Subordination Clause Real Estate: What it is, How it Works

By: ROS Team

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Ever heard of a subordination clause real estate and wondered if it secretly controls your destiny (or at least your property)? Don’t worry, it’s not that dramatic, but it can play a crucial role in real estate dealings. Dive in to learn what a subordination clause is, how it works, and why it might matter to you as a homeowner, buyer, or seller.

What Is a Subordination Clause in Real Estate Contract?

In real estate, a subordination clause is a contractual agreement that ranks certain debts ahead of others in case of default. Imagine it as a queue, where the first debt in line (often the primary mortgage) gets paid before any debts that come later (like a second mortgage). This protects the lender with the subordination clause by ensuring they get their money back first if the property is sold.

How Does a Subordination Clause Real Estate Work?

A subordination clause in real estate acts like a pecking order for claims against a property in the event of default. Here’s how it works:

  • Multiple Liens: When a property has more than one loan attached to it, each loan creates a lien, which is a legal claim on the property’s value.
  • Priority Established: The subordination clause specifies the order in which these liens are paid off. The first lender in line (with the subordination clause in their favor) gets paid first from the proceeds of the property sale.
  • Remaining Funds: After the first lien is paid, any remaining funds go towards the second lien, and so on, until all liens are satisfied or the funds run out.

What Is an Example of a Subordinate Clause?

Here are two scenarios showcasing how subordination clause real estate works:

Scenario 1: Homeowner with Primary and Home Equity Loan:

  • Primary Mortgage: You obtain a primary mortgage from Bank A for $200,000 to purchase a house.
  • Home Equity Loan: Later, you take out a home equity loan from Bank B for $50,000 for renovations.
  • Subordination Clause: The home equity loan agreement from Bank B likely includes a subordination clause stating that their loan is subordinate to the primary mortgage from Bank A.

Default and Sale:

  • If you default on both loans and the house is sold for $225,000:
  • Bank A Gets Paid First: They receive their $200,000 primary mortgage balance because of the subordination clause in the home equity loan agreement.
  • Remaining Funds: The remaining $25,000 goes to Bank B to partially satisfy their $50,000 home equity loan.

 

Scenario 2: Co-signing a Mortgage:

  • Primary Borrower: Your friend needs help qualifying for a mortgage and you co-sign the loan agreement.
  • Co-signer Agreement: You sign a subordination clause agreeing that your assets are subordinate to the primary borrower’s assets in case of default.

Default and Repayment:

  • If your friend defaults, the lender goes after their assets first.
  • Only if their Assets are Insufficient: The lender can then come after your personal assets as a co-signer due to the subordination clause you signed.

Subordination Clause in Commercial Real Estate Lease Agreement

A subordinate clause­ in a commercial real estate rental contract de­termines the ranking be­tween the re­nter’s leasehold right and any funding the­ property owner acquires, such as mortgage­s. The contract specifies whe­ther the renter’s right to occupy the space is secondary or supe­rior in the event of de­fault on loans secured by the prope­rty.

By agreeing to a subordinate position, the renter recognizes that the lender’s claim on the property (through the mortgage) takes precedence over their rental rights in case of non-payment. This implies if the owner fails to repay the mortgage and the property is reclaimed, the new proprietor has no duty to respect the present rental agreement.

Howeve­r, the renter may have­ some security relying upon the­ particular phrasing of the condition and whether the­y negotiated a non-disturbance agreement with the lender. This agreement fundame­ntally expresses that the­ lender will regard the curre­nt rental understanding notwithstanding if they assume­ responsibility for ownership of the prope­rty.

Subordination Clauses in Trust Deeds

Trust deeds can also include subordination clauses, just like mortgages, where certain debts are ranked with other debts secured by the property. The most common situation in the trust deed context is the subordination of a second mortgage or home equity loan to the primary lender. This ensures that the primary lender must be paid before the property is sold in the event of default.

How Does a Subordination Clause Affect a Homeowner?

A subordination clause can impact homeowners in several ways:

  • Limits Refinancing Options: If a homeowner wants to refinance their primary mortgage with a better interest rate, they might need the existing lender to agree to a new subordination clause for any secondary loans.
  • Increases Risk of Losing their Home: In case of default, the subordination clause prioritizes the repayment of the senior loan (often the primary mortgage) before any subordinate loans (like a home equity loan). This can leave less equity available to the homeowner if the property is sold, potentially increasing the risk of foreclosure.
  • Affects Credit Score: Defaulting on any loan, even a subordinate one, can negatively impact the homeowner’s credit score.

How Subordination Clauses Affect Borrowers?

Subordination clauses primarily affect borrowers by limiting their financial flexibility and increasing their risk of losing their property in case of default. They might face difficulties refinancing due to needing lender approval and potentially experience higher interest rates on subordinate loans.

Additionally, during default, the prioritized repayment of senior loans leaves less equity for borrowers, potentially leading to foreclosure. It’s crucial for borrowers to fully understand these implications before signing loan agreements.

Who Benefits From A Subordination Clause in Real Estate?

The primary beneficiary of a subordination clause in real estate is the lender with the clause in their favor. It prioritizes their claim on the property, ensuring they get paid first in case of default and the property is sold. This protects their investment and minimizes the risk of losses.

Other Important Real Estate Clauses

  • Subrogation Clause

A subrogation clause in real estate typically stipulates that if the property owner’s insurer pays for a loss or damage caused by a third party, the insurer has the right to pursue legal action against that third party to recover the amount paid out, effectively stepping into the shoes of the insured to seek reimbursement.

  • Prepayment Clause

This clause outlines the terms under which a borrower can pay off their loan early. It might specify a penalty fee charged for prepayment within a certain period. This protects the lender from losing potential interest income they anticipated over the loan term.

  • Release Clause

This clause outlines the conditions under which a lender releases the lien on the property. This typically occurs when the loan is paid in full. The release clause ensures the property title is clear and unencumbered by the loan.

  • Acceleration Clause

This clause allows the lender to demand immediate payment of the entire loan balance if the borrower defaults. This can occur when the borrower misses a certain number of payments, violates loan terms, or fails to maintain required property insurance.

  • Alienation Clause

This clause, also known as a due-on-sale clause, restricts the borrower’s ability to transfer ownership of the property without the lender’s consent. The lender can then decide whether to allow the sale or demand immediate repayment of the loan balance.

Read Also: What is the Alienation Clause in Real Estate

  • Defeasance Clause

This clause specifies the conditions under which the ownership of the property can revert back to the original owner. This can occur if certain conditions are not met, such as failing to pay property taxes or violating zoning regulations.

What Is a Subordination Clause in Real Estate – Summing Up

A subordination clause may sound complex, but it simply dictates the order in which debts on a property are repaid during a default. This blog post unpacked the key points:

What It Is: A contractual agreement ranking debts, placing the one with the clause first in line for repayment.

How It Works: Imagine a queue – the first in line (often the primary mortgage) gets paid before others.

Examples: Scenarios like home equity loans and co-signing a mortgage were explored.

Impact on Homeowners and Borrowers: We discussed potential limitations on refinancing, increased foreclosure risk, and the importance of understanding the implications.

Who Benefits: The lender with the clause benefits from prioritized repayment, minimizing their risk.

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