Real estate finance in a nutshell 6th edition

WEST’S LAW SCHOOL
ADVISORY BOARD
_________
JESSE H. CHOPER
Professor of Law,
University of California, Berkeley
JOSHUA DRESSLER
Professor of Law, Michael E. Moritz College of Law,
The Ohio State University
YALE KAMISAR
Professor of Law, University of San Diego
Professor of Law, University of Michigan
MARY KAY KANE
Professor of Law, Chancellor and Dean Emeritus,
University of California,
Hastings College of the Law
LARRY D. KRAMER
Dean and Professor of Law, Stanford Law School
JONATHAN R. MACEY
Professor of Law, Yale Law School
ARTHUR R. MILLER
University Professor, New York University
Professor of Law Emeritus, Harvard University
GRANT S. NELSON
Professor of Law, Pepperdine University
Professor of Law Emeritus, University of California, Los Angeles
A. BENJAMIN SPENCER
Associate Professor of Law,

Washington & Lee University School of Law
JAMES J. WHITE
Professor of Law, University of Michigan


I

REAL ESTATE FINANCE
IN A NUTSHELL
SIXTH EDITION
By
JON W. BRUCE
Professor of Law
Vanderbilt University

Mat #40617120


II
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ISBN: 978–0–314–18354–5


III
To my wife
Barbara Edmonson Bruce

*


V

PREFACE
_________
This book is a concise textual treatment of the law of real estate finance. It is designed
primarily to help law students negotiate a law school course on the subject. Other
members of the legal community may use this work as a general reference and starting
point for research. A table of secondary authorities is included to acknowledge sources
and assist readers who desire more information about a topic introduced in this volume.
The material in this book is organized into detailed outline form for two reasons. First,
the format is utilized to give students a thorough overview of the subject and a set of
pegs upon which to hang information gleaned from classroom discussion. Second, the
relative rigidity of this style helped me resist the urge to write a treatise-like work
complete with mountains of footnotes. Such a volume, of course, is inconsistent with the
purpose of the Nutshell Series. Exhaustive discussion, therefore, has been sacrificed in

favor of summarization and clarity. Readers are requested to keep this in mind while
proceeding through these materials.
One final word about the book. Real estate finance is like most property law, overgrown
with rules. The principles, of course, are stated here, but so are the underlying theories.
This approach is intended to afford
VI
readers a better understanding of doctrine as well as an opportunity to begin critically
examining it.
I wish to say thanks to the following people—my wife Barb for her patience and
understanding during the preparation of all six editions of this book; John Stark and Dan
Sterner of the Indianapolis bar for giving me an excellent introduction to the practice of
real estate finance law; Doug Mulligan, my research assistant on the first edition, for his
tireless efforts; Jim Gillespie for his encouragement and helpful comments on the first
edition; Scott Sartin, my research assistant on the fourth edition, for his conscientious
assistance; Jim Ely, a Vanderbilt colleague, for his valuable suggestions about the third
through sixth editions; law librarians, editors, faculty-support staff, and others for their
help with this and prior editions.
JON W. BRUCE
Vanderbilt Law School
November 2008


VII
OUTLINE
_________
PREFACE
Chapter 1. Introduction to Law of Real Estate Finance
I. Mortgage Concept
A. Definition and Description
B. Obligation/Security Distinction

C. Statute of Frauds
II. Historical Development of Mortgage
A. Defeasible Fee as Financing Device
B. Equity of Redemption
1. Creation and Growth
2. Preservation/Clogging
C. Foreclosure
1. Strict Foreclosure
2. Foreclosure by Sale
D. Statutory Redemption
III. Mortgage Theories
A. Title Theory
B. Intermediate Theory
C. Lien Theory
D. Practical Significance of Mortgage Theories
IV. Modern Financing Formats
VIII
Chapter 2. Mortgage Market
I. Purpose of Financing
A. General
B. Construction/Permanent Financing
1. Descriptions and Distinction
2. Relationship Between Construction Lenders and Permanent Lenders
3. Construction Lender’s Special Risks
a. Nature of Risk and Minimizing It
b. Performance and Payment Bonds
c. Liability for Construction Defects


