This article explains the mechanics of a due-on clause which allows a mortgage holder to call the debt due and immediately payable as enforcement of the due-on clause becomes more common in times of rising interest rates.
Rising interest rates bring lender interference
Consider a property encumbered by a trust deed containing a due-on clause that is offered for sale or lease. A tenant is located for the property. On completion of negotiations, the owner and tenant enter into a two-year lease agreement with an option to purchase the property.
Does the lease agreement and option to buy trigger the due-on clause in the trust deed and allow the mortgage holder to call the debt due and payable, and if not paid, foreclose?
Yes! A trust deed’s due-on clause is triggered by a lease agreement for any period of time when coupled with an option to buy the property. Thus, the mortgage holder may call the debt due and payable on their discovery of the lease-with-option to buy transaction and foreclose when not paid in full. [12 Code of Federal Regulations §591.2(b)]
Related Client Q&A:
Lender interference by federal mortgage regs
When real estate is encumbered by a trust deed containing a due-on clause, the transfer of any interest in the real estate allows the lender to enforce the clause limited only by federal mortgage regulations.
Thus, by preemption, Californians are deprived of their state-law right to lease, sell or further encumber their real estate interests free of unreasonable lender interference. [12 United States Code §1701j-3; Calif. Civil Code §711]
For the owner of income property encumbered by a trust deed, due-on enforcement is triggered by:
- leasing the property for a period greater than three years; or
- entering into a lease agreement for any term when coupled with an optionto buy.
When the mortgage holder discovers any of these types of leasing arrangements, the lender can interfere by either:
- calling the mortgage, also known as accelerating the mortgage, by demanding the remaining balance be paid in full; or
- demand the mortgage terms be modified and additional fees paid as a condition for the lender’s consent to the transfer triggering the call, called a formal assumption.
Economics of the due-on clause
In times of consistently rising interest rates (as expected through 2040), mortgage holders seize on any opportunity to enforce the due-on clause as a means for increasing the interest yield earnings on their existing mortgage portfolio.
This legislation authorizing a mortgage lender to use a due-on clause to call or restructure a mortgage debt shifts the lender’s risk of loss to the property owner when long-term interest rates rise by increasing the rate of interest and payments on both fixed rate mortgages (FRMs) and adjustable rate mortgages (ARMs).
Related article:
Federal policy favors this lender interference on the sale, lease or further encumbrance of any type of mortgaged real estate. The interference is deemed a means for maintaining mortgage lender solvency at the expense of mortgaged property owners exercising their right to transfer — alienate — ownership interests in the property.
A real estate interest, such as the fee simple, leasehold estate, easement, or a security interest, when the ownership is encumbered by a trust deed containing a due-on clause, becomes increasingly difficult to market in periods of rising interest rates.
Lender interference is then virtually guaranteed by their relentless cyclical pursuit for ever higher portfolio yields while at the same time property prices are suppressed by continually rising mortgage rates.
The increasing inability of owners to lease their properties and retain existing financing has an adverse economic effect on long-term leasing transactions, as well as sales and equity financing.
Ultimately, as rising mortgage rates bring on lender interference, many long-term tenants, buyers and second trust deed lenders are either driven into unencumbered properties or out of the market.
These conditions further depress property prices since the owner or tenant has a reduced ability to sell, lease, assign a lease or mortgage an interest they hold in the property.
Unless the existing lender’s consent is obtained, the possibility of due-on enforcement and a call weakens the mortgaged owner in negotiations when leasing property containing an initial or extension period longer than three years.
To better represent owners and tenants, leasing agents need to understand which leasing arrangements trigger a due-on clause, which do not, and how to avoid or handle the lender’s consent. The starting point for a leasing agent is to first order out a property profile to determine which mortgages liens are on a property to be marketed for lease or for sale.
Related article:
Due-on-leasing clauses
Consider an owner with a short-term interim construction mortgage on commercial rental property who seeks a mortgage commitment from a lender for long-term, take-out financing.
