Look Out for Morty!

I recently took part in a discussion where the topic was the ability of a lender to call a loan; in that specific instance, a businessman's line of credit. This discussion covered the reappraisal of mortgaged real estate. In a changing market, a lender may want to gauge the change in the degree of risk (lenders may require additional collateral or may reduce the line of credit if the value of the collateral becomes less than the loan amount), and also touched upon "due on sale" clauses.

A typical mortgage deed might contain something like the following (which is the actual text from an actual mortgage):

"18. Transfer of the Property or a Beneficial Interest in Borrower. As used in this Section 18, "Interest in the Property" means any legal or beneficial interest in the Property, including, but not limited to, those beneficial interests transferred in a bond for deed, contract for deed, installment sales contract or escrow agreement, the intent of which is the transfer of title by Borrower at a future date to a purchaser.

If all or any part of the Property or any Interest in the Property is sold or transferred (or if Borrower is not a natural person and a beneficial interest in Borrower is sold or transferred) without Lender's prior written consent, Lender may require immediate payment in full of all sums secured by this Security Instrument. However, this option shall not be exercised by Lender if such exercise is prohibited by Applicable Law.

If Lender exercises this option, Lender shall give Borrower notice of acceleration. The notice shall provide a period of not less than 30 days from the date the notice is given in accordance with Section 15 within which Borrower must pay all sums secured by this Security Instrument. If Borrower fails to pay these sums prior to the expiration of this period, Lender may invoke any remedies permitted by this Security Instrument without further notice or demand on Borrower."

While the likelihood of foreclosure on a residential property due to the above clause is currently not very high because there are so many foreclosures clogging the market, an understanding of what is actually owned and mortgaged is frequently missing in the mind of a typical homeowner.

The popular view of a piece of residential real estate is a plot of dirt with a house on it. While it is true that these items are useful, the actual real estate is something different. Some definitions are in order.

estate : A right or interest in property. Defines an owner’s degree, quantity, nature, and extent of interest in real property. There are many different types of estates, including freehold (fee simple, determinable fee, and life estate) and leasehold. To be an estate in land, an interest must allow possession (either now or in the future) and be differentiated primarily by its duration.

freehold estate : An estate or possessory interest in land that lasts for an indeterminable length of time, such as for a lifetime or forever. Examples include fee simple (also called an indefeasible fee), defeasible fee, and life estates. The first two continue for an indefinite period and are inheritable by the heirs of the owner. The life estate terminates upon the death of the person on whose life it is based.

fee simple estate : Absolute ownership unencumbered by any other interest or estate, subject only to the limitations imposed by the governmental powers of taxation, eminent domain, police power, and escheat.

leased fee interest : A freehold (ownership interest) where the possessory interest has been granted to another party by creation of a contractual landlord-tenant relationship (i.e., a lease).

leasehold interest : The tenant’s possessory interest created by a lease.

Source: Appraisal Institute, The Dictionary of Real Estate Appraisal, 5th ed. (Chicago: Appraisal Institute, 2010).

Typically, when the buyer and seller of a residential property reach a meeting of the minds, the transaction that takes place is a transfer of a fee simple interest in the land and improvements. Theoretically (within the limits imposed by government), the owner of the fee simple interest may sell off all the materials that make up the improvements, and/or all the dirt, rocks, water, oil, or other minerals within the bounds of the property to the center of the Earth and still have the fee simple rights to the empty space left. He would have sold all the "stuff" that was on his real estate, but not the actual real estate itself.

This is one of the hardest concepts to pound into the heads of real estate appraisers, their lender clients, and the borrowers against the real estate. What is being appraised for a mortgage loan is not the dirt and sticks (although they play a part in determining what is available for quiet enjoyment of the real estate) but the market value of the bundle of rights that belong to the mortgagor. In fact, the FNMA/FHLMC forms used to report the appraisal clearly identify the Property Rights Appraised at the very top of the first page. In most cases, the lender is loaning money on the fee simple interest.

This creates some interesting potential problems for the mortgagor. Note that the lender reserves the right to call the loan if any interest in the property is sold without the lender's prior written consent. Let's look at some scenarios.

Pitfall #1. Big Bean Gas Company is aggregating parcels for a drilling unit, and strikes a deal with a group of owners in a subdivision for rights to the shale gas under their lots. Selling the rights to any possible underlying gas is a reduction of the fee simple interest in the property; under clause #18 in the mortgage above, it could trigger an acceleration of the loan payback, including a demand for immediate payment in full.

Pitfall #2. Joe Homeowner wants to move but can't sell his home due to the poor real estate market. He can, however, rent it out. He finds a perfect tenant, and signs a one year lease. The tenant now has a leasehold interest; the fee simple interest has been diminished (even if only for 12 months), and if the lease was entered into without the prior written consent of the mortgagee, acceleration is possible.

It is vital to remember that when a person mortgages real estate, he is signing a deed which gives most of his rights in the estate to the mortgagee in the event that a default situation occurs. It is a sale with a right of redemption. The mortgagor retains the rights to possession and quiet enjoyment of the estate, but those rights are only on loan from the new owner, the mortgagee, until the terms of the mortgage are complete. The rest of the rights to the estate may belong to the lender, and if the mortgagor attempts to take those rights back without the mortgagee's approval, it could be a trespass which could forfeit the entire estate to the mortgagee in foreclosure. When you borrow money, and grant a mortgage deed to the lender, be sure to carefully read the terms of that deed.