C. Residential/Commercial Property

II. Originating/Servicing/Holding
III. Sources of Real Estate Financing
A. Commercial Banks
B. Savings and Loan Associations
C. Mutual Savings Banks
D. Life Insurance Companies
E. Pension Funds
F. Real Estate Investment Trusts
G. Mortgage Banking Companies
H. Other Sources
1. Credit Unions
2. Sellers
3. Syndications
4. State Development Agencies
IX
5. Community Housing Authorities
I. Mortgage Brokers
IV. Obtaining Real Estate Financing
A. Application and Commitment
B. Mortgage Loan Contract
1. Nonrefundable Commitment Fees
2. Borrower’s Remedy for Lender’s Breach
V. Loan Participation and Mortgage–Backed Securities
A. Loan Participation
B. Mortgage–Backed Securities
VI. Secondary Financing
A. The Basics
1. Creation of Junior Mortgages
2. Importance of Mortgagor’s “Equity”
3. Risk and Rate

B. Beyond the Basics/Wraparound Mortgages
VII. Federal Government Involvement in Financing Process
A. Housing Subsidies
B. Mortgage Insurance and Guaranty Programs
C. Secondary Mortgage Market Support Institutions
D. Other Government Involvement
1. Truth in Lending


X
2.
3.
4.
5.
6.

Interstate Land Sales Full Disclosure Act of 1968
National Flood Insurance Program
Real Estate Settlement Procedures Act of 1974
Home Mortgage Disclosure Act of 1975
Comprehensive Environmental Response, Compensation, and Liability Act of
1980
7. Housing and Economic Recovery Act of 2008
8. Emergency Economic Stabilization Act of 2008
9. Future Involvement
VIII. Predatory Lending
Chapter 3. Real Estate Financing Devices
I. Mortgage
A. Purchase Money Mortgage
B. Tax Considerations

II. Deed of Trust
III. Equitable Mortgages
A. Absolute Deed Given as Security
B. Conditional Sale
C. Negative Pledge
D. Vendor’s and Vendee’s Liens
IV. Installment Land Contract
A. Traditional Contract Approach
XI
B. Protecting Purchaser
1. Period-of-Grace Statutes
2. Compelling Equities View
3. Equitable Mortgage View
4. Restitution
5. Waiver
C. Encumbering Purchaser’s Interest
D. Encumbering Seller’s Interest
V. Lease
A. Varieties
1. Ground Lease
2. Space Lease
3. Acquisition Lease


B. Leasehold Mortgage
1. Nature of Security
2. Lease Provisions
a. Term
b. Transfer
c. Default

C. Sale and Leaseback
VI. Mezzanine Loan
Chapter 4. Underlying Obligation
I. Necessity for Underlying Obligation
II. Form of Obligation
III. Description of Obligation
IV. Future Advances
A. The Basic Concept
B. Methods of Securing Future Advances
C. Obligatory/Optional Distinction
1. Obligatory Future Advances
XII
2. Optional Future Advances
a. Priority Problems
b. Notice Issue
D. Obligatory/Optional Distinction Rejected by Statute
E. Construction Lender’s Dilemma
F. Dragnet Clause
V. Interest
A. The Norm
B. Variations From the Norm
1. Alternative Mortgage Instruments
a. Adjustable Rate Mortgage
b. Price Level Adjusted Mortgage
c. Shared Appreciation Mortgage
2. Buy–Down Mortgage
3. Revenue/Equity Participation
C. Due–on–Sale Clause
D. Usury
1. Rate

2. Exemptions
a. Borrowers


b. Lenders
c. Transactions
3. Penalties
4. Federal Preemption
VI. Modification of Obligation
VII. Discharge of Obligation and Mortgage
A. Payment
1. Payment Alternatives
XIII
a. Graduated Payment Mortgage
b. Reverse Mortgage
c. Growing Equity Mortgage
2. Balloon Loans
3. Escrow Accounts
4. Late Charges
5. Default Interest
B. Prepayment
C. Release of Mortgage
D. Statute of Limitations
Chapter 5. Mortgaged Property
I. Mortgageable Interests
A. General
B. Mortgaging Separate Interests in Same Land
C. Description
II. Extent of Mortgage Coverage
A. After–Acquired Property

