COVID-19 is rapidly turning our real estate world on its ear. We have had several clients who have had buyers who lost their loans at the last minute and are inquiring about closing using wrap-around financing.
Virtually all residential and commercial mortgages contain “due on sale” provisions which allow a lender to call its loan due if the property securing its loan is transferred to a party other than the original borrower without lender consent. A sale structured as a wrap-around violates due on sale provisions just like any other sale made without lender consent.
However, given the changes wrought by COVID-19, buyers and sellers may have no other alternative, and are considering a wrap-around sale which violates a due on sale provision. This article will discuss the issues involved in structuring a wrap-around sale.
If the transaction involves a residence occupied by the buyer as a principal residence, the only individual non-commercial financing for the transaction which does not violate the restrictions imposed by the Dodd-Frank Act is seller financing. No unlicensed third-party lender can make a loan secured by a residential property which is the residence of the borrower.
Definition of Wrap-Around. Most of you are familiar with the term “wrap-around sale” but may not know much more about them.
A wrap-around transaction is just a special kind of secondary financing. Secondary because it is behind one or more primary loans. The term “wrap-around” is used because the existing loan is left in place and the wrap-around financing “wraps around” the existing loan.
There is no reason a third-party lender cannot do wrap-around financing, but for the most part they do not. Typically, a wrap-around deal involves the seller providing financing for the transaction.
Perhaps an example will add clarification. Assume a property owner will sell for $350,000 and owes ABC Bank $250,000 on the purchase loan. The buyer will pay $30,000 down. The seller will finance the remainder of the sales price by accepting a $320,000.00 wrap-around note secured by a mortgage against the property. The existing first lien of $250,000 will remain and will be serviced by the seller from payments received from the buyer under the $320,000 wrap-around note.
The buyer in a wrap-around transaction does not assume responsibility for payment of the underlying prior liens. The seller financing “wraps-around” the prior liens.
Preparing the Purchase and Sale Contract. There are no promulgated contract forms which address issues created by a wrap-around sale. If you try to prepare a contract, you will almost assuredly be practicing law and subjecting yourself and your company to liability. However, even though you should not actually attempt to prepare these contracts, be familiar with some of the primary issues.
Basic Contract Documents. For a residential transaction, I would use the TREC One to Four Residential Contract (Resale), or the condo contract if the property is a condo, with a Seller Financing Addendum for the basic seller financing terms such as amount financed, interest rate, payment terms, etc. For small commercial sales, I would use a TAR form. These forms would be modified and supplemented with an addendum containing wrap-around provisions. You can find a Wrap-Around Sale Addendum prepared for our clients here.
Wrap-around Addendum. The wrap-around addendum contains terms addressing the wrap-around transaction. Each deal may have terms unique to the transaction. However, some universal issues need to be addressed including:
(1) Default in Payment of First Mortgage. Remember that the buyer is paying the wrap-around note to the seller and the seller is paying the underlying prior note or notes. If the buyer pays the seller and the seller does not pay the underlying lienholder, the contract should allow the buyer to pay directly to the first lien holder and receive credit under the wrap-around note to the seller. Otherwise, the buyer can be in the position of having to pay the wrap-around note but not be able to protect her interest in the property by ensuring that the prior note is paid.
(2) Tax and Insurance Deposits. Usually the seller will have an escrow account held by the first mortgage lender and will be paying a monthly escrow deposit. If the contract does not require similar payments by the buyer, the seller will have to make the deposits under the terms of the first mortgage and will not be receiving corresponding payments from the buyer. The seller should check the box on the TREC Seller Financing Addendum requiring the buyer to make tax and insurance deposits if the seller must make such deposits on the first mortgage
(3) Hazard Insurance Policy. Insurance for these transactions can be very tricky. If disclosure of the sale is not given to the existing insurance company, insurance coverage may be voided. Most insurance companies will not allow a new owner to assume the existing policy. The first mortgage lender is also an insured party which further complicates the issue. Insurance issues must be negotiated and documented in the sales contract.
(4) Providing Payment Assurances to The Buyer. The buyer will not be paying the first mortgage lender. The seller will be making payments on any prior loans. If there is a default in paying the prior lien holder, the buyer will receive no notice of default from the prior mortgage lender. The notices will go to the seller. The contract should address this issue and attempt to protect the interests of the buyer by setting up a payment procedure which will give the buyer notice if payments are not made on the prior mortgage. There are several ways to address this issue, but space limitations do not permit a discussion in this article.
(5) Disclosure of Risks. The contract should clearly disclose the existence of all prior liens. It should also require that both buyer and seller should receive legal counseling on the risks involved and the contract should briefly set out those risks and require the parties to release the brokers and agents from any liability which may result from the inherent risks.
Hopefully this information will enable you to better represent your clients when attempting to negotiate a wrap-around transaction.