Donald J. Weidner1

Real Estate Finance Spring 2015Dean Don Weidner

• Eight sets of slides for the Spring 2015.– Are available on my web page.– Are also posted on the web blackboard for this course

under “Course Library”.• May be amended slightly.

• Course Syllabus.– Is posted on my web page and on the web

Blackboard for this course under “Syllabus”.

• Assignments.– We shall proceed directly though the Syllabus– The slides will also take us directly through the

Syllabus.

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Seller Broker Buyer

SellerBuyerLender

Listing

Agreement

Contract of Sale

“Interim Contract”

Closing

Background on Contracts and Conditions

Consummation (“Closing”) of the Contract of Sale is subject to certain conditions, which

must be satisfied within a particular period of time, usually involving:

a) title; b) physical condition; and c) financing.

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Contract Conditions

• Text says conditions “are essentially substitutes for information.” – About legal title, physical condition, availability of

financing

• Conditions may also be inserted by the buyer to postpone making a commitment.

• Conditions range from the extremely general to the extremely specific.

• Conditions may leave so much open that a contract arguably fails to satisfy the requirement of a writing under the Statute of Frauds.

• Even if the Statute of Frauds is satisfied, the contract may be too indefinite to support an award of specific performance.

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Illusory Contracts• “Since conditions will characteristically

be phrased in general terms, and their fulfillment left to the exclusive control of one of the parties, there is the added question of illusoriness or mutuality of obligation.”

• “Generally, the problem is small, for the concept of good faith goes far toward preventing reneging parties from using a financing, title or other condition as an excuse for nonperformance.”

Illusory Contracts (cont’d)• On the “excuse” issue, the text says:

“In such cases the court will examine the motive of the party relying on the condition.”

• If a written contract gives me a right, must I show that I am pure of heart before I may enforce it?–Not everyone thinks so. Courts split on their role in applying the “good faith” requirement

• As we shall see in more detail»Gap filler versus mandatory rule

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Homler v. Malas(Text p. 92)

• Seller sought to specifically enforce a buyer’s promise to purchase a single-family residence.

• Contract, on a standard form, had a “subject to financing” clause that conditioned Buyer’s performance.– on Buyer’s “obtaining a loan” (“ability to obtain” had

been deleted).– For 80% of the purchase price.– Repayable monthly over a term of no less than 30

years.– However, there was no mention of:

• Interest rate (left blank).• The amount of monthly payment (left blank).• Amortization terms.

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Homler v. Malas (cont’d)

• Buyer said the contract “is too vague and indefinite” to be specifically enforced because the “terms of the financing contingency are not sufficiently identified.”– Other Georgia courts had said that a failure to

specify a buyer’s interest rate “causes a failure of a condition precedent to the enforceability of the contract.”

• Seller said that there is no need to specify the interest rate in a contract that anticipates third-party financing.– Can you see what the argument might be?

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Homler v. Malas (cont’d)

• Court said: it is not as if the contract had specified interest at the “current prevailing rate.”

• The contract assumed a search for third-party financing.

• Why not use the concept of good faith as a gap filler?

• That is, the concept of good faith would fill the interest rate gap by implying into the contract that interest would be “at the current prevailing rate”

• Stated differently, the default rule (the rule that would apply unless the parties specified a different rule) would be that the unspecified interest rate is the “current prevailing rate”

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Homler v. Malas (cont’d)• How would you decide this case?• Court concluded the contract was too “vague and

indefinite” to be enforced against the buyer and ordered the buyer’s deposit to be refunded.

• Why did the court refuse to use the concept of good faith to fill the interest rate gap?– Everyone agrees the buyer is under a duty to proceed in

good faith. The split is on what that means.

• Does the strikeout suggest a different argument?• “Mutuality of obligation” is a separate issue from

“vague and indefinite” [and apparently, in the eyes of the court, an issue that was not raised]– Could Buyer have enforced the contract against Seller?

• If not, did the contract merely give Option to Buyer?

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Definitions of Good Faith• Every contracting party is under a duty or

obligation of “good faith”– The question is what that duty requires

• UCC general definition: “honesty in fact in the conduct or transaction concerned.”– Honesty to Webster: “uprightness; integrity,

trustworthiness” also “freedom from deceit or fraud.”

• UCC definition for a merchant: “honesty in fact and the observance of reasonable commercial standards of fair dealing in the trade.”

• Many statutes use the term “good faith” without defining it.

• Some scholars say good faith is an “excluder category”--one defined by what is deemed to be outside it rather than by what is in it.

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Liuzza v. Panzer(Text p. 94)

• Contract to sell and to buy for $37,500.• Buyer’s obligation was conditioned “upon the

ability of the [Buyer] to borrow $30,000.00 on the property at an interest rate not to exceed 9%.”

• Buyer applied to an S & L for a $30,000 loan and was rejected because the appraisal was too low.

• S & L appraisal was $32,150.• S & L would only lend 80% of the appraised value

(which was less than the $30,000 loan amount mentioned in the contract as a condition).

