Subordination

Subordination is the ranking of claims against a property or a borrower so that one creditor’s right to payment and to the collateral is placed behind another’s. A senior lender is paid first from cash flow and from foreclosure proceeds; a subordinate lender, and then equity, are paid only from what remains.

How does subordination order the capital stack?

Every dollar invested in a property holds a place in a priority order. The senior mortgage lender holds the first lien on the real estate and is repaid first. A second mortgage, where one is permitted, holds a junior lien on the same property. A mezzanine loan is secured by the ownership interests in the borrower rather than the property, and is structurally behind every mortgage. Preferred equity is paid after all debt, and common equity takes whatever is left.

The order governs two things: who receives cash flow first while the loan performs, and who is repaid first when the property is sold or foreclosed. A subordinate position earns a higher return because it absorbs losses before the senior lender does.

Illustrative example:

The senior lender and the mezzanine lender are paid in full. The preferred equity recovers part of its position, and the common equity is wiped out.

What do subordination and intercreditor agreements do?

A subordination agreement is the document in which a junior creditor agrees that its claim ranks behind the senior lender’s. It takes two forms. Lien subordination ranks the junior creditor’s collateral interest behind the senior lien. Payment subordination goes further and restricts the junior creditor from receiving payments, or from keeping them, while the senior loan is in default.

An intercreditor agreement is the fuller contract between a senior lender and a mezzanine or subordinate lender. It sets out notice obligations, the junior lender’s right to cure a senior default, a standstill period during which the junior lender may not enforce its remedies, the junior lender’s option to purchase the senior loan at par after a default, and the conditions under which the junior lender may take control of the borrower.

What is an SNDA?

An SNDA is a subordination, non-disturbance and attornment agreement among a lender, a landlord and a tenant.

Subordination: the tenant agrees that its lease ranks behind the mortgage, so the lender’s rights on foreclosure are not limited by the lease. Non-disturbance: the lender agrees that if it forecloses, it will not terminate the lease or disturb the tenant’s possession so long as the tenant is not in default. Attornment: the tenant agrees to recognize the lender, or a purchaser at foreclosure, as its new landlord and to keep paying rent under the lease.

Lenders require SNDAs from major tenants because the leases are the income the loan is underwritten on. Without the agreement, a lease signed before the mortgage would be senior to it, and a lease signed after the mortgage could be extinguished by foreclosure, ending the income the lender is relying on.

What does subordination mean for a borrower adding mezzanine or preferred equity?

Senior loan documents commonly prohibit additional debt, liens and pledges of ownership interests without the lender’s consent. A borrower that wants to add a mezzanine loan or preferred equity therefore starts with the senior lender: consent and an intercreditor or recognition agreement.

The junior capital sits behind the senior loan in every respect. Its payments are subordinate, its remedies are subject to standstill, and its ability to take control of the borrower is conditioned on the senior lender’s transfer requirements.

For the borrower, subordination also changes the covenant picture. Combined debt service coverage and combined loan-to-value tests count the junior capital, a default under one instrument commonly triggers a default under the other, and the consent rights of two capital providers apply to leases, transfers and management changes.

How subordination shows up in LoanBoss

LoanBoss handles subordinate debt alongside senior loans, including the debt fund, mezzanine and preferred equity positions that come with bridge financing, and the LoanBoss team abstracts lender approval requirements and lease requirements from each loan, so the consent provisions that govern a junior position sit in the loan abstract beside the senior loan’s covenants.

Frequently Asked Questions

Related Terms

• Mezzanine Loan
• Preferred Equity
• Covenant
• CMBS
• Loan Abstract
• Lender Consent Requirements: Leases, Transfers and Management Changes Your Loan Documents Control
• Bridge and Debt Fund Loans: Extension Tests, Notice Deadlines and What Trips Borrowers

Part of the LoanBoss CRE Debt Glossary. For hedging-specific terms, see Pensford’s resources.