior mortgage, the prior lender is being asked to accept a lower priority in the repayment of its mortgage if the homeowner forecloses. How do lenders determine the priority of their mortgage or other lien? As stated above, priority is achieved by determining in what order liens are recorded in the land records. A subordination agreement operates to allow one lender to postpone the priority of its lien in favor of a subsequent lien placed by a different lender in the land records. Subordination agreements are nothing more than a contract between the lenders, but often lenders will insist that they are the product of "standard" document forms.
The following terms and phrases are critical to the operation of a subordination agreement:
"Subordinate" – to place in a position of lower priority in the event of foreclosure.
"Priority" – to have a higher place on title and right to repayment.
"Mortgagor" – the borrower of the mortgage loan, often referred to as the "Grantor."
"Mortgagee" – the lender of the mortgage loan, also referred to as the "Grantee."
When is a Subordination Agreement Necessary?
Subordination agreements are required in a number of circumstances, including the following:
- Refinancing. When a loan secured by a real property interests is paid off with an existing note and deed of trust being replaced with a new note and deed of trust, the original lender should obtain a subordination agreement from all junior lienholders. Even though the lien of the new lender that steps into the shoes of the old lender will have priority under the "first to record" rule, with a subordination agreement the lien of the new lender will have priority over all burdens and encumbrances recorded after the old lender’s lien was recorded.
- Additional Lender. The original lender of a secured loan may reduce the priority position of its lien in favor of a new lender who is loaning funds to the borrower and requiring a deed of trust lien. The new lender may insist on the priority of its lien with respect to the prior lender’s lien. In those circumstances, the prior lender will require a subordination agreement from the borrower, and perhaps the new lender, subject to the new lien or encumbrance. If the new lender has not yet determined that the property is suitable for both first priority financing and a second financing, the new lender may only be willing to loan funds if the prior lender agrees to a subordination of its lien.
- Mechanic’s Liens. A property owner may want to get one or multiple mechanic’s lien priority over an existing deed of trust. That can be accomplished with a subordination agreement. The priority of the mechanic’s lien lien will relate back to the date of the recording of the mechanic’s lien.
- Construction Contract. If a contractor has a construction contract with a property owner and the construction contract gives the contractor a lien against the property, the contractor may require the prior lender to subrogate its lien in favor of the contractor’s lien in connection with a refinancing of the existing loan. The contractor may require a subordination agreement from the property owner to give its lien priority over the lender’s lien.
Legal Aspects of Subordination Agreements
The rights and obligations of the parties to a subordination agreement often are of equal or greater significance to the parties than the rights created by the debt instruments or documents secured by the subordination agreement. Whether a subordination agreement expressly adopts the terms of the senior debt or states that the terms of the junior debt will control, if they are inconsistent, generally will determine which set of documents controls when the creditor holding senior debt seeks judicial enforcement of its rights against the borrower. Subordination agreements often include a variety of remedies available to debt holders to remedy a default by a subordinated creditor. These may include the right to foreclose on collateral in which the subordinated creditor has a junior security interest, to compel the subordinated creditor to exercise its remedies and to take possession of or include in foreclosure any assets that have not been duly perfected or recorded. Because a subordination agreement creates so many rights that can be enforced in a variety of ways against the subordinated creditor, it is critical for the subordinated creditor to obtain the benefit of legal counsel when reviewing the terms of a subordination agreement.
Sample Subordination Agreement Wording
The use of sample subordination agreements can be helpful to reference when you need to get an up-close look at the practical side of these documents. I encourage you to be on the lookout for sample subordination agreements used in real-life situations, and if you come across a website or other source of samples that look helpful, please post information about them in comments.
Even if you are able to find a sample subordination agreement and the practioner who prepared it, be careful using a sample agreement as your own. Although they can be very helpful for educational purposes, the risks associated with using a sample agreement include: (a) failing to recognize the force and effect of the subordination agreement contained in the sample; (b) failing to realize the necessity of making the practical and logistical arrangements for the subordination agreement to become effective under state law; (c) failing to consider recent developments in the law that affect the subordination agreement; (d) adopting an outdated sample subordination agreement; and (e) failing to effectively tailor the sample subordination agreement to your present needs .
