S.E.C. Real Estate Observer

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Editor’s Note: This article originally appeared in the November 1973 issue of the Real Estate Observer.

You know – a lot of us tend to forget the “velvet hammer” in making real estate transactions for our clients who are buying with cash or are exchanging desirable vehicles. The term applies to the position the new owner takes when he owes the seller a purchase money 2nd and the seller is simultaneously executing a lease back on the property. To insure the seller’s performance on the lease back the seller puts his 2nd purchase money up to secure his performance on the lease back.

Let’s see how it works:

Mr. Able exchanges for a $300,000 building from Mr. Baker putting in a $50,000 free and clear lot and giving Mr. Baker a $50,000 purchase money 2nd above the existing $200,000 loan. In the exchange, Baker agrees to lease back the building at 7% spendable cash return to Able on his investment (7% of $50,000 invested = $3,500).

Able’s broker has been around the barn a couple of times, and he asks that Baker “guarantee” his performance on the lease back by putting his $50,000 purchase money second up as collateral security so that if Baker should default on the lease, the purchase money second will be null and void

Now what happens?

The purchase money 2nd due Baker from Able, and the lease back agreement, are put into an escrow with specific instructions to the escrow agent that upon satisfactory proof of default on the lease by Baker, they are authorized to record a full (or partial – depending on what was originally negotiated) satisfaction of that purchase money 2nd deed of trust.

The satisfactory proof could be a written notarized statement signed by both Able and Baker that the lease was in substantial default and the escrow was to follow its written instructions. Check with your attorney on other methods of resolving the default.

Benefits?

Obviously Able now has a superior lease from Baker because the 2nd he owes Baker is security for the lease. If Baker defaults, Able owes $50,000 LESS on the property which is a neat benefit to Able. Baker, of course, must have enough benefits coming to allow him to make the transaction in the first place. Normally he will be acquiring something very desirable to him such as cash, good paper, or property that motivates him strongly. If he should not perform on the lease back as per the agreement then WHAM!!! comes the velvet hammer and Baker loses $50,000 in paper -or whatever the balance is when the default occurs.