Commercial Loan Subordinate Financing

Commercial loan subordinate financing rules describe what may sit behind a first mortgage on an investment property. The junior piece is often a second lien or a seller carry, a note the seller takes for part of the price. The first-lien holder cares because that junior debt can take cash the senior payment needs, and because a junior creditor can take actions in a default that interfere with the senior loan. The senior loan’s intercreditor or subordination terms are how those risks get written down. They are the rules that actually close, and they differ by program.

This page is about a recorded lien on the property, or a seller note secured that way, standing behind a first mortgage. It is not a guide to drafting mezzanine documents. Mezzanine financing is commonly a pledge of ownership interests in the borrowing entity. Enforcement sits in the entity’s documents. A second mortgage sits on the real estate. That structure has its own explainer. If you need it, read it with counsel. Stay here if the question is a second mortgage or a seller who will carry paper behind a commercial first lien.

Nothing here is legal advice, a promise that a second lien will be allowed, or an offer of credit. An inquiry is not an approval.

Why commercial loan subordinate financing rules exist

A first mortgage is paid first from a foreclosure of the property. A second lien is paid from what remains, if anything remains. That order is the meaning of subordinate. It is also why the senior creditor writes rules. A junior creditor who can accelerate, add a large default rate, or foreclose on a short fuse can force a sale at a bad time or strip cash the senior loan was counting on. The senior terms slow that down.

Borrowers meet the same issue as math. Every required payment on a junior note is more debt service. Coverage is:

DSCR = net operating income ÷ annual debt service

If debt service includes only the first mortgage, the ratio ignores the second payment. If the program includes both payments, the ratio falls. A result of 1.00 means income in the formula equals the debt service you counted. A higher result is cushion. Programs choose the debt service definition, and they choose whether a junior payment is allowed at all.

Commercial loan LTV guidelines usually show a first-lien leverage line and, when subordinate debt is permitted, a combined line. Combined leverage adds the first loan and the junior balances, then divides by value. The combined ceiling often sits higher than the first-lien ceiling, because the senior piece is still a smaller share of value, and it is still a ceiling the program sets. This page will not quote a universal combined percent. Two programs can look at the same second lien and set different caps, or refuse the second lien.

Commercial loan covenants are where the ongoing rules live after closing: extra debt limits, cash-flow tests, and consent before you grant another lien. A subordination agreement signed at closing and a covenant that forbids new debt have to agree. A seller carry the covenant forgot to permit is a default waiting for an audit.

What the senior terms usually cover

A subordination or intercreditor agreement is the contract between the senior creditor and the junior creditor. Names vary. The themes are stable, and the exact clauses are negotiated. Counsel reads them. A borrower should still know the themes so the term sheet is not a surprise.

• Priority. The junior lien stays behind the first mortgage, including advances the senior documents allow, such as certain protective advances.
• Standstill. The junior creditor agrees not to enforce against the borrower or the collateral for a period, or not without notice to the senior creditor. The SBA’s public standby form, described below, is one example of a standstill idea. Private commercial files write their own periods.
• Payment limits. The junior note may be allowed regular payments, payments only from excess cash after the senior debt service, or no payments at all until the senior loan is paid. A note that accrues and a note that bills monthly are different risks.
• Amendment limits. The junior creditor may be barred from raising the rate, shortening the maturity, or increasing the balance without senior consent. A quiet increase in the junior balance raises combined leverage after closing.
• Cure rights. The senior creditor, or sometimes the junior, may want notice and a chance to cure the other’s default. Who gets how many days is a negotiation.
• Bankruptcy and foreclosure. The agreement says what each party may do if the borrower files, and whether a junior foreclosure can wipe out or must respect the senior lien. That is lawyer work. The business point is that the first lien’s position should survive the junior creditor’s remedies.

If the junior party will not sign, the senior loan often will not fund with that junior lien in place. A seller who wants carry and also wants a free hand to foreclose is asking for two things the senior side rarely grants together. Decide that before the purchase contract promises the carry.