B. Easements
C. Fixtures
D. Condemnation Awards
E. Insurance Proceeds
F. Rents and Profits
III. Waste of Mortgaged Property
A. Doctrine of Waste
B. Mortgagee’s Remedies for Waste
1. Damages
2. Injunction
3. Foreclosure


XIV
Chapter 6. Transfer of Mortgagor’s Interest
I. Mortgagor’s Interest
II. Conveyance of Mortgaged Property
A. Mortgagor’s Power to Convey
B. Effect of Conveyance on Mortgage
1. Mortgage Is Discharged
2. Mortgage Survives
C. Rights and Obligations of Parties When Mortgage Survives Conveyance
1. “Subject to” Conveyance
a. Grantee’s Rights and Obligations
b. Mortgagor’s Rights and Obligations
2. “Assumption” Conveyance
a. Grantee’s Rights and Obligations
b. Mortgagor’s Rights and Obligations
c. Successive “Assumption” Conveyances/Break in Chain of Assumptions
d. Termination or Modification of Assumption Contract

3. Extension Problem
D. Acquisition by Mortgagee
1. Deed in Lieu of Foreclosure
2. Merger
XV
III. Due–On–Sale Clause
A. General
B. State Law Background
1. Automatic Enforcement Approach
2. Impairment of Security View
3. Resolution
C. Federal Home Loan Bank Board Regulations
D. Garn—St. Germain Depository Institutions Act of 1982
1. General
2. Window Period Loan Exception
3. Exempt Transfers
4. Role of Office of Thrift Supervision
E. Practical Considerations
IV. Further Encumbrance of Mortgaged Property
V. Transfer at Mortgagor’s Death


Chapter 7. Transfer of Mortgagee’s Interest
I. Mortgagee’s Interest
II. Assignment of Mortgage Loan
A. Basic Concept
B. Ordinary Assignment/Assignment as Security Distinction
C. Assignee’s Rights
D. Applicability of UCC Article 9
E. Recording Mortgage Assignment

F. Secondary Mortgage Market
XVI
III. Defenses Available Against Assignee
A. Nonnegotiable Obligation
B. Negotiable Obligation
C. Estoppel Certificate
IV. Payment Problems After Assignment
A. Payment by Mortgagor
1. Negotiable Obligation
a. Established Principles
b. Amended UCC Position
2. Nonnegotiable Obligation: Notice Problem
a. Actual Notice
b. Record Notice
c. Inquiry Notice
B. Payment by Grantee
1. Negotiable Obligation
a. Established Principles
b. Amended UCC Position
2. Nonnegotiable Obligation: Notice Problem
a. Actual Notice
b. Record Notice
c. Inquiry Notice
C. Servicing Arrangements
V. Conflicting Assignments
A. Traditional Approach
1. Nonnegotiable Obligation
2. Negotiable Obligation
B. UCC Article 9 Approach
VI. Fractional Assignments (Loan Participation)

A. Forms of Loan Participation
XVII
B. Agreement Establishing Priority
C. Priority Absent Agreement—Participation Certificates
D. Priority Absent Agreement—Series of Notes
1. Pro Rata Rule
a. Guaranty Exception
b. Priority–for–Assignees Exception
c. Order-of-Maturity Exception
2. Priority of Assignment Rule (Pro Tanto Rule)
VII. Assignment by Operation of Law (Subrogation)
A. Parties for Whom Subrogation Is Available
1. Mortgagor as Surety After Conveyance
2. Junior Mortgagee
3. Lender of Pay-Off Funds
4. Purchaser of Mortgaged Property
B. Conventional Subrogation
C. Right to Formal Assignment
VIII. Assignment as Security
IX. Transfer at Mortgagee’s Death
Chapter 8. After Default and Before Foreclosure
I. Default
A. Definition and Significance of Default
XVIII
B. Common Types of Default
1. Failure to Pay Principal and Interest
2. Failure to Pay Taxes or Insurance
3. Waste

