December 06, 2005

Intercreditor Agreements, Mezzanine Loans, and Commercial Financing

Without an Intercreditor Agreement the Senior Lender Can Foreclose on the Mezzanine Lender

First mortgage lenders on commercial properties usually do not want their borrowers to put additional financing on the property. The reason why is because the additional loans have interest payments. The borrower may use the limited amount of positive cash flow from the property to make the payments to the second mortgage holder or the mezzanine lender rather than keep the property in good repair.

If a first mortgage lender failed to put a due-on-encumbrance clause in its mortgage, the first mortgage lender might foreclose on a heavily encumbered property, only to find that the property was a run-down rat hole. A due-on-encumbrance clause allows a first mortgage lender to demand that its entire loan balance be immediately paid in full if the borrower put an unauthorized second mortgage or mezzanine loan on the property. Such a demand is called an acceleration of the note. The painful issue for the borrower is that this required prepayment would invoke the prepayment penalty clause, and ten-point prepayment penalties on $15 million mortgages are common. Ouch!

Mezzanine loans are a form of junior loan, and they are prohibited according to the language of most modern commercial first mortgages. Mezzanine loans are only allowed if the first mortgage lender permits them. The agreement reached between the commercial first mortgage lender and the mezzanine lender that permits a mezzanine loan is called an intercreditor agreement.

The terms of an intercreditor agreement have to be negotiated to allow the mezzanine lender to execute a UCC foreclosure on the stock of the company that owns the real estate. The first mortgage lender has to agree to stand still while the mezzanine lender completes its UCC foreclosure and takes control of the property. This part of the intercreditor agreement is called the standstill agreement. In the standstill agreement the first mortgage lender agrees not to exercise its due-on-alienation (sale, change of ownership, etc.) clause.

The intercreditor agreement will also provide for notice to the mezzanine lender if the borrower defaults on the first mortgage in any way. The intercreditor agreement will also allow the mezzanine lender to cure any defaults on the first mortgage and to step into the shoes or to replace the borrower in the event of a default.

Many intercreditor agreements will allow the mezzanine lender to buy out the first mortgage note. The question then remains, at what price? Does the first mortgage lender get to charge its defeasance or yield-maintenance prepayment penalty? Some of these prepayment penalties can be immense. These are the types of matters that have to be negotiated.

For several years it was very time-consuming to negotiate an intercreditor agreement with the servicer of a CMBS loan. Negotiations could often take three months or longer. Can you imagine the frustration of the borrower?

Fortunately a standard intercreditor agreement has emerged known as a CMSA form intercreditor agreement. As a result, intercreditor agreements with CMBS loan servicers can now be negotiated in less than a month.

There is a good reason why CMBS lenders and life companies are now willing to allow mezzanine loans on their properties. Mezzanine loans usually come from financially strong investment funds or huge investment banks. They serve as a secondary source of repayment. If the borrower goes belly-up, the mezzanine lender will usually step up and bring the first mortgage current.

The reason why investors and mortgage bankers need to know about intercreditor agreements is because some commercial loan documents from CMBS lenders and life companies on loans made in the late 1990's specifically prohibit mezzanine loans. The borrower will be unable to put additional debt on the property because the mezzanine lender will be unable to get an intercreditor agreement. In cases like this, it may be possible to obtain a preferred equity investment.

Investors, developers, and mortgage bankers can find scores of mezzanine lenders using C-Loans.com.