Real Estate Financing – Part I – Class 10

This is the first of three classes focusing on issues related to real estate financing. This is a
complicated subject!
What is a loan?
Let’s start with the basics. A “loan” is a thing that is borrowed, usually a sum of money, that is
expected to be paid back with interest. Almost all loans in the real estate world are “secured
loans.” What does it mean to be secured? It means the borrower has pledged some kind of
“collateral” to the lender in exchange for the lender making the loan. If the borrower fails to repay
the loan, the borrower forfeits the collateral to the lender.
For this class, we will focus primarily on acquisition loans and construction loans. Acquisition
loans are loans to borrowers to acquire real property. These loans are different depending on
whether the borrower is acquiring residential or commercial property. Construction loans are loans
to cover costs associated with building or renovating structures. Often, lenders accept interest-only
payments during the duration of construction, but costs increase greatly once construction is
complete. Frequently, this means a construction loan must be refinanced after construction is
finished.
Commercial (and residential) loans are typically secured by a lien on the property, which gives the
lender the right to foreclose on the property (or collateral) if the borrower defaults on the loan
payments. Commercial loans may also be secured by other assets of the borrower, such as
equipment, inventory, or accounts receivable. These security instruments are referred to as
mortgages or deeds of trust.

Mortgages and Deeds of Trust

At its heart, a mortgage is an ability to use the value of real estate to finance commerce. Generally,
references in the materials to “mortgages” includes deeds of trust. A “deed of trust” is simply a
special form of mortgage generally providing special means of enforcement.
A “mortgage” is an interest granted in real property to secure the payment or performance of some
debt. If the debt is not paid, then the property is taken to satisfy the debt. This definition has several
implications concerning the requirements for creating a valid mortgage:
• The mortgage is an interest in real property, so its creation must comply with the formalities
associated with real property conveyances – a writing in a form that satisfies the statute of
frauds and other statutory requirements (i.e. acknowledgement of signatures aka
notarized);
• Recording the mortgage is necessary to protect against competing interests;
• There must exist a debt or other obligation to support the mortgage and the debt or
obligation creates rights independent of the mortgage;
• The mortgagee’s remedy following the mortgagor’s default is to take ownership of the real
property encumbered by the mortgage.
In mortgage documents, a borrower is referred to as the “mortgagor” and the lender is referred to
as the “mortgagee”.
A deed of trust is a legal document that transfers the title of a property to a third party, called a
“trustee”, who holds the title as security for a loan. The borrower is called the “trustor”, and the
lender is called the “beneficiary”. The trustee has the power to sell the property at a public auction
if the trustor fails to pay back the loan according to the terms of the deed of trust. This process is
called a “trustee’s sale” or a “nonjudicial foreclosure”. Deeds of trust are commonly used in
some states instead of mortgages, because mortgages involve a judicial foreclosure process that
requires a court order to sell the property.
The main difference between a mortgage and a deed of trust is the number of parties involved and
the foreclosure process. A mortgage involves two parties: the borrower and the lender. The
borrower owns the property and promises it to the lender as collateral. A deed of trust involves
three parties: the borrower, the lender, and a neutral third-party trustee. The trustee holds the title
to the property until the loan is paid off.
Another difference is how the lender can foreclose on the property if the borrower defaults on the
loan. A mortgage has a judicial foreclosure, which means the lender has to go through the court
system to take the property. This can be a lengthy and costly process for both parties. A deed of
trust has a nonjudicial foreclosure, which means the trustee can sell the property without court
approval. This can be faster and cheaper, but it also gives less protection and recourse to the
borrower.
Deeds of trust have some advantages and disadvantages for both borrowers and lenders compared
to mortgages. For borrowers, deeds of trust may offer lower interest rates and faster loan approval,
since they avoid the costs and delays of a judicial foreclosure. However, deeds of trust also limit
the borrower’s rights to challenge the foreclosure or redeem the property after the sale. For lenders,
deeds of trust provide more flexibility and control over the foreclosure process, since they do not
need to involve the court or follow strict legal procedures. However, deeds of trust also expose the
lender to more risks of liability or fraud, since they rely on the trustee to act impartially and
faithfully on behalf of both parties.
Fixtures – Another Form of Collateral
The first challenge is coming to grips with the concept of “fixtures.” Fixtures
are items of personal property attached to buildings or real property (a/k/a “annexed to realty”),
but retaining their separate identification, capable of being removed from the real property without
substantial damage to the realty/improvements and upon removal, revert to their status as personal
property. For example, a sink, a fence, or a ceiling fan are fixtures because they are fixed to the
property and cannot be easily moved. A fixture is different from a personal property, which is
something that easily can be moved and belongs to a person. For example, a chair, a lamp, or a
painting are personal properties because they are not attached to the property and can be taken
away. A fixture involves a greater sense of permanence.
What is the difference between a fixture and lumber, drywall, and other building materials?
Combining building materials and labor creates an “improvement” to real property.
Improvements lose their separate identity and become part of the real property. Improvements to
real property are incorporated into the property to the extent their removal causes damage; fixtures
are capable of removal and, beyond the value of the fixture itself, the property is not materially
damaged by the removal. Compare the impacts to the structure of removing plumbing or wiring
(both improvements) versus removing a ceiling fan or a stove.
Beyond these general statements, it is not possible to create a definitive definition of “fixture.” The
state law defining what constitutes a fixture is varied, and in most cases (including Washington)
hopelessly inconsistent. When confronted with an item of collateral of an indeterminate nature, it
is best to proceed on a dual track, taking the steps necessary to create a valid collateral and security
interest as if the item were both personal property and real property.