Seller carry and the coverage test

Seller carry means the seller finances a slice of the price and takes a note. It can reduce the cash the buyer brings. It can also add a payment. Walk an illustration with round numbers, not a quote.

Value and price are $2,000,000. The first mortgage is $1,300,000. The seller carries $200,000. The buyer brings the rest in cash, including costs, so the combined property debt is $1,500,000. Combined leverage is $1,500,000 ÷ $2,000,000 = 0.75, or 75 percent, in this illustration only. A different program’s ceiling might sit above or below that figure. The illustration shows the arithmetic of adding the liens. It does not state a cap.

Net operating income is $160,000. The first mortgage payment is $110,000 a year. The seller note requires $18,000 a year. If the program counts both:

DSCR = $160,000 ÷ ($110,000 + $18,000) = $160,000 ÷ $128,000 = 1.25

If someone advertises the deal on the first mortgage alone:

DSCR = $160,000 ÷ $110,000 = 1.45

The 1.45 left out a bill the borrower must pay. A senior program that includes junior debt service will underwrite 1.25, or it will require the seller note to stand by with no current payments. Standby does not make the $200,000 disappear. Combined leverage still includes it. Model the junior maturity beside the first loan’s maturity.

A public example, and why your file will not copy it

The U.S. Small Business Administration publishes SBA Form 155, Standby Creditor’s Agreement. SBA describes the form’s purpose as a way for a standby creditor to subordinate lien rights to the SBA lender and to refrain from acting against the borrower or the collateral without consent. A copy of the note is attached. Lenders in that program may use Form 155 or their own standby agreement. The form is a public example of the category: priority plus a promise to stand still.

Use your commitment for the rules on your loan. If the standstill is negotiated away, expect the senior side to stop.

What to settle in the term sheet

Put the junior debt in the first conversation so nobody underwrites a fantasy capital stack.

• The junior balance, rate, payment, and maturity. If any of those are “to be agreed with the seller,” the senior file cannot finish.
• Whether payments are current, standby, or excess-cash only.
• The combined leverage the program will allow, in writing, for this property type.
• Whether junior debt service is inside the coverage test.
• Who must sign the subordination, and whether the seller’s counsel has seen the form.
• A covenant path that permits this junior lien and restricts the next one.
• Title order: first lien first, junior lien subordinate.

Then recompute cash to close. Seller carry reduces cash only for the slice of price it finances. It does not fund reserves or immediate repairs unless the documents say so.

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Frequently Asked Questions

What is subordinate financing on a commercial property loan?

It is debt that stands behind a first mortgage, often a second lien or a seller note taken for part of the purchase price. The senior lien is paid first from the property. The junior piece is paid only if the senior terms and the foreclosure outcome allow it. The senior creditor’s subordination or intercreditor terms set what the junior creditor may do.

Does a seller carry always count in the coverage ratio?

It counts when the program includes the junior payment in debt service. A standby note with no current payment may be left out of the payment test and still counted in combined leverage. A monthly seller payment that is omitted from the ratio overstates coverage. Ask which debts are inside net operating income divided by debt service, and run the version that includes every bill you must pay.

Can the junior lender foreclose if the senior loan is current?

Often the subordination agreement restricts that. A standstill can require notice and a waiting period, or bar enforcement unless the senior creditor consents. The exact right is in the signed agreement. If the seller will not accept a standstill, the first-lien program may refuse the carry, so have counsel read the enforcement section before you rely on it.

Is a second mortgage the same as mezzanine debt?

A second mortgage is a lien on the property, junior to the first mortgage. Mezzanine debt is commonly a pledge of equity in the entity that owns the property, documented and enforced differently. This article stays with liens on the real estate and with seller carry. Mezzanine terms are a separate legal project.

Will every commercial first mortgage allow a seller second?

Some programs allow a seller carry inside a combined leverage limit and a coverage test. Some allow it only if payments are deferred. Some refuse junior liens. The ceiling and the payment rule differ, so get the subordinate terms in the term sheet before the purchase contract promises the seller a note.