Real estate investors look for ways to earn a competitive return on investment while exposing themselves to minimal risk. One way to reduce investor or lender risk is through a hypothecation agreement. Therefore, in this article we’ll answer, “What is a hypothecation agreement?” and show you an example hypothecation agreement form. Then, we’ll discuss what you must know about hypothecation in real estate and elsewhere. Finally, we’ll discuss rehypothecation and answer a few frequently asked questions.
What Is a Hypothecation Agreement?
To understand what is a hypothecation agreement, let’s first define hypothecation. Specifically, it’s the pledging of collateral to secure a loan without relinquishing collateral ownership rights, possession, or title. A hypothecation agreement or hypothecation letter specifies the terms of the hypothecation arrangement. Importantly, it states the legal recourse available to lenders in case of debtor default. Usually, recourse is through a lien on the collateral property. Indeed, if the debtor defaults on the loan, the lender can seize the collateral and sell it to make itself whole.
Here you can find a sample hypothecation agreement form from the SEC archives.
What Should I Know About Hypothecation?
There are many aspects of hypothecation, which we’ll explore now.
Hypothecation in Real Estate
Usually, hypothecation in real estate appears in a transaction like a mortgage on commercial or residential property. That is, a borrower pledges an asset as collateral to secure a real estate loan. In doing so, the borrower does not give up ownership rights, title, or possession of the property. Nor does the borrower forgo any income that the property generates. On the contrary, the lender has no claim on the property’s cash flows.
Generally, a lender uses a hypothecation agreement when the owner of the collateral is not the obligor on the secured obligation. For instance, suppose Tom pledges his home as collateral for his fiancée Mary’s construction loan on her home. Tom is the owner of the collateral (his home) but isn’t the obligor on the secured obligation (Mary’s home). Hence, the hypothecation agreement specifies that Tom’s home, but not Tom, secures Mary’s construction loan.
A hypothecation agreement may specify that a tenant cannot hypothecate its interest in a lease or premises without landlord consent. The example below shows this kind of hypothecation agreement.
The situation changes if the borrower defaults on the loan. That’s because the borrower provides a lien to the lender as part of the loan agreement. When a borrower defaults, the lender can exercise the lien by foreclosing on the property. Then, it can sell the property to recoup any losses. If any sale proceeds remain, they go to the former owner of the property.
A second mortgage complicates the picture. If a lender forecloses and takes possession of the property, it becomes responsible for paying the second mortgage until it sells the property. Typically, the first and second lien holders work out an agreement on how to handle this unfortunate occurrence.
Differences Between Mortgage and Hypothecation Agreement
Although similar, a mortgage deed and a hypothecation agreement are not the same things:
- Title: In a mortgage, the title of the property passes from owner to lender as collateral for the loan. However, in a hypothecation agreement, title and possession remain with the borrower unless default occurs.
- Indications: A mortgage indicates that the borrower transfers its interest in the asset to the lender. Instead, a hypothecation agreement indicates that the borrower pledges the property as loan security.
- Tenure: Mortgage deeds are long-lived. Hypothecation agreements can be long-lived or short-lived, depending on the context.
Investment hypothecation occurs when a trader or investor pledges collateral for a margin loan to purchase or short securities. Specifically, broker/dealers (BDs) offer margin accounts that allow traders to borrow up to 50% of the securities’ value. The margin account agreement contains a hypothecation agreement for the collateral. Typically, the hypothecation agreement specifies important items:
- Form of Collateral: Cash collateral is possible, however, in most cases, the trader’s position serves as collateral for the loan. That is, the trader hypothecates the securities in the position to guarantee the margin loan.
- Credit Payments: Naturally, margin loans charge interest that the trader has to periodically pay to the BD. Failure to meet these credit payments can cause the BD to sell collateral and call for its replacement. Alternatively, the BD can sell some of the trader’s position to collect its margin interest.
- Margin Call: In a margin call, the trader’s position loses value so that the margin loan covers more than 50% of the position. Accordingly, the BD can demand more collateral in the form of additional prepaid securities or cash to restore the balance. If the trader fails to meet the call in a short period, the BD can liquidate the position.