Why are fixtures important?

Fixtures are another form of collateral that create a security interest. The way lenders secure their
interests in these fixtures is by filing a “fixture filing.” This is called “perfecting an interest”. A
fixture filing is similar to recording a deed or a deed of trust. It is a way of providing notice to the
world that the lender holds an interest in the fixtures.
Fixture filings are created by and governed by the “Uniform Commercial Code (“UCC”)”. The
UCC is a set of rules that helps people do business with each other across different states. It covers
things like buying and selling goods, borrowing and lending money, and using checks and credit
cards. The UCC is a model statute drafted by an association of lawyers in the 1950s. It is a model
statute for states, and since its drafting, all 50 states have adopted the UCC in relatively unaltered
form, meaning that all states have virtually the same provisions in their state laws for certain
commercial issues governed by the UCC, including perfecting security interests in fixture filings.
The UCC helps businesses that need to borrow money or use credit. It tells them how they can use
their assets (things they own) as collateral (security) for a loan, and how they can protect their
rights in those assets from other creditors (people they owe money to). It also tells them how they
can use negotiable instruments (documents that promise to pay money) like checks, promissory
notes, or certificates of deposit, and how they can transfer (give or sell) those documents to other
people.
The UCC is a way for businesses to have more clarity and confidence when they engage in
commercial transactions with other businesses or consumers. It is a way for states to have more
uniformity in their laws that affect commerce.
The UCC does not apply to real property; but the UCC governs the process to obtain a security
interest in personal property, which will continue to encumber the personal property after it
becomes a fixture even though the fixture becomes incorporated into the improvement. Similarly,
a security interest may be created in fixtures constituting improvements and the security interest
may continue even though the fixture is removed and becomes personal property.
These arrangements are necessary to facilitate financing construction of improvements; lenders
can advance funds for the purchase of equipment and perfect a security interest in the purchased
goods without the risk of losing priority to another lender financing construction of the
improvements when the equipment is incorporated into the structure.
The UCC has its own vocabulary. The lender acquires a “security interest” in the personal
property (collateral). The security interest is created by a written “security agreement” and the
security interest “attaches” to the item of collateral. The security interest is “perfected” in the
collateral by filing a “financing statement” in the state recording office specified by the UCC. A
“perfected security interest” is one that can withstand an attack by a subsequent bona fide
purchaser for value. Like recording real property conveyances, proper filing under the UCC
imparts constructive notice to all persons subsequently dealing with the debtor and the collateral
as to the existence of the lender’s security interest in the collateral.
Let’s think about how this works in real life: Imagine you want to buy a new TV for your room,
but you don’t have enough money to pay for it. You go to a store that offers you a loan to buy the
TV, but they want some guarantee that you will pay them back. They ask you to sign a paper that
says if you don’t pay them back, they can take the TV away from you. This paper is called a UCC
financing statement, and it gives the store a security interest in the TV.
Now imagine you want to install the TV on your wall, so you can watch it from your bed. You use
some screws and brackets to attach the TV to the wall. The TV is now a fixture because it is
attached to the real property (your house). But what if you don’t pay back the loan to the store?
Can they still take the TV away from you? What if your parents sell the house? Does the TV go
with it?