• Can the Buyer walk away from the deal at this point?– Before refusing to close, what more, if anything,

must Buyer do to avoid breaching the Buyer’s implied obligation to act in good faith?

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Kovarik v. Vesely (Text p. 95)

• Contract provided for Buyers’ obligation to buy for $11,000. Buyers were to pay– $4,000 down, with the – balance to be financed through a “$7,000

purchase-money mortgage from the Fort Atkinson S & L.”

• Fort Atkinson S & L rejected the Buyers.• Seller offered to provide $7,000 financing on the

same terms that Buyers requested from Fort Atkinson.

• Buyers refused the offer of Seller financing• Seller sued to specifically enforce the contract.

– Did the court correctly conclude that good faith required the Buyer to accept the Seller’s offer of seller financing?

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Kovarik v. Vesely (cont’d)

• The majority apparently held that the obligation of good faith prevents the buyer from relying on the letter of the contract, which seems to say that the buyer’s obligation is contingent on the buyer’s ability to obtain a loan from the specified lender

• However, a buyer could reasonably want:– A third-party lender to provide a “reality check”

on value; and – A standard institutional approach in the

administration of the loan • especially in the event of default.

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Kovarik v. Vesely (cont’d)

• Court also rejected the Buyer’s argument that the incomplete financing clause failed to satisfy the Statute of Frauds requirement of a writing.

• The financing clause referred to “$7,000 purchase-money mortgage from the Fort Atkinson S & L.”.– How is this clause incomplete?

• The court’s reasoning: “the loan application . . . is a separate writing which is to be construed together with the original contract of the parties, and together they constitute a sufficient memorandum to satisfy [the Statute of Frauds].”– Is there one transaction or two?

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Kovarik v. Vesely (cont’d)• An alternative approach: A reasonable

interpretation of the contract would look at the standard practice among savings and loan associations with respect to this particular type of loan to complete the contract.– That is, business practice and the rule of

reasonableness would fill in the gaps

• However, that does not mean that the buyer should be forced to accept purchase money financing from the seller.

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Variables that Determine Debt Service

“Debt Service” is the amount of payment required per unit of time (usually monthly or annually) to service a debt. The 4 variables that determine debt service are:

1) Amount of loan• Usually determined by

• Applying a loan/value ratio to • An appraisal of value

2) Length of loan3) Rate of interest4) Amortization terms—the terms under which

principal is repaid

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Loan to Value Ratio

• May be in statute, regulation or internal policies.• Some legislative terms used to mandate

maximum loan to value ratios:– appraised value– estimated value– reasonable normal value– estimated replacement cost– actual cost

• Subject to a range of interpretations

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Loan to Value Ratio (cont’d)

• Many lenders believe that the loan/value ratio gets in their way and fails to serve as a meaningful protection to their shareholders.– They believe that there is greater protection in

exacting credit standards, increased site scarcity, inflation or other factors

– Or, they are simply very eager to do a deal.– They might also be planning to sell the loan

and thus avoid any risk attendant to it—they have no “skin in the game”

– Therefore, they often avoid the ratio.

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Length (“Term”) of Loan

• The longer the length, or term, of the loan, the lower the Debt Service

• Consider, for example, an $18,000 home improvement loan. If the interest rate is 6%, the monthly Debt Service is– $199.98 over 10 years– $116.10 over 25 years– $ 99.18 over 40 years

• The cost for the benefit of lower debt service: the longer the term, the more interest is paid.

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Rate of Interest

• The greater the rate of interest, the greater the Debt Service.

• Example, a 25-year $100,000 home improvement loan. Monthly Debt Service at– 4% is $ 528 (2012)– 6% is $ 644– 8% is $ 770– 10% is $ 908– 17% is $ 1,436 (1980)

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Points• “Point” is one percent of the face amount of a

contract debt.• Points can be characterized differently, ex., as

interest, as compensation for services, etc.• Basic way points can work:

– Buyer executes note to Seller for $40,000 (interest, length, amortization terms also specified).

– Lender purchases note from Seller charging 6 points [$40,000 X 6% = $2,400]).

– That is, Lender pays only $37,600 for the $40,000 note [$40,000 minus the $2,400].

– Buyer still pays “interest” on full $40,000 face amount of the note.

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. . .

PASSAGE OF TIME

SELF AMORTIZING LOANS

First type: Constant Payment

DEBT SERVICE COMPONENTS

Principal Interest

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. . .

PASSAGE OF TIME

SELF AMORTIZINGSecond Type: Constant Amortization

DEBT SERVICE COMPONENTS

Principal Interest

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. . .

PASSAGE OF TIME

NON SELF AMORTIZING

DEBT SERVICE COMPONENTS

BALLOON

Principal Interest

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Goebel v. First Federal(Text p. 368)

The note to the S & L provided:1. Interest shall be paid monthly.2. Initial interest rate was 6% per annum.3. The initial interest rate may be changed

from time to time at the S & L’s option.4. There will be no interest rate change during

first 3 years.5. Borrower will get 4 months written notice

before any interest rate change.6. Borrower has 4 months from receipt of

notice of a change to prepay without penalty.