4. Construction Difficulties
C. Waiver of Default
II. Acceleration
A. Acceleration Clause
B. Curing Default Before Acceleration
C. Triggering Acceleration
D. Curing Default After Acceleration
1. General Rule
2. Equitable Relief


E. Due–On–Sale Clause
III. Right to Possession and Rents
A. Significance of Mortgage Theories
B. Mortgagee in Possession
1. Definition
2. Rights
3. Obligations
a. Management
b. Accounting
c. Liability to Third Parties
4. Problem of Leases Existing at Default
a. Prior Leases
b. Junior Leases
C. Assignment of Rents
XIX
D. Receiver
1. Background
2. Grounds for Appointment
3. Receiver’s Powers

a. Collecting Rent From Junior Lessees
b. Collecting Rent From Mortgagor in Residence
c. Operating Mortgagor’s Business
IV. Equity of Redemption
A. Availability
B. Parties Who May Redeem
C. Amount Required for Redemption
D. Result of Redemption
1. By Mortgagor or Mortgagor’s Successor
2. By Junior Interest Holder
E. Enforcement of Right to Redeem
F. Waiver/Clogging
G. When Right of Redemption Ends
1. Foreclosure
2. Termination by Other Means
V. Alternatives to Foreclosure
A. Workout Arrangement
B. Deed in Lieu of Foreclosure
C. Sale/“Short Sale”


D. Recovery on the Note Alone/“One Action” Rule
Chapter 9. Priorities
I. General Principles
II. Recording Statutes
XX
III. Selected Issues
A. Purchase Money Mortgage
1. Distinguishing Features
2. Preferred Priority Position

B. Subordination Agreements
1. Subordination of Purchase Money Mortgage to Construction Loan Mortgage
a. Background
b. Subordination Agreement in General
c. Describing Construction Loan
d. Obtaining Construction Loan Described
e. Diversion of Construction Loan Funds
f. Optional Advance Risk
2. Subordination of Lease to Mortgage and Vice Versa
3. Subordination of Fee to Leasehold Mortgage
C. Fixtures
D. Mechanics’ Lien Statutes
1. General
2. Amount
3. Priority
a. Relation Back to Commencement of Construction
b. Other Approaches
4. Constitutionality of Mechanics’ Lien Statutes
XXI
5. Other Protection for Mechanics and Materialmen
a. Stop Notice Statutes
b. Equitable Liens
E. Tax Liens
1. State and Local Real Estate Tax Liens
2. Federal Income Tax Liens
F. Lis Pendens
G. Marshaling
1. Two Funds Rule

2. Sale in Inverse Order of Alienation Rule
3. Anti–Marshaling Clause
Chapter 10. Foreclosure
I. Availability and Purpose
II. Statute of Limitations
III. Federal Legislation Affecting Foreclosure
A. Mortgagor in Bankruptcy
1. Automatic Stay of Foreclosure Proceedings
2. Nullification of Prior Foreclosure Sale
B. Mortgagor in Military Service
IV. Foreclosure by Judicial Sale
A. Parties Defendant
1. Necessary/Proper Parties
2. Intentional Omission of Junior Lessees
3. Lis Pendens
XXII
B. Sale Procedures
C. Confirmation/Adequacy of Sale Price
D. Purchaser
1. Purchaser’s Title
2. Purchaser Versus Omitted Junior Lienor
3. Purchase by Mortgagee
4. Purchase by Mortgagor
E. Distribution of Proceeds
F. Deficiency Judgment
1. General
2. Anti–Deficiency Legislation
V. Foreclosure by Power of Sale
A. Comparison to Judicial Sale
1. Form of Security Device

2. Sale Procedures
3. Purchaser’s Title
4. Purchase by Lender
5. Deficiency or Surplus
6. Judicial Review
B. Constitutional Issues
1. Governmental Action
2. Notice and Hearing


