What You Should Know About Subordinate Loans

It’s no secret that the biggest barrier to entry in real estate is CAPITAL.

Real estate investing is a capital-intensive business and capital sources for investors span a wide range. From conventional mortgages to credit cards, investors have funded their real estate investments in just about every way imaginable.

As a hard money lender, we are in the business of providing creative solutions to help real estate investors grow their portfolios. Perhaps one of the most commonly requested loans is subordinate loans.

Here is everything you need to know about them.

(1) What are Subordinate Loans?

Subordinated debt is a junior debt (secondary or lower) that is paid after all first liens have been paid in the event of a default. 

The best way to think of subordinate debt is in the context of loan default and foreclosure sale.

A borrower typically defaults on a loan in one of two ways. (1) The borrower misses payments or (2) the balloon amount is past due.

In either case, the lender(s) on the property have a right to foreclose on that property. Once the lender(s) initiate the foreclosure process, it will ultimately result in a foreclosure sale.

When a foreclosure sale occurs in the state of Ohio, it is taken to public auction. The public auction is usually conducted at and by the County Sheriff’s Office or online (e.g. Auction.com).

Now, pretend that there was a first-position loan on a property for $100,000 and a second-position loan for $20,000.

Further, let’s assume the property goes to auction and sells for $110,000. The first position is made whole for $100,000, but there is only $10,000 left over for the second position.

*Skipping over added fees to the principal amounts like legal fees and interest owed at default interest rates.

Unfortunately, the second position in this case is going to lose $10,000 or 50% of their loan amount.

If you’re starting to think that subordinate loans are dangerous… you’re right.

(2) The Most Common Type of Subordinate Debt

The most commonly used form of subordinate debt is a Home Equity Line of Credit commonly referred to by its acronym – HELOC.

From 2007 to 2022, over 800,000 HELOCs have been issued totaling nearly $131 billion.

With a HELOC, there is usually a first-position mortgage on a property that will get paid back first in the event of a foreclosure sale. The HELOC (subordinate debt) will then be paid with any remaining proceeds from the sale after the first position has been completely made whole.

HELOCs are typically offered on a primary residence with significant equity.

While HELOCs are common on primary residences, they are hard to come by for an investment property. And for good reason.

(3) Why Most Lenders Won’t Do Subordinate Loans

Lenders face a number of risks when underwriting a property. They must assess the character and capacity of the borrower as well as the value of the asset.

Private and hard money lenders use the value of the asset they are lending on to offset the risk of their loan. And this makes sense for most lenders taking the first position, but subordinate lenders face an additional risk: the lender that precedes them.

Here is what can cause subordinate debt holders to lose all of their principal in high-equity properties.

Example: Investor Joe’s Fix & Flip

Let’s use an example borrower – “Investor Joe”.

Investor Joe decides to flip a house in Cincinnati, OH. He needs $150,000 to purchase the property and $30,000 to fix the property up. He plans to sell the property for $210,000 for a $30,000.00 gross profit.

Joe raises capital from “Investor A” who funds the purchase price ($150,000) for a first-position loan and “Investor B” who funds the rehab ($30,000) for a second position on the property.

This project is going well for Joe. Most of the work is finished, but he runs out of cash for a few things that went over budget. Unable to make payments on the loans or finish the project, Joe finds himself in default.

Lender A approaches Joe about the default. Joe explains his situation and asks for additional capital but is denied. The same goes for Lender B.

Lender A approaches Joe and offers a solution that keeps Joe out of court. Instead of going through the foreclosure process, Lender A offers to take over the deed of the property and work out the project.

Joe reluctantly agrees and now, Lender A is the deed holder as well as the first-position mortgagor.

At this point, Lender A decides to foreclose on themself to recover as much cash as they can. In doing so, the project goes to the foreclosure sale.

At the foreclosure sale, the property sells for $189,000 (90% of $210,000). You might be thinking that Lender A is going to walk away with their full $150,000 and Lender B is going to walk away with their full $30,000… but Lender B is in trouble.

What Lender B didn’t realize was that the note for Lender A had a default interest rate of 24% per year. Because the foreclosure process is time-consuming and often bottlenecked, it took nearly a year since default to sell the property.

At this point, $36,000 ($150,000 x 24%) in interest had accrued to Lender A making their balance owed $150,000 in principal plus the $36,000 in interest for a total of $186,000.

After legal fees, Lender A isn’t even technically made whole from the sale and Lender B’s $30,000 position has completely vanished.

This is just one example of how second-position loans with reasonable equity positions can vanish quickly.

Takeaways About Subordinate Loans

1. Subordinate debt is any debt that is second to another debt.
2. Subordinate debt exists widely in the form of HELOCs but is less common in investment lending.
3. Subordinate lenders are at the mercy of the first-position loan.
4. Most commercial loans are written to gather as much equity from the sale of the property in the event of a default.

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