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Goebel (cont’d)• Nine years later, Lender declared that the

interest rate was being increased and that Borrower had the option to– Pay increased monthly Debt Service, or– Increase the length of the loan.– [No mention was made of amortization

terms/balloons].

• Court’s said it would construe the ambiguous language in the note against the drafter, especially– when the drafter has much greater bargaining

power, and– when the drafter supplied its “standard form.”

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Goebel (cont’d)

• As to increasing monthly Debt Service, court said expressio unius controlled: The note contained provisions to increase Debt Service in some situations but did not mention increasing debt service to reflect an increase in interest rate.

1. Note stated that monthly Debt Service could be increased to accommodate future advances; and

2. Note stated that Lender had a right to payment for taxes, insurance and repairs “on demand”

1. Lower court said this included the right to increase monthly Debt Service.

3. Yet the note “fails to make similar provisions” for an increase in interest rate

1. Therefore, the promisor could not be required to pay more monthly debt service to satisfy an increase in interest rate.

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Goebel (cont’d)

• As to increasing the term (the length of the loan), the court focused on the language that all Principal and Interest “shall be paid in full within 25 years.”

1. Lender argued this clause was intended for its benefit and that it, therefore, could set it aside.

2. The court appears to have begged the conclusion when it said that this clause was for the Borrower’s benefit.

– And, therefore, Borrower could not be forced to pay debt service for a longer term

Goebel (cont’d)

• How else could you implement the interest increase provisions (if you can’t increase either the amount of the monthly payments or the term of those payments)?

• The court said it was not nullifying the provisions increasing the interest rate because an interest increase would still be collectible:1. To offset any prior interest rate declines 2. In the event of a prepayment of the mortgage

• “Due on sale” clause was enforceable– How does this fit with what the court

said about a balloon (“this method was not used”)?

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Note to Goebel v. First Federal• No argument was made that an interest increase was

either unconscionable or illegal.• See also Constitution Bank (Text p. 378): “If the lender

may arbitrarily adjust the interest rate without any standard whatever, with regard to this borrower alone, then the note is too indefinite as to interest. If however the power to vary the interest rate is limited by the marketplace and requires periodic determination, in good faith and in the ordinary course of business, of the price to be charged to all of the bank’s customers similarly situated, then the note is not too indefinite.”

• Recall, “good faith” can be a “gap filler” to salvage an otherwise indefinite contract, particularly by importing the limitations of the marketplace

• Recall, too, that the borrower had the option to prepay without penalty upon an interest rate increase.– Indicating that market forces might limit the lender from

exacting an increase.

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Pre-Depression Residential Financing • Amount. At least theoretically, very low loan/value

ratios, typically 50-60% of appraised value. – Lenders stretched their appraisals. – Borrowers took out second, third, mortgage loans.

• Length. Seldom for more than 10 to 15 years. In 1925, the average length for mortgages issued– by life insurance companies was 6 years; – by S &Ls was 11 years.

• Rate of Interest: Junior mortgages were at higher rates of interest.

• Amortization Terms: Balloons were common.In the Great Depression: 1 million American families lost

their homes to foreclosure between 1930-1935 (many fewer than in years following 2006).

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Post-”Great” Depression Mortgage Insurance• Amount. Government undertook to insure loans with

much higher Loan/Value Ratios (consumers were unable to pay big down payments coming out of the depression)

• Length. To decrease the debt service on the larger loan amounts, the government insured longer loans. Terms increased up to 40 yrs. for certain projects.

• Rate of Interest. The government would not insure loans above a certain interest rate. “Points” became important.

• Amortization Terms. Government would only insure consumer loans that were fully self-amortizing. Fundamental Lesson of Great Depression seemed to be: never require a consumer to pay Debt Service that escalates over time.

--We subsequently forgot or rejected that lesson.

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The American Dream of Home Ownership

Americans Living in their Own Homes

• 1940 41%• 1950 53%• 1981 65%• 2006 69%*

*By 2008, many suggest that federal housing officials trying to raise the homeownership rate as high as possible helped cause the “subprime”

crisis by encouraging loans to high-risk borrowersMany also fault Chariman Alan Greenspan’s Federal Reserve Board for

keeping interest rates too low for too long. Ben Bernanke does not.

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1) Adjustable Rate Mortgage (ARM) (a.k.a. “Variable Rate Mortgage” or VRM)

2) Graduated Payment Mortgage (GPM)– And its variant the Growing Equity Mortgage

(GEM)

3) Renegotiable Rate Mortgage (RRM)

4) Shared Appreciation Mortgage (SAM)

5) Price Level Adjusted Mortgage (PLAM)

6) Reverse Annuity Mortgage (RAM)

“NEW” TYPES OF CONSUMER MORTGAGES(Text p. 374)

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1) ADJUSTABLE RATE MORTGAGE• Interest rate rises and falls according to

some predetermined standard.– Often used in commercial transactions.