Editor’s note — “Take-out financing” is a commitment to provide permanent financing after construction is complete and a requisite rate of occupancy is attained.
Funding of the take-out mortgage is conditioned on the property being 80% occupied by tenants with initial lease terms of at least five years.
The owner locates tenants for 80% of the newly constructed property, all with lease terms of five years or more. The occupancy condition being met, the lender funds the mortgage. The trust deed securing the mortgage contains a due-on clause.
The five-year leases entered into to qualify for the refinancing precede the recording of the refinancing. Thus, as preexisting leases, they do not trigger the due-on clause in the new lender’s trust deed since the leaseholds have priority to the mortgage holder’s security interest.
However, after recording the trust deed, the owner continues to lease space on their property to additional tenants for five-year terms. None of the new leases are submitted to the lender for approval. Thus, no waiver of the due-on clause is obtained before entering into these new leases.
Mortgage interest rates rise over the subsequent months. Then, a former loan officer of the lender visits the property and requests a rent roll to review their security interest in the property. The officer discovers the new tenants have lease terms exceeding three years.
The lender sends a letter to the owner informing them the lender is calling the mortgage since “It has recently come to our attention…” that the owner has entered into lease agreements with terms longer than three years without first obtaining the lender’s consent — an incurable violation of the due-on clause in the trust deed.
The owner claims the lender cannot call the mortgage since the lender required medium-term leases as a condition for funding the mortgage. Thus, the lender is estopped from invoking the due-on clause.
Can the lender call the mortgage or demand a recast of its terms?
Yes! Requiring leases with terms exceeding three years as a condition for funding the mortgage did not waive the lender’s right to call or recast the mortgage when the owner entered into leases with a term greater than three years after the trust deed was recorded.
It has recently come to our attention…
When a trust deed lien with a due-on clause encumbers income property, the owner, prior to entering into a lease agreement, needs to orchestrate one of the following situations to avoid a call:
- lease the property for an initial three-year period with options to extend for three-year periods but without an option to buy;
- obtain the lender’s consent before leasing; or
- negotiate the elimination of the due-on clause from the trust deed.
Related article:
Assignment or modification of the lease
The tenant’s assignment or encumbrance of their leasehold interest in property does not trigger the due-on clause in a trust deed which encumbers the owner’s fee interest. However, the owner’s modification of an existing lease agreement triggers the due-on clause when the modification:
- extends the term beyond three years from the date of modification; or
- adds a purchase option.
For example, consider an owner who enters into a long-term lease agreement with a tenant. Later, the owner takes out a mortgage secured by a trust deed containing a due-on clause.
After the trust deed is recorded, the tenant assigns their leasehold interest in the property which has more than three years remaining to another person who will take occupancy, all with the owner’s approval, as agreed to in the lease agreement.
Here, the tenant’s lease assignment does not trigger the lender’s due-on clause. The lender’s trust deed only encumbers the owner’s fee interest, not the tenant’s leasehold interest in the property. Thus, the tenant’s assignment of their unencumbered leasehold does not trigger the lender’s due-on clause in the trust deed lien on the fee ownership. The leasehold assignment did not transfer any part of the fee interest which is the lender’s security.
However, consider an owner who releases their tenant from all liability under an existing lease agreement as part of an agreement with the substitute tenant for their assumption of the lease. A trust deed with a due-on clause encumbers the owner’s fee interest, whether the trust deed is junior or senior to the lease.
Here, the release of the original tenant from the lease agreement coupled with an assumption of the lease agreement by the new tenant constitutes a novation. The novation legally cancels the original lease agreement and establishes a new lease agreement with the owner conveying an interest in the secured property to the new tenant on the same terms. [Wells Fargo Bank, N.A. v. Bank of America NT & SA (1995) 32 CA4th 424]
Related article:
Negotiations and conduct as waiver
Commercial mortgage lenders have the power, through their federally permitted use of the due-on clause, to dictate the fate of the majority of long-term real estate leasing transactions since most real estate is encumbered by trust deeds.
