Subordination Clause Definition, Explanation, and Examples
In commercial real estate, a subordination clause ranks one claim on a property behind or “subordinate” to another. In most cases, subordinate clauses are used when a property owner takes on a second position loan, such as a mezzanine loan, a supplemental loan, or preferred equity, on top of their original first position mortgage. A subordination clause can also be used in residential real estate when a homeowner takes on a second mortgage or HELOC on top of their original home loan.
Subordination clauses are often defined by intercreditor agreements, which define the rights and responsibilities of each lender and the borrower in various legal and financial scenarios. In addition to mortgage agreements, subordination clauses are often used in commercial leases to define the rights of the lender and the tenants if a property foreclosure occurs.
In this article, we’ll review the importance of subordination clauses in multiple scenarios, including their application to general commercial loans, mezzanine loans, preferred equity, and commercial leases. We’ll also provide real-world examples of subordination clauses in action.
Subordination Clauses in Commercial Real Estate Loan Agreements
As previously mentioned, a subordination clause is often used in an intercreditor agreement to define the rights and responsibilities of each lender. In most cases, the subordination clause posits that, in the case of property foreclosure and sale, the original, first-position lender will need to be fully reimbursed before the second-position lender receives any funds.
Only after the second position lender receives their full reimbursement will equity investors, starting with preferred equity investors (if there are any) receive any funds.
Subordination Clauses, Mezzanine Loans, and Preferred Equity
In commercial real estate, subordination clauses are often used when a borrower takes out a second-position mortgage in the form of a mezzanine loan. A mezzanine loan is a type of second position loan which typically comes with higher interest rates than first position mortgages.
A mezzanine loan boosts the leverage on a property beyond what an investor could achieve from a single loan, leading to potentially higher returns as measured by metrics such as IRR, equity multiple, and cash-on-cash return.
Mezzanine financing is often considered a hybrid of debt and equity because in many cases, a mezzanine lender can often benefit from the potential upside profit in the investment’s equity. This is referred to as an equity kicker.
The main two benefits of mezzanine loans compared to equity investments is that the lender (or debt investor) gets a guaranteed return. Unlike an equity investor, they also have rights to the property as collateral for reimbursement (even though their lien is the second position).
Preferred equity is another type of investment that will often be included in some subordination clauses. Preferred equity is similar to mezzanine lending because the investor is guaranteed a specific rate of return in the form of interest payments, and, should the borrower default on their loan, they will be paid back before the other equity investors, after the first (and potentially the second) lender.
Unlike mezzanine debt, however, preferred equity is stock, not a loan, so preferred equity investors do not have the right to directly repossess the property as collateral. However, they may have the right to take away control of the legal entity that owns the property from other equity investors (GPs and LPs) during certain types of defaults.
Subordination Clause Examples
For example, let’s say that a borrower defaults on their 5-year loan for a commercial property that was worth $2 million at the time of the loan issuance and is now worth $2.1 million, with the remaining loan term left at 4 years. The loan was originally set at 70% LTV, (for a total loan amount of $1,400,000) but they have paid it down to 65% LTV (based on the current property value) prior to their default and the foreclosure on the property.
Therefore, before any unpaid future interest, the lender still is still owed $1,365,000. However, directly prior to foreclosure, the lender took out an additional $200,000 mezzanine loan, bridging the loan up to almost 75% LTV and boosting the combined loan amount to $1,565,000.
Directly after foreclosure, the property is sold at market price, and, after closing costs and agent fees, the amount of money remaining is $1,964,000. Let’s say that the lender would have made $218,000 in interest if the loan had been carried through its full term and that the intercreditor agreement posits that the first-position lender can claim all unpaid interest before the second-position lender receives their distribution.
Therefore, the lender is owed $1,583,400. The amount of funds left over after the lender is fully reimbursed is now $380,600. The remaining unpaid interest on the mezzanine loan is $64,000, so the mezzanine lender is reimbursed $264,000. At this point, there are now $116,600 in funds remaining, which will go to the investors, first the preferred equity investors (if there are any), then the LPs (limited partners), and finally the GPs, which will likely not receive any funds in this scenario.
The Importance of Subordination Clauses in Intercreditor Agreements
As previously mentioned, the subordination clause in a commercial real estate deal will nearly always be detailed within the intercreditor agreement between the first and second-position lender. The intercreditor agreement posits exactly how and how much, and under what circumstances each lender will be repaid.
For instance, in the example above, the initial lender could have instead accepted a prepayment penalty for defaulting on the loan instead of being reimbursed for all outstanding interest. In addition, whether a loan is recourse or non-recourse heavily impacts the nature of both subordination clauses and intercreditor agreements.
If a loan is recourse, this means that the lender or lenders can go after the borrower’s personal property, including homes, cars, bank accounts, and wages, to make themselves whole. In some cases, the first loan will be non-recourse, and the second loan will be full recourse. This would mean that the second position lender could attempt to go after the borrower’s personal assets if they were not fully compensated by property sale proceeds.
Alternatively, both lenders could have full recourse provisions, which would typically give the first position lender the first right of repossession or garnishment, after which the second position lender could attempt to do the same.
It should be noted that even non-recourse loans have “bad boy” carve-outs, which stipulate the situations in which a non-recourse loan becomes full recourse. This typically happens when gross misconduct occurs, such as embezzlement, lying on P&L statements, or intentionally declaring bankruptcy. However, recourse provisions may be triggered by relatively minor missteps, such as turning in late P&L statements to a lender.
A subordination clause may sometimes clarify or amend the non-recourse loan provisions, including carve-outs, so this is another aspect to examine when examining intercreditor agreements, loan agreements, and other related contracts.
Subordination Clauses in Trust Deeds
A subordination clause may also appear directly in a trust deed. A trust deed is a legal document many lenders use to set up property recourse in the case of borrower default. The borrower is the trustor, while the lender is the beneficiary, with third-party acting as a trustee. The trustee, which is often an escrow company or law firm, is responsible for selling the property and providing the lender with the proceeds.
Subordination Clauses in Commercial Leases
Subordination clauses may not simply involve the relationship between lenders and the borrower; they may also involve stipulations regarding the tenants. Commercial lease agreements often contain a subordination clause that subordinates the tenant’s interest in the property to the lender. This means that if an investor defaults on their loan, the tenant could potentially suffer from early lease termination and possible eviction.
However, in many cases, a tenant may be able to convince the lender(s) to sign a non-disturbance agreement, preventing them from losing their space should the owner default on their mortgage. This can be especially important for larger businesses, such as major anchor tenants, where moving locations early can cost hundreds of thousands or millions of dollars.