• A borrower must pay for an interest rate increase in one of the following three ways:--1. Debt service payments will increase; or--2. The length of the loan will increase; or--3. The amortization terms will change (a balloon will be created or increased)

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Adjustable Rate Mortgages (cont’d)

Protections provided for consumers:Limit the frequency of interest rate increasesLimit the magnitude of each interest rate

increaseLimit the total amount of interest rate increasesRequire downward adjustments if the standard

declines.Offer borrowers the right to prepay without

penalty upon an interest rate increase

Note: a borrower may not be able to refinance, even if rates have dropped (ex., creditworthiness, value decline)

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Adjustable Rate Mortgages (cont’d)

• Consumer protections (cont’d)“Balloon” disclosure rules may define a

balloon more narrowly than simply as a note that requires any payment at the end of the debt service schedule larger than those that came before

– Ex., as any payment more than twice the size of a preceding payment (as in Florida).

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2) GRADUATED PAYMENT MORTGAGE

• Monthly payments gradually rise, while the interest rate and the term of the loan may stay the same.

• Initial concept (back in the Nixon administration): Help the young family that reasonably expects its income to grow substantially over the years following the loan closing. – Initial, low payments are not sufficient to amortize

the debt or even to pay all the interest, but later payments make up for it.

GRADUATED PAYMENT MORTGAGE (cont’d)

• The Growing Equity Mortgage is another form of increasing payment mortgage.

• Text discusses it as a “long term, self-amortizing mortgage under which the borrower’s monthly payments increase each year by a predetermined amount, typically 4%.”– Apparently, it never goes negative as to interest

or principal.– That is, equity “grows” throughout the life of the

loan• Note: borrow can tailor his or her own growing

equity provisions with prepayment privileges.

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3) RENEGOTIABLE RATE MORTGAGE (a.k.a. “Rollover Mortgage”)

• Series of renewable short-term notes, secured by a long-term mortgage with principal fully amortized over the longer term.– Patterned after pre-depression instruments, says the

text.

• As initially approved for consumer transactions, the interest rate could be adjusted up or down every 3 to 5 years and could rise or fall as much as 5 percentage points over the entire 30-year life of the mortgage.

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4) SHARED APPRECIATION MORTGAGE

• Lender agrees to lend, for example, at a flat rate below the current market rate in return for borrower’s agreement that: If the home is sold before the end of x years, the lender will

receive a percentage of the increase in value; If the home is not sold within x years, an appraisal will

establish the value at that time and the borrower will pay a lump sum “contingent interest” equal to the lender’s share of the appreciation.

BUT::::if the borrower requests, the lender must refinance an amount equal to the unpaid loan balance plus the contingent interest.

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5) PRICE LEVEL ADJUSTED MORTGAGE

• It is the loan principal, NOT the interest rate, that varies over the term of the mortgage.

• The principal is adjusted up or down according to a prescribed inflation index.

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6) Reverse Annuity Mortgage

• Designed to enable seniors to draw cash out of the equity in their homes.

• The typical Reverse Annuity Mortgagee makes monthly payments to the borrower over the borrower’s lifetime or over a predetermined period.

• With each monthly payment to the borrower, the debt increases.

• Typically, the debt is to be repaid at the earlier of death of the borrower, or x years from the loan origination, money to come from sale of the property or the borrower’s estate.

New Mortgages (cont’d)• The Garn-St. Germain Depository Act of 1982

“preempts state regulations of nontraditional mortgages that are more stringent than counterpart federal regulations.” Text p. 377.– The Act also gave the states limited time to

reinstate their programs and very few did.• Similarly, Congress, preempted “any state

statute or constitutional provision that limited interest rates on first lien, residential mortgage loans.” Id.– Other real estate loans are not covered.

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Post Mortgage Meltdown (Text p. 382)

• In 2008, the Federal Reserve Board adopted a rule under the Truth in Lending Act that prohibits creditors from making “higher-price mortgage loans” without assessing consumers’ ability to repay.– Compliance is presumed if certain

underwriting practices followed.

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Dodd Frank

• In 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act required that, “for residential mortgages, creditors must make a reasonable and good faith determination . . . that the consumer has a reasonability ability to repay the loan according to its terms.”– With a presumption of compliance for

“qualified mortgages.”– Creditors encouraged to refinance “non-

standard mortgages.”

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Dodd-Frank (cont’d)

• Dodd-Frank puts the new Consumer Financial Protection Bureau in charge of consumer fraud and protection issues. The new Bureau is took over management of the Federal Reserve Board rules requiring assessment of ability to pay. proposed.

• “In the commercial arena, originators of mortgage backed securities will be required to retain five percent of the credit risk on mortgages placed into pools, reducing incentives to sell weak mortgages to investors.” Text at 389.

