Why this matters: This article covers an owner’s use of property rights which allows a mortgage holder to capitalize on the due-on clause to extract further profit by calling the mortgage due and payable, or waiving the call to modify the interest rate and payment schedule at current market rates.
Part 1 of this multimedia article series explores when the due-on clause is used during an economic cycle in a sale, lease or hypothecation of property.
Does a tenant’s assignment of their leasehold trigger the due-on clause?
A tenant acquires an ownership interest in real estate on the landlord and tenant entering into a lease agreement. Thus, the landlord conveys a possessory right to exclusively use the property, called a leasehold estate.
Further, the tenant may transfer their leasehold interest by conveying either:
the tenant’s ownership of the leasehold to another person such as a sale of the leasehold estate, a grant called an Assignment of Lease [See RPI Form 596]; ora security interest to a lender as a lien on the leasehold such as a trust deed to secure a money obligation, sometimes called a collateral assignment.
A landlord’s fee simple ownership in a parcel of real estate remains with the landlord after conveying a leasehold interest to a tenant. Landlords often encumber their ownership with a trust deed lien originated by a lender, called refinancing or further financing. The mortgage lender’s trust deed form has a boilerplate provision entitled due-on rights or assumption. [See RPI Form 450 §3.3]
Here, neither type of assignment by a tenant of their leasehold estate triggers a mortgage holder’s due-on rights in a trust deed lien, unless:
the fee owner alters the tenant’s leasehold rights and obligations.
For example, consider an owner of commercial real estate who enters into a lease agreement granting the tenant a leasehold for more than a three-year term. After leasing the property, the owner refinances the property, recording a trust deed with a due-on clause.
Later, the tenant assigns their leasehold interest in the property to a new tenant when the remaining term is more than three years. The owner approves and consents to the assignment — as provided in the lease agreement — and the new tenant takes possession of the property. [See RPI Form 552 §9]
Here, the tenant’s assignment of the leasehold does not trigger the due-on clause. The mortgage holder with their lien encumbering the owner’s fee simple may not call the mortgage due. The due-on clause is not triggered by the tenant’s assignment of their leasehold or the owner’s consent to the assignment.
Further, the mortgage encumbers only the owner’s fee interest. The mortgage is not a lien on the tenant’s pre-existing leasehold interest carved out of the fee simple. The fee owner transferred no interest in the property by consenting to the tenant’s assignment. The tenant did, however, transfer their leasehold interest.
Now further consider the landlord who consents to the tenant’s assignment of their leasehold estate with a remaining term greater than three years. However, the landlord releases the original tenant from all liability under their lease agreement. Additional documentation includes an assumption of the lease agreement, obligations by the buyer of the tenant’s business opportunity (bus op).
The tenant sold their bus op which included an assignment of the tenant’s leasehold occupancy rights to the substitute tenant. The bus op buyer will continue the use of the premises to operate the business. These things happen during recessions.
Here, the mortgage holder secured by the owner’s fee simple interest in the property may call the mortgage due and payable.
What triggered the due-on clause in the mortgage was the release of the original tenant from liability coupled with the new tenant’s assumption of the lease agreement obligations. The owner altered the terms of the tenancy sufficiently to result in a new lease agreement as a matter of real estate law, called a novation. Critically, a novation functions as a cancellation of the original lease agreement.
As a new lease agreement, a leasehold interest in the mortgaged property was conveyed to the new tenant by the fee owner.
The mortgage holder may call the mortgage due when:
the original tenant is released from liability on the lease agreement;the new tenant assumes the lease agreement obligations; andthe remaining lease term exceeds three years.
When the call is not paid, the mortgage holder can enforce the payoff by foreclosure. [Wells Fargo Bank, N.A. v. Bank of America NT & SA (1995) 32 CA4th 424]
Lease term extensions and options to buy
Existing lease agreements are often modified by a change in a provision. The change triggers a call under the due-on clause in a trust deed encumbering fee title when the change:
extends the lease term beyond three years; orgrants the tenant a purchase option to acquire the owner’s fee simple.
Typically, an owner of commercial income property wants long-term leases to run for more than three years, an owner’s objective well known to mortgage lenders. For an owner’s due-on avoidance, each leasing period negotiated and agreed to with a tenant is for a term of three years or less, including:
the initial term granted in a lease agreement; andeach option period granted to extend the term of the leasehold.
When arranging a mortgage, the wording of the due-on clause in the trust deed document may by agreement be removed or modified. Through negotiations before the lender originates the mortgage, the owner can work out wording to narrow or remove the mortgage holder’s right to call the mortgage.
When the due-on clause in a trust deed is not removed or modified, and the leasehold period granted to the tenant exceeds three years, either initially or on exercise of an option to extend or renew, the mortgage holder may call the debt due.
Related video:
Due-on-further encumbrance
Here, we discuss an owner’s second trust deed activities which trigger the due-on clause in a senior mortgage and permit the mortgage holder to call the debt due, such as:
a further encumbrance of the property creating a lien junior to an existing mortgage;a deed-in-lieu of foreclosure conveying title to the junior lienholder; ora foreclosure sale by a junior lienholder.
