IMPORTANCE OF SUBORIDINATION OF DEVELOPMENT LOANS TO RESTRICTIVE COVENANTS

By: Eric B. Coleman, Esq.

Serious problems can occur if a lender fails to subordinate its development loan to a community’s restrictive covenants, restrictions, and easements during or prior to development. If the loan goes into default and the lender forecloses, the result can be chaos for the association and property owners. Developers and property managers should be cognizant early in the development of the potential for such issues, particularly where there is a successor declarant. If not properly subordinated, the foreclosure of a development loan can wipe out restrictive covenants and easements, result in common property being owned by a lender (or worse, no one), and result in utter confusion over what the owners can do, who will pay for it, and who has authority to make things right.

Typically, security deeds for development-and-construction loans and the restrictive covenants that will govern the new development are recorded relatively concurrently. At a minimum, there is typically continuity between the parties involved. The usual situation is this: a developer acquires a piece of property it intends to subdivide, develop, and resell financed by a construction-and-development loan. The developer and lender agree on a development strategy and securitization of the development loan. Their efforts are coordinated, their lawyers communicate, and the efforts are typically well organized. In such cases, the lender subordinates its security deed to the covenants by signing a consent and subordination, which is attached to the covenants, or by a separate subordination agreement recorded concurrently with, or in some cases subsequent to, the recordation of the covenants.

But sometimes, particularly where there is turnover either of the developer or lender, multiple development loans are secured by the undeveloped property, or the project is significantly reorganized, a security deed can be recorded that takes priority over restrictive covenants, easements, and restrictions that are crucial to the operation of a covenant-controlled community. The results can be disastrous.

Winter Capriola Zenner recently helped a community where the lender failed to subordinate its security deed to the covenants and restrictions of a community of single-family homes that was under construction. The community had a private water system containing infrastructure within association easements. But when the lender foreclosed, the common-area easements housing the water system were wiped out and part, but not all, of the water system was transferred to the purchaser at the foreclosure sale. The community was left in chaos, no one had full authority to operate the water system, and whoever had practical ability to operate it had no authority to collect payment for it (because that authority was contained within the community’s restrictive covenants). Ultimately, WCZ attorneys were able to work with a number of involved parties to prepare and file the necessary easements and agreements to keep the system running. But the entire issue could have been avoided had the lenders subordinated their security interest to the governing documents.

There are dozens of similar stories, where access rights, assessment rights, gate operation, road ownership, and other similar rights important to life in a covenant-controlled community were lost or compromised by the foreclosure a security deed not properly subordinated to restrictive covenants. This is a result that developers, lenders, and owners all want to avoid. Industry professionals, including property managers, should verify that all security deeds for development and construction loans are subordinated to restrictive covenants before foreclosure proceeds begin and it becomes too late to fix.