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Appraisals: Three Basic Indications of (or ways of approaching) Value (Text p. 387)

1. Sales Comparison Approach (recent sales of comparable properties)

• Also known as “Market Data” Approach• The approach is less valid if there is an

inactive market or if the property is unique

2. Replacement Cost• Cost of replacing a building (and the land

under it) minus depreciation charges on the building

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Appraisals: Three Basic Indications of Value (cont’d)

3. Capitalized Value of Income (many methods):

--Gross Rent Multiplier—very rough (and less valid if there are few or no sales of comparables)--Apply a Capitalization Rate to current net operating income—only slightly more refined--Estimate a stream of future cash flows and reduce it to its present value—more refined

Reconciliation relates these three factors (recent sales, replacement cost and capitalized value of income)-- it does not simply average them. A reconciliation may select one factor as the most important.

Three Ways of Looking at the Cash a Property Generates

1. Extraordinarily rudimentary: estimate a value that is a multiple of gross rent receipts.

2. Somewhat more refined: estimate a value of the property by applying a capitalization rate to its current net operating income.

3. More refined: estimate net operating income for each year well into the future and reduce each of those receipts to its present value.

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Sales Price of Comparable Properties

Gross Rental Revenues of Comparable Properties

= Multiplier

GROSS MULTIPLIER Derive value from gross rentals

Assume a Recent Sale of Comparable

Property:

12 Million Sales Price

2 Million Gross Rental Revenue

= 6 [Gross Multiplier]

Applying this rough method, a comparable property with only $600,000 of

Gross Rent receipts would therefore have a $3,600,000 value (six times gross rent receipts)

($600,000 X 6 = $3,600,000)

Capitalizing Value of Net Operating Income

Begin by considering the net cash flow on a property you currently own and have financed.

Net cash flow is simply the sum of all cash receipts from operations minus all cash spent (ignoring any capital improvements), including debt service.

As we shall discuss more fully, to derive taxable income or loss from net cash flow, simply subtract the depreciation deduction and add back in amount paid to amortize debt.

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NCF versus NOI

Net Cash Flow=Rent Receipts–Real Estate Taxes–Maintenance– Insurance–(Principal + Interest)

Now assume you are a buyer valuing a property and you don’t yet know how you will finance your acquisition. You might look at its net operating income.

Net Operating Income is NCF apart from the current owner’s debt service (principal and interest).

NOI = Rent Receipts – Real Estate Taxes – Maintenance – Insurance

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CAPITALIZATION RATE Capitalize the value of the current net operating income

Basic idea: x 8% = $1,000 per year

is how much an investor will pay for the right to receive $1,000 per year if the investor will insist on an 8% return on his or her investment.

In this example, is $12,500

A. If I expects an 8% cash return [stated in fractions]

The price

x 8/100 return = $150,000

Divide each side of the equation by 8/100

( x 8/100) x 100/8 = 150,000 x 100/8 = $1,875,000

B. If I expects a 12% cash return [stated in decimals]

.12 return = $150,000The price

x

Divide each side of the equation by .12

x .12/.12 = $150,000/.12 = $1,250,000

1)

2) 2)

1)

How Much Will An Investor Pay for a Building that has a $150,000 Net Cash Flow?

Capitalizing Value of NOI

• Another way of looking at Net Operating Income is as the amount of cash flow that is available to service your acquisition debt.

• How much would you pay for an annual NOI of a certain amount? The answer depends on the rate of return you expect on your investment in a particular asset. That expected rate of return is your capitalization rate, for example, 5%.

• To determine value, divide the net operating income by the Cap Rate, for example:– NOI of $300,000 = $6,000,000 Value– Cap Rate of .05

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Capitalizing Value of NOI

• Some individuals are uncomfortable dividing by decimals (by the .05 Cap Rate). The following statement avoids dividing by decimals. Again, NOI is $300,000 and the Cap Rate is .05—that is, you expect a 5% return on investment in this particular property.

NOI x. 100 = Value

Cap. Rate

300,000 X. 100 = $6,000,000

5

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Capitalized Value of NOI (cont’d)

• Suppose you expect a greater return on your investment, say, 8% rather than 5%. How much would you pay for that $300,000 operating income?

• $300,000 x. 100 = $3,750,000

8

The higher the rate of return you expect, the less you will pay for the income stream.

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Eyeballing Capitalized Value of NOI (cont’d)

• Very simply (and rounded slightly)

1% cap rate is 100 [100/1] x. NOI ($300,000) = $30,000,000

2% cap rate is 50 [100/2] x. NOI ($300,000) = $15,000,000

3% cap rate is 33.33 [100/3] x. NOI ($300,000) = $ 9,999,000

4% cap rate is 25 [100/4] x. NOI ($300,000) = $ 7,500,000

5% cap rate is 20 [100/5] x. NOI ($300,000) = $ 6,000,000

6% cap rate is 16.67[100/6] x. NOI ($300,000) = $ 5,001,000

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DISCOUNTED NOI (NCF Apart from Debt Service)

Values property by a) estimating future net operating income for each year and b) discounting those future flows of cash to their present value. Discounting is the obverse of compound interest.

