Substitution of Collateral - "Walking The Loan"

One of the least known and one of the most powerful tools for the Real Estate Investor is the use of Substitution Of Collateral. Let’s look at an example using this technique.Mr. Riley owns 100 acres of prime timberland in East Texas. The fair market value of this land is $500,000. The land is free & clear of encumbrances. Mr. Riley would like to purchase an Apartment Complex in Tyler, Texas – owned by Mrs. Graves. The price of the apartments is $400,000. Mr. Riley buys the apartments with $100,000 down and Mrs. Graves finances the balance for Mr. Riley who executes a $300,000 note secured by a Deed of Trust.

Mr. Riley is an experienced investor who has bought, sold, and/or exchanged several properties in the past. When he negotiates the purchase of the apartments he receives the future right to substitute collateral for the $300,000 he owes Mrs. Graves on the apartments. The contract and Deed of Trust stipulate that the substitute property must be of equal or greater value of the property being substituted for. The wording could also be something like, “The property being offered as Substitute Collateral must have an appraised value of $125% of the amount of the money owed”, or whatever number is agreeable by the parties.

To continue our example: Let’s say that 3 years go by. Mr. Riley has upgraded the apartments, increased rents, etc. and the Fair Market Value of the apartments is now $550,000 and the remaining balance on the loan to Mrs. Graves is $291,840. Mr. Riley has an opportunity to exchange the apartments for a Commercial Strip Center which has a great future growth in value potential. However, the owner of the Strip Center will not accept the apartments with the loan on them. He wants them free & clear.

So, Mr. Riley exercising his right of Substitution of Collateral, moves the loan on the apartments, owed to Mrs. Graves, “Walks The Loan”, to the 100 acres of timberland. The apartments are now free and clear and Mr. Riley can complete his exchange for the Strip Center.

I highly recommend to anyone that anytime they are negotiating a purchase wherein the seller, or anyone else, is providing the financing, always ask for the right to substitute collateral in the future. Even if they, at present, don’t foresee a use for it, it is a good right to have.

Also, it does not have to be Real Estate. The collateral could be Private Property, Stocks, Bonds, Jewelry, Boats, Planes, Automobiles, etc.

These posts are the opinion of the author who is not engaged in rendering legal, accounting, or investment advice. If such advice is required or desired, the services of competent professional persons should be sought.