When a property has multiple loans or liens, the question becomes: who gets paid first in the event of a sale or foreclosure? This is where a subordination agreement comes into play. It’s a legal document that establishes the priority order of various claims. In this article, we’ll explore the types of subordination agreements, their legal requirements, how to negotiate them, and the potential risks and benefits.
What is a Subordination Agreement?
A subordination agreement is a legal document that determines which lender gets paid first when a property has multiple loans or liens. It sets the priority between creditors, ensuring everyone knows their place if the property is sold or foreclosed. For example, if you refinance your primary mortgage, the new loan typically needs to maintain its top priority over any other loans, like a second mortgage or home equity line of credit (HELOC). This agreement helps prevent disputes and keeps the transaction smooth.
Types of Subordination Agreements in Real Estate
There are two main types of subordination agreements. Each of them differs based on when the subordination takes effect and how much control the subordinated party has over the process.
1. Executory Subordination Agreement
In an executory subordination agreement, the subordination is conditional, meaning it only takes effect when a certain event or condition occurs. Until that trigger happens, the subordinated party keeps their existing claims and security interest. This type of agreement is often used because it offers flexibility, which allows future financing transactions to occur without creating additional legal work to realign priorities at that time. However, it’s still important that all parties follow through with the agreement. If the subordinated party later refuses to execute the subordination when the triggering event happens, it could lead to a breach of contract.
For example, consider a commercial real estate developer who plans to secure additional financing once a project reaches a certain milestone, such as 50% completion. The original lender may agree to subordinate its claim under the condition that the second loan is only triggered once this milestone is met. This allows the developer to negotiate future financing without giving up the lender’s priority status until the condition is fulfilled. The flexibility makes executory subordination agreements useful in managing credit risk and facilitating further financial transactions without immediately altering the lender’s position.
2. Automatic Subordination Agreement
Unlike the executory type, an automatic subordination agreement gives the subordinated party no further control once the subordination is in place. Here, subordination takes effect automatically as soon as a certain event or condition occurs, with no additional action needed from any involved party. The subordinated party’s claims are instantly placed behind the primary lender’s claims.
For example, in a commercial lease, an automatic subordination agreement might state that the landlord’s mortgage lien takes precedence over any claims the tenant may have. This type of agreement reassures lenders that their position will remain protected without the need for further negotiation or involvement from other parties after the subordination has been established.
Legal Requirements for a Subordination Agreement
To be enforceable, a subordination agreement must meet certain legal criteria:
- Execution: All parties must sign the document, and it should be notarized to validate signatures.
- Recording: The agreement must be officially recorded in the county’s public records to be recognized legally.
- Identification of Parties: Clearly outlines all involved parties and their roles.
- Debt Details: Specifies the subordinated debt, including the loan amount, interest rate, and repayment terms.
- Priority of Claims: Defines the order in which debts will be repaid, establishing the priority.
- Consent: Existing creditors with higher-priority claims must provide consent.
How to Negotiate a Subordination Agreement
Negotiating a subordination agreement requires careful planning and communication to ensure all parties are on the same page. To help you through the process, here are a few effective strategies to keep things smooth and straightforward.
1. Understand Lender Priorities
Lenders typically don’t want to give up their priority position, especially in cases where they hold a second mortgage or HELOC. When refinancing a primary mortgage, the lender for the second loan may hesitate to subordinate, as their security decreases if the property is foreclosed. Be prepared to provide documentation proving the refinancing will improve the borrower’s ability to repay both loans.
2. Work with Both Lenders Early
It’s important to engage both the primary and secondary lenders as soon as the refinancing process begins. Waiting until the last minute could lead to delays in closing. Open communication is key to ensuring both lenders are comfortable with the terms and that the subordination process can move forward smoothly.
3. Leverage Your Creditworthiness
If the borrower has a strong credit history and a stable financial situation, they may be in a stronger position to negotiate favorable terms in the subordination agreement. Lenders are more likely to agree to a subordination if they feel the borrower can manage both loans responsibly.
4. Negotiate Fees
In some cases, lenders may charge fees for agreeing to a subordination. It’s worth negotiating these fees to ensure they’re reasonable and in line with industry standards.
Potential Risks and Benefits of a Subordination Agreement
While subordination agreements can offer several benefits, they also come with certain risks. Understanding both is critical for all parties involved.
Benefits
- Refinancing Opportunities: Subordination agreements enable property owners to refinance their primary mortgage, often at a lower interest rate, while still maintaining a second loan or HELOC. This flexibility can be a major financial advantage.
- Lender Cooperation: By formalizing the relationship between different lenders, subordination agreements help ensure smooth cooperation and reduce the likelihood of legal disputes in the event of foreclosure.
Risks
- Lender Reluctance: Secondary lenders may be reluctant to agree to a subordination agreement, especially if the new loan increases the financial risk on the property. This can result in delays or additional fees.
- Increased Foreclosure Risk: In the event of foreclosure, the secondary lender, who agreed to the subordination, may not receive full repayment. This risk can make it harder for the borrower to obtain a second loan or HELOC in the future.
Closing Thoughts
Ultimately, subordination agreements are an essential component of real estate transactions that involve multiple loans or liens on a property. They clarify the priority of each loan, ensuring lenders understand their position in the event of a sale or foreclosure. Whether you’re refinancing a mortgage, developing a commercial property, or dealing with a second loan, understanding how subordination agreements work can help you protect your interests and maintain good relationships with lenders.
If you’re considering a subordination agreement, partnering with an experienced title company like Nest Title & Escrow can make all the difference. We understand the complexities of real estate law and will guide you through each step, ensuring all the paperwork is in order and deadlines are met. Our team will work closely with both lenders to smooth out the process, especially as it leads up to closing. With Nest, you’ll have a team that’s focused on protecting your interests and ensuring a hassle-free transaction from start to finish.