How much would you pay to purchase a 10-year position as landlord the right to receive $1,000 yr. rent for 10 years? The answer depends upon the rate of return you insist on.

1 .833 x $1,000 = 8332 .694 x $1,000 = 6943 .5794 .4825 .4026 .3357 .2798 .2339 .19410 .162 x $1,000 = 162 $4,193

HYPO: What is the total present value of the right to receive $1,000 in cash at the end of each of the next ten years? If the investor insists on a 20% rate of return? Because the 10, $1,000 payments are spread over the next 10 years, their total present value is the sum of the present value of each of the future payments. That Is:

936 Second Ave. L.P. v. Second Corporate Dev. Co., Inc.

(Text p. 681)

• Long-term net lease of three adjoining buildings with mixed residential and retail spaces.

• Lessee had option to renew for two, 20-year terms.

• Renewal rent was 7% of the “value of the demised premises.”– “Demised” is here and generally synonymous

with “leased”• Value to include “the value of both the land and

the buildings.”

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936 Second Ave. (cont’d)

• More specifically, the lease defined “value of the demised premises” to mean– “the value of the demised premises together

with all buildings and improvements thereon including any and all additions and improvements erected by Tenant.”

• The lease is silent as to whether the lease itself should be taken into account in determining the “value of the demised premises.”

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936 Second Ave. (cont’d)

• Lessor appraiser said $ 7.1 million.

• Lessee appraiser said $ 3.4 million.

• Major difference: Lessee’s appraisal is lower because Lessee’s appraiser considered the effect of the net lease itself on the value of the premises. – Lessor’s appraiser did not. In effect, treated the real

property to be “free and clear” of the lease.

Note 3: “Lessor’s appraiser employed both the comparable sales and income capitalization approaches; lessee’s appraiser used only the income capitalization method.”

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936 Second Ave. (cont’d)

• N.Y.Ct.App. reverses two lower courts and holds that the lease itself must be considered in determining the “value” of the demised property.

• Cites Plaza Hotel: “the market value . . . is the amount which one desiring but not compelled to purchaser will pay under ordinary conditions to a seller who desires but is not compelled to sell.”– Standard definition of fair market value

• Then: “valuations of land must take into consideration all encumbrances thereon, including reasonable restrictions as to its use, unless there is a clear provision to the contrary.”

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936 Second Ave. (cont’d)

• “Special attention must be given to limitations on ownership rights, which include easements, encroachments, leases and the disposition of air or subsurface rights and an appraiser must ‘analyze all of the economic benefits or disadvantages created by the lease.’”

• Unless the lease provides otherwise, appraisers generally consider highest and best use, but they “necessarily must examine any restrictions . . . that may impact the highest and best use for which the property may be utilized.”

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Donald J. Weidner65

PLAZAOWNS THE BUILDING

BUILDING

LAND½

PLAZA½

HOTEL

CP

Operating

Agreement

SUBLEASE OF ½ FEE INTEREST

LEASE OF ½ FEE INTEREST

LEASE

Plaza Hotel Associates340 N.Y.S.2d 796 (N. Y. Sup. 1973)

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Plaza Hotel Facts

• Lease provided for rent to increase to 3% of the “value” of “all of the land,” exclusive of the building and improvements.

• It also provided that, if LL and T could not agree on value, appraisers would determine value.

• An appraisal valued the land alone at $28,000,000.

• Tenant sued to set appraisal aside on ground that it was too high because it was based on the assumption that the land was vacant and available for its highest and best use.

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Plaza Hotel Highlights• Court set aside the appraiser’s valuation, stating

that the appraiser “erroneously valued the land as available for its highest and best use, and not as already encumbered by the long term lease which restricts the use of the land to hotel purposes only.”– Wasn’t the appraiser’s approach based on standard

wisdom?• Consider: since the fee and the building on it

were separately owned, the fee could be sold separately. Hence, it is possible to ask: how much would someone pay for the fee.– How would you value the fee? Discount the cash flow?

• Having set aside the appraiser’s determination of value, the court undertook to determine value.

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Plaza Hotel Highlights

• The court distinguished price from value:– “Price is determined by short term factors

and by the caprices of the market.” – “Value . . . is dependent upon long term

factors and is directly related to the intrinsic worth of the property that resists the impact of temporary and abnormal conditions.”• “[V]alue, even more than price, is a

matter of judgment.”

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More from Plaza Hotel

• “The concept of a fluid market such as that existing in regard to corporate securities, where one sale can indicate the value at the time, is just not true with respect to real estate.”

• The lessee’s 3 appraisals of the land alone ranged from $8.5 million to $11.5 million.

• The lessor’s 3 appraisals of the land alone ranged from $33.3 million to $34.5 million.

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Plaza Hotel (cont’d)

• Plaza Hotel noted: – “In considering the opinions of the experts, the

court is not unmindful that ‘the appraisal of rental property necessarily involves the discretionary application of one or more accepted methods of computation’ and we must recognize that appraisers retained in litigated matters, within the limits of professional integrity, tend to adopt those formulae which favor their employer’s position.”