3. Waiver
VI. Strict Foreclosure
VII. Statutory Redemption
A. Availability
B. Parties Who May Redeem
C. Amount Required for Redemption
XXIII
D. Result of Redemption
1. By Mortgagor or Mortgagor’s Successor
2. By Junior Lienor
E. Waiver
F. Comparison to Equity of Redemption
G. Criticism of Statutory Redemption
VIII. Foreclosure Escalation
Chapter 11. Financing Cooperatives and Condominiums
I. Background
II. Cooperatives
A. Cooperative Concept
B. Financing Cooperatives
1. Construction or Acquisition Financing

2. Loans on Units
3. Default on Blanket Mortgage
III. Condominiums
A. Condominium Concept
B. Financing Condominiums
1. Construction Financing
2. Conversion Financing
3. Loans on Units
a. General
b. Priority vis-à-vis Assessment Liens
Chapter 12. Reform
I. Need for Reform
XXIV
II. Reform Measures
A. Federal Level
1. Nationwide Foreclosure System


2. Other Preemption
3. Standard Mortgage Forms
4. Further Federal Action
B. Uniform Land Security Interest Act
1. General
2. Significant Provisions
a. Coverage
b. New Terminology and Concepts
c. Rights and Obligations Before Foreclosure
d. Foreclosure Procedures
3. Status
C. Uniform Nonjudicial Foreclosure Act

D. Restatement (Third) of Property—Mortgages
INDEX


XXVII

REAL ESTATE FINANCE
IN A NUTSHELL
SIXTH EDITION

*


1


CHAPTER 1
INTRODUCTION TO LAW OF REAL ESTATE FINANCE
This introductory chapter presents an overview of the law of real estate finance.
Because the mortgage is the cornerstone of real estate finance, it is the focal point of this
chapter and for that matter the entire book.

I. MORTGAGE CONCEPT
A. DEFINITION AND DESCRIPTION
A mortgage is the transfer of an interest in land as security, usually for the repayment
of a loan, but occasionally for the performance of another obligation. The typical
mortgage transaction is relatively uncomplicated. A landowner borrows money from an
institutional lender and enters a written agreement with the lender that the landowner’s
real estate is collateral for the loan. In legal terminology the landowner-borrower is a
mortgagor, the lender is a mortgagee, and the agreement is a mortgage. If the

mortgagor fails to pay the mortgage loan, the mortgagee may enforce its security
interest by using appropriate foreclosure procedures to have the mortgaged land sold to
satisfy the debt. (In all of
2
the illustrations in this book “MR” refers to the mortgagor and “ME” refers to the
mortgagee).
B. OBLIGATION/SECURITY DISTINCTION
A mortgage exists solely as security for an underlying obligation, ordinarily a promissory
note. See Ch. 4, pp. 74–76 (considering necessity for underlying obligation and form of
obligation). Consequently, every mortgage lives, travels, and dies with the obligation it
secures.
Illustration: MR executes a promissory note and a mortgage to ME. ME assigns the
note to A, but through inadvertence fails to assign the mortgage to A. Nonetheless, the
mortgage follows the note into A’s hands by operation of law. See Ch. 7, pp. 132–137
(discussing assignment of mortgage loan).
Illustration: MR executes a promissory note and a mortgage to ME. MR pays ME in
full. ME returns the note to MR, but ME does not release the mortgage. ME has no
further rights under the mortgage. The security interest created by the mortgage lapses
when the underlying debt is satisfied. See Ch. 4, pp. 94–101 (analyzing discharge of
obligation and mortgage).
C. STATUTE OF FRAUDS
A mortgage, as the transfer of an interest in land, falls squarely within the scope of the


