California Department of Real Estate Reference Book Chapter 12 Real Estate Finance:
Wrap-Around Deeds of Trust or Mortgages (Over-Riding or All-Inclusive Trust Deeds or AITDs)
A word of caution is required before discussing this type of financing. Prior to using this security instrument, it is essential that an analysis of the existing financing (typically a conventional loan) be undertaken to learn whether the deed of trust or mortgage includes due-on-sale or due on further encumbrance clauses. Most loans made by depository institutions or licensed lenders, including FHA insured or VA indemnified loans, contain in their loan documents (promissory notes and security instruments), acceleration provisions that either include or substantively describe due-on-sale or due on encumbrance clauses/provisions. These clauses preclude the transfer of the security property to a new owner or the further encumbrance of the property by the owner holding title without the existing lender’s prior approval. CHAPTER TWELVE 224
Practitioners should be aware that the full implementation of the Federal Deposit Institutions Act of 1982 (Garn-St. Germain Act) has resulted in federal preemption of state law that restricted the right of lenders to accelerate the maturity date of loans secured by real property (regardless of the maturity date set forth in the loan documents) in the event the borrower either transferred the title to or further encumbered the security property, as defined. This includes AITDs and real property sales contracts.
When the security property is an owner-occupied residence, certain exemptions from the exercise of this right were included in the Garn-St. Germain Act. This preemption has limited the ability to lawfully use AITDs and real property sales contracts. Implementing an AITD and a real property sales contract in violation of a due-on-sale or due on further encumbrance clause may result in an allegation of fraud upon the existing creditor/lender and/or professional negligence, including a breach of fiduciary duty. Accordingly, the advice of knowledgeable legal counsel is recommended to ensure the transaction is being conducted lawfully and each party is receiving what they intended and for which they bargained.
During periods of credit shortages and/or “tight-money,” it is may be impossible for some potential buyers to qualify for conventional loans and for other borrowers to refinance existing loans secured by commercial real estate (as defined) held for the production of income or for investment. Often the purpose for refinancing is to raise additional capital or to improve the rate and terms of the financing. The opportunity to refinance may be severely limited. For example, the existing loan may be “locked” precluding prepayment for a prescribed period. Further, the existing loan may not be locked but may include a substantial prepayment penalty or include a yield maintenance agreement that imposes substantial costs for the owner of the property at the time of refinance or prepayment of the existing loan. In addition, loan-to-value ratios established by depository institutions and licensed lenders may limit the ability to refinance. In such circumstances (among others), these owners and their agents may elect to use an AITD as a means of further encumbering or selling the security property.
An AITD, like a junior deed of trust or mortgage, should not disturb the existing loan, yet the debtor is able to borrow an additional amount against the security property to obtain cash or to permit the sale of the property. After the AITD has been arranged, the new lender typically assumes payment of the existing loan while funding a new loan in an increased principal amount at a higher interest rate. The increased principal amount of the AITD includes the unpaid principal balance of the existing loan plus the loan funds advanced (or the AITD reflects the amount of the purchase price being “carried back” by the owner as the seller of the security property).
The borrower makes payment on the AITD to the new creditor/lender that in turn makes payment to the holder of the existing loan, which remains the senior encumbrance against the security property. Although the AITD “wraps around” the existing loan, it is in effect a junior encumbrance that secures the repayment of the debt/loan representing the difference between the unpaid balance of the existing loan and the principal loan amount secured by the AITD. This method has also been used to finance a sale of real estate where the purchaser has only a small down payment. In the case of a seller “carry back”, the AITD evidences the time differential payment of the purchase price. The buyer/borrower executes an AITD to the seller who will collect a larger loan payment from buyer/borrower, and the seller will continue to make payments on the existing loan. The interest rate spread between the amount required under the AITD and the nominal rate on the underlying promissory note evidencing the debt/loan results in an expected profit for the creditor/lender.