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A Different [Florida] View on “Free and Clear” Appraisal

• Compare Taylor v. Fusco Management, 593 So.2d 1045 (Fla. 1992): “[T]he market value of leased property at the time a lessee exercises an option to purchase the property should be computed as if the property were unencumbered by the lease. Any intent to value the property otherwise should be clearly stated in the lease.”

• The lease was a 99-year lease. The price of the option to purchase, in the tenant’s view, was the present value of the rents (economically, a prepayment of the rent).– That is, the discounted cash flow (Slide 58)

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Florida Statute on Balloon Mortgages(Supplement p. 39)

• Fla. Stat. sec. 697.05(2)(a)1 has its own definition of balloon mortgage.

• “Every mortgage in which the final payment or the principal balance due and payable upon maturity is greater than twice the amount of the regular monthly or periodic payment of the mortgage shall be deemed a balloon mortgage.”

Florida Statute on Balloon Mortgages(Cont’d)

• With certain exceptions, “there shall be printed or clearly stamped on such mortgage a legend in substantially the following form:– THIS IS A BALLOON MORTGAGE AND THE

FINAL PRINCIPAL PAYMENT OR THE PRINCIPAL BALANCE DUE UPON MATURITY IS $-----, TOGETHER WITH ACCRUED INTEREST, IF ANY, AND ALL ADVANCEMENTS MADE BY THE MORTGAGEE UNDER THE TERMS OF THIS MORTGAGE.”

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Donald J. Weidner74

Florida Statute on Balloon Mortgages(Cont’d)

• The statute also has special provisions concerning “the case of any balloon mortgage securing the payment of an obligation the rate of interest on which is variable or is to be adjusted or renegotiated periodically, where the principal balance due on maturity cannot be calculated with any certainty.”

• Failure of a mortgagee to comply with these provisions “shall automatically extend the maturity date of such mortgage.”

Florida Statute on Balloon Mortgages(Cont’d)

• Note that the Florida Statute on Balloon Mortgages has several exceptions important for commercial real estate purposes:

– “Any mortgage, the periodic payments on which are to consist of interest payment only, with the entire original principal sum to be payable upon maturity;”

– “Any mortgage securing an extension of credit in excess of $500,000;” and

– “Any mortgage granted by a purchaser to a seller pursuant to a written agreement to buy and sell real property which provides that the final payment . . . will exceed the periodic payments thereon.”

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Donald J. Weidner76

Provisions in Mortgages

• The typical “mortgage” transaction involves two separate documents:– 1. A note– 2. A mortgage.

• We have been considering some of the variables in notes.

• We now turn to take an even longer look at the variables among and within mortgages and mortgage substitutes.

• We’ll then take up more of the law of notes.

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DRAGNET CLAUSE IN MORTGAGE(Text p. 380)

• A dragnet clause in a mortgage uses a single property to secure the original debt and any other debt owed, or to be owed, by the mortgagor to the mortgagee.– The clause “drags” other debts into the

mortgage

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• Courts vary in approach to dragnet clauses • Some “interpret” dragnet clauses narrowly, holding,

ex., that dragnet clauses will only secure subsequent debts directly related to the property.

• Some “presume” that a future advances clause only covers advances of the same quality or relating to the same transaction, – perhaps unless the documentation concerning

the subsequent advance refers to the original mortgage as providing security.

DRAGNET CLAUSE IN MORTGAGE(Cont’d)

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State Bank of Albany v.Fioravanti(Text p. 381)

• 1966: Fee Owner executed $2,500 Note #1 and Mortgage #1 on Lot 1. – Mortgage #1 had a dragnet clause providing

that additional subsequent debt would be secured by the mortgage, but no more than $2,500.

– Lender recorded Mortgage #1.• 1973: Fee Owner executed $6,800 Note #2 &

Mortgage #2 on Lot 2 to same Lender. – No reference was made to Lot 1.

• Fee Owner conveyed Lot 1 to Grantee who assumed “the payment” of Mortgage #1 on Lot 1.

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Fioravanti (cont’d)• Fee Owner paid in full the 1966 Lot 1 Note #1 in

connection with which Mortgage #1 (with the dragnet clause) was issued and recorded on Lot 1.

• Fee Owner defaulted on the 1973 Note #2, causing Lender to foreclose Mortgage #2 on Lot 2. – Lender got a $3000 deficiency judgment in the

foreclosure of Mortgage #2.• Lender sued Grantee of Lot 1 to foreclose Mortgage

#1 on Lot 1 to recover $2,500 of the $3,000 deficiency from the foreclosure of Mortgage #2 on Lot 2.– Recall, the dragnet clause in Mortgage #1 had a

$2,500 limit on the additional debt that could be dragged in.

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Fioravanti (cont’d)

• HELD: “payment of the 1966 note [secured by Mortgage #1 on Lot 1] could not terminate the bank’s right to foreclose the mortgage [#1].” – To decide otherwise would defeat intent.