Statute of
3
Frauds. Thus, mortgages, as well as agreements to execute mortgages, must be in
writing to comply with the Statute. Equitable principles, however, may dictate that a
mortgage arises by operation of law or is enforceable even though it is unwritten.
Illustration: Y asks Z for a loan to pay several bills. Z makes the loan upon Y’s oral

pledge that Y’s farm is security for the loan. Y defaults. Z seeks to foreclose and have
the farm sold. Z has no right to do so, because Y’s oral pledge is unenforceable. As a
general rule, simply lending money does not constitute sufficient part performance to
take an unwritten security arrangement out of the Statute of Frauds. Hence, the loan is
unsecured.
Illustration: C asks D for a loan to purchase a specific parcel of real estate. D makes
the loan upon C’s oral promise to give D a mortgage on the property to be purchased. C
uses the loan proceeds to purchase the property, but refuses to execute a mortgage to
D as promised. C defaults. D seeks to foreclose and have the land sold. D generally
may do so because an equitable mortgage arises by operation of law in order to permit
D to obtain payment out of the product of D’s loan. Such a mortgage is not subject to
the Statute of Frauds. D also might prevail on another ground. Hardship on D,
advancement of the loan proceeds, and their use to purchase the property may be
considered to constitute sufficient part performance to satisfy the Statute of Frauds,
rendering C’s oral promise enforceable.
4

II. HISTORICAL DEVELOPMENT OF MORTGAGE
Real estate finance is best understood by one who is thoroughly acquainted with the
development of the mortgage concept. An abbreviated jaunt through legal history,
therefore, is in order. During this excursion, note how the legal pendulum swings first in
the mortgagee’s favor, then in the mortgagor’s direction, and so on, back and forth,
throughout history.
A. DEFEASIBLE FEE AS FINANCING DEVICE
At early English common law, a mortgage was simply a deed of a defeasible fee from
the mortgagor to the mortgagee. If the debt was repaid at maturity, or “law day” in
common law parlance, the mortgagee’s estate terminated, and the mortgagor again
owned the land. If, however, the debt was not paid at maturity, the mortgagee’s
defeasible fee became a fee simple absolute. Because the law courts strictly enforced the
time for payment, the mortgagor lost the land even if the mortgagor tendered payment

just a day late.
B. EQUITY OF REDEMPTION


1. Creation and Growth

In order to mitigate the harsh results of this common law approach, the equity courts
intervened. If a mortgagor could establish a sound reason
5
for failing to perform as agreed in the mortgage, equity would permit the mortgagor to
recover the land by paying the debt after the maturity date. This right of late payment
eventually was extended to all mortgagors without regard to the existence of individual
equities and became known as the equity of redemption. See Ch. 8, pp. 179–182
(discussing equity of redemption).
2. Preservation/Clogging

Equity courts have always zealously preserved the mortgagor’s equity of redemption.
Any clause in the mortgage or in a contemporaneous agreement that has the effect of
eliminating or impairing the mortgagor’s equitable right to redeem is termed clogging and
is prohibited. Otherwise a mortgage could be transformed into a defeasible fee by the use
of a simple waiver clause. The courts’ protective approach in this regard gave rise to the
maxim: “once a mortgage, always a mortgage.”
Illustration: MR executes a mortgage to ME. At the same time, MR gives ME an
option to purchase the mortgaged land for a nominal sum if MR defaults. The option is
unenforceable as a contemporaneous clog on MR’s equity of redemption. It is really a
disguised waiver. See Ch. 6, pp. 121–123 (considering when mortgagee may properly
acquire mortgaged property from mortgagor).
6
C. FORECLOSURE
1. Strict Foreclosure

The creation of an immutable equity of redemption placed the mortgagee in a difficult
position. The defaulting mortgagor’s right to redeem effectively prevented the mortgagee
from selling or improving the mortgaged property. The English equity courts thus came to
the aid of mortgagees by developing the concept of foreclosure of the equity of
redemption. After default and at the mortgagee’s request, the equity courts set a time
period within which the mortgagor was required to pay the debt or lose the right to
redeem. If the mortgagor failed to pay within the period specified, the mortgagee
obtained a fee simple absolute. This method of terminating the mortgagor’s equity of
redemption became known as strict foreclosure.
2. Foreclosure by Sale

Strict foreclosure was inherently unfair to the mortgagor because the value of the
mortgaged land acquired by the mortgagee frequently exceeded the debt. The legal
pendulum, consequently, began to swing back in favor of mortgagors. This time our state