Summer 1979, Vol 4, No 1
During the last decade, interest rates on permanent mortgage loans used to finance income-producing properties have moved irregularly upward and currently are at just below their peak levels. These high levels of interest are a principal reason why many proposed real estate developments are not economically feasible, especially in the case of multi-family residential projects. The continued existence of high interest rates has resulted, how ever. in more frequent use of an
unusual form of second mortgage financing, the wrap-around (WA) mortgage loan. The WA mortgage loan offers a lender the advantage of an above-market yield while at the same
time enabling an investor-borrower to increase the wealth contribution of an existing real estate investment. Just how both parties to the transaction can thus benefit has nut been
previously analyzed in articles dealing with WA mortgage financing. This article, therefore, strives to present the essential financial characteristics of a typical WA mortgage loan from two perspectives: 1) that of a lender seeking to enhance the value of its mortgage portfolio, and 2) that of an investor borrower seeking to deal with the adverse financial and tax effects of increasingly larger amortization payments on a low interest rate permanent mortgage loan.
The WA Mortgage Loan: Enhancing the Lender’s Yield
The WA mortgage loan is a second lien which has as its principal amount the sum of 1) the outstanding balance on an existing first mortgage loan and 2) the additional funds advanced. After the WA mortgage loan closing, the WA lender receives debt service payments on the total debt and agrees to make principal and interest payments on the existing first mortgage loan, but only to the extent that such payments are
received from the borrower. In addition, the WA mortgage lender has the right, subject to the provisions of the existing first mortgage loan, to pay off the existing mortgage debt
and succeed to its priority. The WA mortgage note generally carries an interest rate which is less than the going market rate
for first mortgage loans. The WA lender, however, obtains the advantage of financial leverage because the interest rate on the existing first mortgage loan is lower than the interest rate on the WA mortgage loan. For example, assume that a first mortgage loan in the amount of $1,000,000, carrying a 6% interest rate, exists on a multi-family residential property. Assume further that a WA mortgage loan of $1,500,000 at 8% is negotiated. At the mortgage loan closing, the WA lender actually advances only $500,000, and during the first month this lender will earn a 12% annual yield on the net amount advanced.
The WA lender’s yield will change each month as debt service payments reduce the existing mortgage debt. Furthermore, as will be clear from the following example, the net amount
invested through a typical WA mortgage transaction (whereby both additional funds are advanced and the amortization term is extended) increases each month until the existing mortgage debt is completely amortized.