- Rehypothecation: The hypothecation agreement states whether or not to allow rehypothecation (see below) and if so, how much.
The definition of rehypothecation is when a BD reuses a trader’s pledged collateral as collateral for the BD’s own trades and borrowings. This provides the creditor with leverage since the creditor doesn’t have to tie up its own assets. In the U.S., laws limit the amount of rehypothecation to no more than 140% of the original debit balance.
Interestingly, the creditor doesn’t carry the non-cash collateral available from rehypothecation on its balance sheet. A trader can indicate that it doesn’t want the BD to rehypothecate the trader’s collateral. The BD must then decide whether to grant a margin account to the trader. In some cases, the trader receives compensation for allowing the BD to rehypothecate the trader’s collateral. That compensation can take the form of lower interest rate on margin loans or a rebate of fees.
Video: Hypothecation, Rehypothecation and Churning
What Should I Know About Hypothecation?
Risks of Investment Hypothecation Agreements
When a Broker/Dealer grants a margin account to a trader, it must be able to handle three important risks. Normally, standard reports reveal these risky practices and prevent them from occurring.
- Sometimes, traders use prepaid securities, such as Treasury bills, to collateralize a margin account. The risk is that the trader may sell this collateral even as the position remains in effect.
- Traders may “double-dip” on financing margin transactions by hypothecating the same collateral multiple times.
- If the BD must execute a margin call, it might be costly for the BD to realize the collateral’s full value.
Repos and Reverse Repos
Repurchase agreements, or repos, allow a party to sell securities to a second party and buy it back later. The first party pays less than the sale proceeds to buy back the security. The buyback discount is the seller’s source of profit on the repo agreement. Thus, repo agreements are actually loans in which the sold securities act as rehypothecated collateral. Big banks and hedge funds use rehypothecated securities from their customers to undertake repo transactions. Most repos have an overnight term in which the buyback occurs the day after the sale. However, participants also use longer-term and open-ended repos.
A reverse repo is a repo transaction from the point of view of the borrower/buyer rather than the lender/seller.
Hypothecation Agreement Forms
The following language is for a real estate hypothecation agreement form and comes from Law Insider:
Hypothecation. Tenant shall not hypothecate, mortgage, or encumber Tenant’s interest in this Lease or in the Premises or otherwise use this Lease as a security device in any manner without the consent of Landlord, which consent Landlord may withhold in its sole and absolute discretion. Consent by Landlord to any such hypothecation or creation of a lien or mortgage shall not constitute consent to an assignment or other transfer of this Lease following foreclosure of any permitted lien or mortgage.
There are other types of hypothecation agreements, such as those for investments and repos. We leave it to the curious reader to ferret those out via appropriate Internet searches and their legal counsel.
If you’re interested, you can read this real-world example of a hypothecation agreement.
Frequently Asked Questions
What is hypothecation in commercial real estate?
Hypothecation in commercial real estate is the posting of collateral to secure a loan. Typically, a rental building operates as its own collateral. However, construction loans require other collateral since the borrower hasn’t built the underlying property yet.
Why is a mortgage like a hypothecation contract?
They aren’t really the same. In a mortgage, the borrower hold’s the property’s title until the borrower repays the loan. In a hypothecation agreement, the borrower keeps title to the property.
What’s the difference between hypothecation and pledges?
In a pledge, you intend to transfer the asset to another owner. In hypothecation, your intent is to collateralize the asset to guarantee a loan. Importantly, you plan to maintain title to the hypothecated asset after you repay the loan.
What is a hypothecation letter?
Hypothecation letter is another name for a hypothecation agreement. Sometimes, we call a hypothecation agreement a hypothecation deed. These are all synonyms for the same document that specifies the terms of a hypothecation arrangement.
When is a hypothecation agreement used?
Broker/dealers routinely use hypothecation agreements when setting up margin accounts. In real estate, a landlord uses a hypothecation agreement to prevent subleasing. Also, lenders use hypothecation in real estate when a different property secures a mortgage or building loan.