Mortgage as collateral: always good, right?

1st mortgage or a 2nd or 3rd mortgage as collateral

Sometimes in the Private Debt market, loans are offered with a mortgage as collateral. Upon closer examination, it appears to be a 2nd or 3rd mortgage. First mortgages provide more security than second or third mortgages because in the event of bankruptcy or default, holders of first mortgages have priority over second or third mortgages. This also means that holders of second or third mortgages often do not have the right to initiate a foreclosure sale, which increases the risk. None of that has to be a problem as long as your total loan to value is low. So: keep looking critically!

Loan to value ratio (LTV)

Of course, the loan to value ratio (LTV) is important. For example, an LTV of 60% means that the loan is only 60% of the property’s appraised value, providing a solid cushion against potential depreciation. An example: for a loan of € 600,000 with a 1st mortgage on real estate with an appraisal value of € 1 mio, an LTV of 60% arises. Then you could already be €100,000 in interest arrears and then the collateral would have to be sold for eventually less than €700,000 before the principal + interest is not paid. That’s a nice buffer! But we also sometimes see financing with a 1st mortgage with an LTV of 100% or higher. Then it’s a different risk after all.

Appraisal

An appraisal report is very interesting. This report should provide insight into the value of the collateral. Read the report carefully: where did the appraisal value come from? Does the appraiser have solid experience on similar properties in the region in question? In practice, we see valuations on rental capitalizations passing by that are on the high side in relation to the actual quality of the property. An acceptable LTV in such a case may give a distorted picture.

Alternative uses of the property

Flexibility in the use of the property plays a significant role in the risk assessment. The agricultural sector is a prime example of this: suppose you finance a pig farm with a fine appraisal report and low LTV, but pig prices are in a slump, there are no buyers. After all, the stables can only be used for keeping pigs. There is no alternative use. Such a situation occurs in many more sectors.

The lien and its impact

Last but not least, the lien. Ouch! This could hurt! If a contractor does not receive his payments, he can stop construction and file a lien. That right is legally above the mortgage right, and it allows the contractor to sell the (often half-finished) property to cover his costs. So of great importance to properly assess an investment/financing plan with the main question: is there sufficient capital to complete or deliver the property?

Mortgage as collateral: always good?

It’s a little more nuanced than that. Proper assessment requires proper analysis. In that case, a mortgage right is a strong right. Investing in Private Debt does not have to be risky, provided you know what to look out for when making a loan.