Here are five sources to consider when looking for sample subordination agreement templates:
- Sources such as online blogs and websites written by and for attorneys that follow a particular area of practice. Two examples of good sources for sample subordination agreements are the following two blogs:
- Any sample subordination agreement template that is included with the credit facility documents and forms that you have received and which is used by lenders and loan servicers or their counsel.
- Any regulations, published policies or published letters issued by government agencies that might have created sample subordination agreement template obligations. One example is Fannie Mae’s guide for mortgage lenders.
- Any subordination agreement template that might have been approved by a court or a judge.
- Respected articles and publications such as The American Bar Association publications.
Advantages and Disadvantages of Subordination Agreements
Subordination agreements are often used in the complex world of commercial real estate finance, but like any other real estate tool, there are both pros and cons to using them. For the existing mortgage holders, becoming subject to a later-acquired mortgage means greater short-term risk of recovery in the event of loan default by the borrower. This is because subordination means that in the case of default and foreclosure, the existing mortgage holder will recover its collateral only after the later-acquired mortgage holder has recovered its collateral. On the other hand, subordination provides existing mortgage holders a more reliable yield by lowering the interest rates at which subordinate (later-acquired) mortgages can be made to the mortgagor. Subordinate mortgage loans, on average, are more risky (in terms of default) than first mortgages. But once the existing mortgage is subordinated, it will likely be priced at a lower interest rate than if it had been made senior to the later-acquired mortgage, resulting in a higher return to lenders overall. For developers and borrowers, subordination allows capital to be raised from subordinate sources for construction, renovations or tenant improvements when capital markets are tight, interest rates are high or the sources cannot bear the risk of a higher-priced first mortgage.
Negotiating a Subordination Agreement
As previously described in the Sample Subordination Agreement blog post, the equity owner, the senior lender and the junior lender all have an interest in the success of the project, so each party should be somewhat flexible with respect to the terms of the subordination agreement. A number of considerations should be taken into account when negotiating a subordination agreement. First, the parties should consider carefully the possible future capital requirements of the project. The amount of junior financing available and the potential for future funding generally are important factors in evaluating subordination terms from the perspective of the junior lender. The timing of senior lender advances and disbursements of junior lender funds also should be considered in anticipation of the possible tolling of the applicable statute of limitations.
Second, the parties should assess whether the issuance of equity interests in exchange for the junior financing could provide sufficient capital to reduce significantly the amount of any potentially outstanding junior loans at maturity. While a subordination agreement technically will not include terms governing such matters, it is again in the best interest of the parties to contemplate them on a practical level.
Third, the parties, in negotiation with each other, also can review the ability to capitalize a financing entity through grants, deferred fees, unsecured liabilities and other instruments that do not require current funding or that have such funding subordinated to the senior financing.
Subordination Agreements in Action: Real-world Examples
A borrower is expanding its business and needs financing to acquire new inventory through a purchase money loan from its bank but is unable to secure the loan without subordination of the bank’s loan to an existing security interest. In order to subrogate the bank, the bank will require a subordination of the existing security interest to the bank’s security interest covering the purchase money loan. Because this scenario is not unusual, banks often request subordination agreements from existing secured parties to provide a priority status for a new loan.
An individual commercial real estate investment controls a property for lease to residential tenants. The ownership entity also owns an undeveloped parcel across the street that it intends to re-develop into a new office development complex. A new lender requires subordination of all other existing liens or equity interests to the lender’s lien prior to making a $10M loan secured by the leases of the undeveloped property. Because significant construction is planned for the new property , the lender wishes to have the ability to control all aspects of its collateral, including securing vacant parcel across the street. Without a subordination agreement, the landlord could be faced with restrictions on its ability to manage its collateral and leasing of the leased improvements.
A retailer/brand owner, who has been able to successfully sell its brand through online e-commerce sales, attempts to expand its retail presence through opening physical retail locations. The retailer is unable to secure financing against its existing inventory due to another entity’s security interest in the goods, or "inventory", unless the security interest is subordinated to the new financing. The lender is reluctant to extend credit or review its underwriting only to discover at the end of the process that it may not be able to secure its security interest.