Consider an owner-occupant of a single family residence (SFR) subject to a first mortgage which funded the purchase of the property, called a consumer-purpose mortgage. The trust deed contains a due-on clause.
The owner retains a broker to arrange an equity loan to be secured by a second trust deed on their property.
The broker, an old hand at second trust deed lending, tells the owner they are concerned about due-on enforcement by the senior mortgage holder during times of rising mortgage rates. The owner is advised the further encumbering of the property with a junior lien triggers their mortgage holder’s due-on clause, unless the activity is exempt.
On inquiry, the owner informs the broker they will continue to occupy the property as their residence.
Will the origination of an equity loan on title to an owner-occupied SFR property junior to an existing purchase-assist mortgage trigger the due-on clause in the mortgage?
No! When the owner continues to occupy the SFR and encumbers title with a second mortgage, it does not trigger the due-on clause in an existing purchase-assist mortgage. Due-on enforcement based on a further encumbrance is not permitted by the holder of a consumer-purpose mortgage on an owner-occupied one-to-four unit residential property. [12 Code of Federal Regulations §191.5(b)(1)(i)]
However, this permissive further-encumbrance rule is not what concerns a mortgage broker for an owner-occupied SFR encumbered with a purchase-assist mortgage. The concern is the further-encumbrance bar is a narrow single-event exception limited in application only to the origination of the junior mortgage, not later transfers of the owner’s interest.
Here, a foreseeable event — risk — for second trust deed holders is the owner may default, and any foreclosure sale under the second mortgage triggers the due-on clause. A second lienholder foreclosing does not want the risk of a payoff demand from the first mortgage holder when they acquire title.
Thus, junior financing also must include a written waiver of the senior mortgage’s due-on clause to allow the junior lender to become owner of the property by foreclosure or by deed-in-lieu of foreclosure.
The future trend of rising mortgage rates through the 2030s gives mortgage holders financial incentive to call mortgages on the transfer of any interest in the secured real estate — with exceptions for consumer-purpose mortgages on owner-occupied, one-to-four unit residential properties.
For real estate other than an owner-occupied, one-to-four unit residential property subject to a purchase-assist mortgage, a different rule applies. In contrast, any further encumbrance without first obtaining the existing mortgage holder’s consent and waiver of their due-on clause triggers the due-on clause. [See RPI Form 410]
Then the due-on-foreclosure call
Consider a parcel of real estate subject to a first and a second mortgage. The origination of the second mortgage either complied with a due-on exception barring lender interference or was consented to or waived by the holder of the first mortgage.
The property owner defaults on the first mortgage. The junior mortgage holder reinstates the first mortgage and begins foreclosure on the second lien, logical first steps to foreclosing but deficient, as now explained. The second mortgage holder keeps the first mortgage current and the mortgage holder advised of the foreclosure proceedings.
On acquiring title to the property at the trustee’s sale, the junior mortgage holder informs the senior mortgage holder they are now the owner-by-foreclosure, called a real estate owned (REO) property.
The senior mortgage holder promptly informs the junior mortgage holder as the owner of the property that the mortgage is now due and payable based on the transfer of the property by trustee’s deed. Intuitively, the mortgage holder offers to waive the call on the new owner’s assumption of the mortgage and a modification of the note’s interest rate and payments to current market rates. An assumption fee will also be incurred.
May the senior mortgage holder call their mortgage due based on the completion of foreclosure by the second mortgage holder?
Yes! A senior mortgage holder may call their mortgage due on completion of a foreclosure sale by a junior lienholder — on any type of real estate, no exceptions. To avoid the call, the second mortgage holder needed to negotiate a waiver of the due-on clause on either:
the origination of the senior mortgage or the second mortgage; or (belatedly at)any time prior to the second mortgage holder’s foreclosure sale.
The clause is also triggered by any involuntary foreclosure, such as a tax lien sale, or a judgment lien foreclosure sale. [Garber v. Fullerton Savings and Loan Association (1981) 122 CA3d 423 (Disclosure: the legal editor of this publication was the attorney of record for the buyer in this case.)]
During periods of rising mortgage rates and recessions, the further risk of a senior mortgage holder enforcing their due-on clause has a debilitating effect on an owner’s ability to enter into equity financing and carryback sales.
Prudent lenders and carryback sellers are unwilling to accept a junior position as security for money owed without a waiver of the due-on clause by an existing mortgage holder. A lender holding a lien junior to an existing mortgage is exposed to the risk of paying off the principal balance on the senior mortgage when they are forced to foreclose on the real estate. [Calif. Civil Code §2904]
The junior lender making payments on a senior mortgage to keep it current prior to the trustee’s sale does not waive the due-on clause triggered by the later-occurring trustee’s foreclosure sale under the junior lender’s second trust deed.
Related article:
(Re)introducing the due-on clause
Stay tuned for our final installment in this multimedia article series which explores exceptions and waivers to due-on clause enforceability.