To avoid these problems, the store can file another paper that says they have a security interest in
the TV as a fixture. This paper is called a UCC fixture filing, and it is filed in the same place where
your parents recorded their deed for the house. A UCC fixture filing tells everyone that the store
has a claim on the TV, even if it is attached to the house. It also tells your parents that they can’t
sell the house without paying off the loan or removing the TV.
A UCC fixture filing is a way for lenders to protect their rights in goods that are attached to real
property. It is different from a regular UCC filing, because it requires more information about the
real property and where it is located. It is also different from a mortgage or a deed of trust, because
it does not create a lien or a mortgage on the whole property, but only on the specific goods that
are fixtures.
The major points to remember about the UCC and fixture filings are:
• The UCC does not apply to real property – the intersection between real property and
personal property is at “fixtures.” The UCC allows a lender to retain a security interest in
personal property attached to the real property; however, if the item has become so
integrated into the real property that it has lost is character as a fixture, the UCC security
interest will no longer be applicable, and the lender must use a mortgage to encumber the
real property.
• Understanding the broad differences between real property, personal property, and fixtures.
• Filing is essential under the UCC – an unperfected security interest is worthless, since the
whole point of creating the security interest is to protect the creditor’s claims against third
parties. The UCC has detailed rules concerning where to file – state, local or national filing
offices. For fixtures, the filing is in the applicable real property recording office, so anyone
searching real estate records (such as a prospective mortgagee) should be able to discover
that an individual has granted a security interest in fixtures located on a specified piece of
property.
If you are dealing with real estate, a search of UCC filings at the state and recording office level
is essential to make certain you determine if prior debts have been incurred affecting the real estate
serving as collateral in your transaction. There are commercial search firms available to conduct
searches, although the liability of these firms for inaccurate search is normally limited to the fee
charged for the search. Some title insurance companies offer limited policies insuring the accuracy
of UCC searches, similar to title insurance policies, but much less comprehensive.

Why do we care so much about recording and priority?

The concept of mortgage or deed of trust priority is about who gets paid first when a property is
sold or foreclosed. A mortgage or a deed of trust is a document that gives a lender the right to sell
a property if the borrower does not pay back the loan.
When a property has more than one mortgage or deed of trust on it, each mortgage or deed of trust
has a priority based on when it was recorded. The first mortgage or deed of trust recorded has the
highest priority, the second has the next highest priority, and so on. The priority determines who
gets paid first from the proceeds of the sale or foreclosure of the property.
For example, suppose a property has two deeds of trust (or mortgages) on it: one for $100,000
recorded in January and another for $50,000 recorded in February. If the property is sold for
$120,000, the first deed of trust will get paid $100,000 and the second deed of trust will get paid
$20,000. The remaining $30,000 will go to the borrower. If the property is sold for $90,000, the
first deed of trust will get paid $90,000 and the second deed of trust will get nothing. The borrower
will also get nothing.
The concept of priority is important for borrowers and lenders to understand because it affects
their rights and risks. Borrowers should be careful not to take out more loans than they can afford
to repay or risk losing their property. Lenders should be aware of their position in relation to other
lenders and how much they can recover if the borrower defaults.