• TO EMPHASIZE: The note and mortgage are two separate instruments. One can survive the other.

• Dissent: Lender’s document did not specify that the Lot 1 Mortgage would survive the payment of the Lot 1 Note– Construe a document that is at best ambiguous

against the person that drafted it.

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Note 1 to Fioravanti

• In Florida, dragnet clauses are construed against the drafter.

• In particular, pre-existing debt must be specifically included. – United Nat’l Bank v. Tellam, 644 So.2d 97 (FL

3d DCA 1994) (invalidated attempt to drag in pre-existing debt rather than future debt). Existing debts must be specified and future debts may not be dragged in if they were not anticipated at making of the Mortgage.

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Note 2 to Fioravanti (p. 416)

• The Restatement of Mortgages permits dragnet clauses only if

(a) the future debt is incurred in a transaction similar to the original mortgage; [or]

(b) the original mortgage described with adequate specificity the additional types of loans that will be secured by the mortgage; or

(c) the parties expressly agreed at the time of the future advance that it would be secured by the original mortgage.

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AFTER ACQUIRED PROPERTY CLAUSE(Text p. 381)

• Secures a single debt with a mortgage that purports to encumber both the property originally mortgaged and all future property the borrower will acquire.

• Attempts to bring future property under the mortgage rather than future debt.

• However, real estate lenders only get limited benefit from after acquired property clauses in mortgages.

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AFTER ACQUIRED PROPERTY (Cont’d)

• The reason: A mortgage with an After Acquired Property clause will be outside the chain of title of the after-acquired property.

• Subsequent purchasers or mortgagees of a second parcel will not find the After Acquired Property clause in the recorded chain of title of the second parcel. – Hence they will not be bound by that clause.

• The purpose of the recording acts is to allow buyers and lenders to rely on the instruments properly recorded in a particular parcel’s chain of title.

AFTER ACQUIRED PROPERTY (Cont’d)

• In sum: a subsequent purchaser (or mortgagee) of the second parcel will defeat the lender-mortgagee of the first parcel who is trying to rely on the After Acquired Property clause in the mortgage on the first parcel.– This is true whether a tract or a grantor-

grantee index is used.

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Donald J. Weidner87

EVOLUTION OF PROTECTION OF MORTGAGORS(Text p. 337)

The “mortgage deed,”

says the legal historian Maitland,

“is one long suppressio veri and suggestio falsi.”

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1) Defeasible fee enforced according to its terms

Stages in Evolution of Mortgage Law

Borrower LenderDeed

Fee simple subject to condition subsequent

Lender’s estate ends ONLY if borrower pays everything

off exactly on time.

2) Equity relieved Borrower in special circumstances

3) Special circumstances were always found• The equity of redemption came to be called an

estate in land.

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Stages in Evolution of Mortgage Law (cont’d)

4. Lenders were permitted to strictly foreclose the borrower’s equity of redemption

• Lenders were permitted to end the borrower’s right to redeem the land from the mortgage

• Strict foreclosure decree states: pay up now or be barred (foreclosed) from asserting any interest in the future.

5. Lenders were required to foreclose by Judicial Sale

• The proceeds of a foreclosure sale are distributed:• First, to the lender, to pay what is due to the lender

(principal, interest and costs)• Second, any surplus is paid to the borrower.

• Thus, the lender gets what was promised to the lender, repayment, interest and no more.

Donald J. Weidner90

Stages in Evolution of Mortgage Law (cont’d)

6. Legislatures in roughly half the states supplement the equity of redemption and other judicial protections of borrowers with an additional Statutory Right of the Borrower to Redeem from a Foreclosure Sale

• In short, the mortgagor (and, often, a junior lienor) is permitted, for a specific period of time, to redeem “from the sale” by paying, to the foreclosure sale purchaser, the foreclosure sale price plus, in some cases, certain additional amounts.

• There are many approaches to the consequences of nullifying the foreclosure sale.

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Stages in Evolution of Mortgage Law (conclusion)

Where that leaves us.1. Leading Rule today: There may be no

contemporaneous (with the loan origination) waiver of the equity of redemption.

– No matter how clearly stated, understood and agreed to, a contemporaneous waiver of the equity of redemption is unenforceable.

2. However, in many states: Powers of sale, authorizing a sale out of court, whether they are contained in mortgages or in deeds of trust, are enforceable (and popular).

– In these states, the only two necessary steps to foreclose are notice and sale.

Donald J. Weidner92

THE PRACTICAL REALITY OF CHOICE OF SECURITY INTEREST

1) A Mortgage2) A Deed of Trust3) An Absolute Deed Standing by Itself4) An Absolute Deed with Collateral

(accompanying) Documents• Collateral documents such as a lease back or an

option to repurchase

5) An Installment Land Contract• Also called “contract for deed” or “bond for title”

6) A Negative Pledge7) A Lease8) A Proprietary Lease in an Cooperative