Lenders are faced with an ever-increasing number of defaulted commercial real estate mortgages, forcing them to either modify the loan or foreclose on the collateral Workouts remain attractive for lenders with loans in which the value of the property is insufficient to repay the outstanding balance.

This active workout market has caused lenders to employ various non-traditional means to make themselves whole. One such method is the use of an equity kicker, equity participation, shared appreciation or contingent interest loan, in which the lender receives, in addition to traditional interest payments, the right to a percentage of the income or profits from the property. With the promise of future income, a lender may be more willing to negotiate terms with the defaulting borrower.

A mortgage loan with an equity participation generally involves a below market, fixed interest-rate payment to the lender at a high loan-to-value ratio and additional interest payments. It is based on the gross or net cash flow generated by the operation of the property. Shared appreciation payments may also be calculated based on a percentage of the appreciated value of the property at the time of any stipulated equity event, such as a sale or other transfer.

Lenders must be aware of various legal complications in connection with equity participations. One possible complication is that the equity participation will constitute additional interest that may violate applicable usury laws. Though in many states usury statutes do not apply to commercial transactions, in certain jurisdictions lenders must structure the equity participation to avoid violating usury restrictions.

Lenders should also consider whether the right to receive a percentage of the borrower's income will survive the maturity of the loan. In certain jurisdictions, a mortgage containing an equity participation that grants a right to receive gross or net income cannot survive the payment in full of the loan. A lender in that case should structure the participation at a fixed amount due on the maturity date of the loan. The lender may also consider structuring the equity participation as an agreement, separate and independent of the mortgage, so that the right to receive profits survives the termination or release of the mortgage. However, this contractual agreement would not typically be recorded against the property in the manner that a mortgage is recorded and third parties would not be afforded notice of the contractual agreement.

Another legal claim that a borrower could make is that the equity participation violates the common law doctrine prohibiting any clog of the equity of redemption. Under common law, no agreement between a mortgagor and mortgagee may prevent the former from redeeming and retaining ownership of the property by paying the indebtedness in full prior to a valid foreclosure decree. If any provision in the loan documents prevents the mortgagor from being able to redeem the property after default, then such provision may be invalidated as a "clog" on the equity of redemption.

Clogging issues should not normally arise in connection with contingent interest and shared appreciation mortgage loans. The mortgagor will have the opportunity to redeem the property in a subsequent foreclosure. Since these types of transactions make capital available to borrowers and allow lenders to participate in the properties' value over time, courts would be reluctant to invalidate them. A lender may also avoid a clogging issue by assigning a set value to the equity participation and allowing the borrower to liquidate the equity participation by paying such amount.When a lender foreclosures in an equity participation loan with a contingent interest or shared appreciation, borrowers have argued that the mortgage is a disguised equity interest of the lender in the property and the proceeding should be dismissed. To avoid such a claim, the mortgage should clearly state that the contingent interest or shared appreciation components are part of the mortgage loan transaction and do not grant the lender any equity in the property.

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Equity Participations in Property Loan Workouts

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