Preliminary Overview of Remedies for Defaults on Loans

In the discussion of remedies upon default (which is part of the assigned reading for the next class),
the Text notes the difference between “lien theory” and “title theory” states. The primary
difference relates to the right of the lender to take possession of the property and collect rents and
profits (i.e. crops). In title theory states, the lender generally has a right to possession immediately
upon default; in a lien theory state, there is no right to possession by the lender until foreclosure.
Washington is a lien theory state, as confirmed by RCW 7.28.280, which was originally enacted
in 1869 when Washington achieved statehood:
A mortgage of any interest in real property shall not be deemed a conveyance so as to
enable the owner of the mortgage to recover possession of the real property, without a
foreclosure and sale according to law . . . RCW 7.28.280
This necessarily means in lien theory states the concept of a “mortgagee in possession” is
something of an oxymoron; the mortgagee has no rights of possession prior to foreclosure, and
upon foreclosure there is no longer a mortgage. However, in title theory states, issues relating to
mortgagees in possession are significant and impact the conduct of lenders following a default.
The practical effect on pre-foreclosure conduct of a mortgagee in a lien theory state can be seen in
the Jordon v. Nationstar case, which is part of the reading materials.
One basic rule of mortgage law is every mortgagor has the right to redeem the mortgaged property
from the lien of the mortgage. This right is referred to as the “equity of redemption.” The
debtor/mortgagor has this right until the equity of redemption is “foreclosed” by the lender, so,
when we speak of foreclosure of the mortgage, we are really describing the process by which the
lender/mortgagee is terminating the right of the debtor/mortgagor to regain ownership of the
property following a default under the obligation secured by the mortgage.
The “equity of redemption” is different from statutory redemption rights existing under various
state laws. Statutory redemption (See Chpt. 6.23 RCW) is an independent right granted by state
statute to pay the debt following the completion of the foreclosure process and regain ownership
of the foreclosed property. Statutory rights of redemption vary from state to state in terms of time
periods and procedures.
A deed of trust is a form of mortgage in which the mortgagor has granted a “power of sale”
authorizing the mortgagee to cause a foreclosure of the mortgage by private sale without necessity
of judicial procedure. The power of sale in a deed of trust allows the deed of trust to be foreclosed
without judicial procedure following default. Some states recognize the validity of a power of sale
within a mortgage and without the necessity of utilizing a deed of trust. Depending upon the state,
there may be other characteristics unique to a deed of trust. The principal differences between a
mortgage and a deed of trust relate to remedies upon default and will be discussed more in the next
classes.

Cases

Purchase + Sale 1. 16th Street Investors v Morrison .pdf – Option language “would like to have to
have the option to purchase condo” - Call option converted PSA into agreement to Agree. 2.
Keystone land vs xerox –Agreement to agree unenforceable – unless there is objective
mechanism or formula for reaching agreement, and terms that apply in case no agreement
reached. I.E. 3rd party bcontract to negotiate,” the parties exchange
promises to conform to a specific course of
conduct during negotiations, such as negotiating
in good faith, exclusively with each other, or for a
specific period of time, but the parties do not
intend to be bound if negotiations fail to reach
ultimate agreement on the substantive deal 3. Alby v. Banc One Financial – Reverter
clause Property reverted to original owner if mortgage. Reverter clauses restriction on
alienation, court ruled reverter clause valid.Washington follows the reasonableness approach to
restraints on alienation is reverter clause unreasonable restriction on alienation. - property reverted
to original owner if owners took out a mortgage. Fee simple determinable estates are subject to
the rule against restraints on alienation 4. Pendergrast case -