However, an owner intending to lease their real estate for a period greater than three years and avoid lender interference needs to consider:
- eliminating or placing some limitation on a lender’s due-on-clause use when negotiating the origination of the mortgage; or
- negotiating a waiver of the lender’s due-on rights each time they enter into a lease agreement. [See RPI e-book Landlords, Tenants and Property Management, Chapters 30 and 35]
Due-on clause waiver agreements are basically trade-offs compelled by the existence of a due-on clause in a trust deed. The lender will demand some monetary extraction for waiving or agreeing to eliminate or limit its future due-on rights.
This consideration typically takes the form of increased points on origination, increased interest on the trust deed note, a shorter due date and an assumption fee for each consent. [See RPI Form 410]
The lender’s waiver of its due-on rights applies only to the current lease transaction under review for consent. Unless additionally agreed, any later leasing of the property which triggers the due-on clause allows the lender to call or recast the mortgage again, due to the nonwaiver provision in the trust deed.
Besides obtaining a written waiver agreement, waiver of the lender’s due-on rights may occur by the lender’s conduct. This waiver-by-conduct is critical for buyers taking title subject to the mortgage — no formal assumption. When a lender fails to promptly enforce its due-on rights upon gaining knowledge of a sale, lease or further encumbrance transaction, the lender loses its right to later enforce the clause based on that event.
Waiving the due-on clause by conduct
For example, consider an owner who enters into a lease agreement with a tenant for a term exceeding three years. The leased property is encumbered by a mortgage secured by a trust deed containing a due-on clause. The lender is informed of the leasing arrangements by letter to put the lender on notice, or during an annual audit.
The lender then calls the mortgage due under its due-on clause based on the lease transaction. However, the lender continues to accept payments from the owner for several months after the call while stating it is unilaterally reserving its due-on rights. The lender makes no other comments regarding the call.
Here, the lender, by its conduct of accepting periodic payments which are inconsistent with a call, waived the right to enforce the due-on clause. The lender accepted payments from the owner for an extended period of time after calling the mortgage and doing nothing to enforce the call. [Rubin v. Los Angeles Federal Savings and Mortgage Association (1984) 159 CA3d 292]
Related article:
Broker liability for due-on avoidance
Again, a lender can call the mortgage only when it discovers a lease agreement with a term longer than three years, or a lease with an option to buy, or a sale or further encumbrance.
When the tenant’s option to purchase is not recorded and the lease agreement is for a term less than three years, the lender might not discover the transfer which triggered its due-on clause.
However, when the lender later discovers the lease with its option to purchase, the lender’s only remedy against the owner or the tenant is to call the mortgage due or agree to recast the mortgage as a condition for retroactively waiving its right to call.
The lender cannot recover any retroactive interest differential from the owner or tenant for a higher rate they would have charged at the time the clause was actually triggered. Also, when the lender calls the mortgage, it cannot add the retroactive interest differential to the mortgage payoff amount. [Hummell v. Republic Fed. Savings and Mortgage Assn. (1982) 133 CA3d 49]
However, an advisor, such as a leasing agent or attorney, assisting the owner or tenant to hide the lease and option to purchase from the lender to avoid due-on enforcement may be found to have wrongfully interfered with the lender’s legal right to call or recast the mortgage.
Here, the advisor assisting the owner or tenant to hide the lease and option to purchase may be held liable for the lender’s losses, called tortious interference with prospective economic advantage.
The advisor’s liability is dependent upon:
- the extent the actions were intended to conceal the lease agreement and prevent a call by the lender; and
- the foresight that the advisor had regarding the lender’s likely losses due to the concealment. [J’Aire Corporation v. Gregory (1979) 24 C3d 799]
The lender’s losses caused by the advisor’s interference when considered wrongful are calculated based on the interest differential between the note rate and the market rate at the time the lease commenced, retroactive to the date of commencement. Hence, the title of retroactive interest differential.
Related article:
Want to learn more about managing rental property during the recession? Click the image below to download the RPI book cited in this article.
If the lender finds a lease agreement with a duration that is greater than three years, they have the legal right to call in the mortgage.