Cross collateralization borrowing is when the borrower looking to buy Asset “A” using Asset “A” and include a separate Asset “B” as security on the loan. Asset “B” can be either free or clear or already used as collateral on a separate loan as secondary security on the Asset “A” loan.
Cross collateralized borrowing can be attractive for lenders as they will have additional security against what they lend over what they would have without it. The lower risk could result in lower finance costs or greater flexibility in the loan terms.
However we should note that while the low cost of borrowing is a clear benefit of cross collateralization, there are also risks associate with this borrowing strategy.
The advantages and disadvantages entirely depends on the individual circumstances but here are some key highlights:
Cross Collateral Impact on Equity Withdraws
If the investor is looking to withdraw equity down the track a crossed collateral loan can make the process easier or more difficult.
As condition of withdrawing equity the bank could require an updated valuation of the asset. In this instance where all assets and lending are grouped together, then it will require a revaluation of the whole portfolio. The value would be beholden to the ups and downs of all of the assets in the portfolio.
The net gain is the sum of all of the gains and losses in the portfolio with the outcome dependent on multiple variables.
On the otherhand if the assets were held separately, then investors can choose to withdraw equity from the strongly performing asset and not the weaker performing asset dragging down the whole portfolio from an equity perspective.
Lender Concentration Risk in a Cross Collateralized Facility
Usually the first requirement for cross collateralize loans is that the same bank must provide all of the loan. This means the real estate investor will be exposed to the banks lending and interest rate policy across their whole portfolio. This can be further complicated if mezz financing is used.
If the lender changes their policy or lending strategy down the track, all of the refinancing risk is concentrated in one place.
In the case if the borrowing facilities were separate across multiple lenders. The investor would have to only refinance a portion of the portfolio that is exposed to the market at that point in time.
By retaining all borrowing exposure with a single bank, the borrower is trapped unless they meet credit and lending criteria of another lender for their whole portfolio.
Restriction on Proceeds for Sale
If one of the asset is sold is a cross collateralize relationship. The bank could dictate first priority of the proceeds to repaying borrowed amount.
This means the equity portion of the proceeds can be nominated by the bank to repay them first before any withdrawals thereby reducing total capacity to reinvest the equity to make up the lost income from the asset just sold.
For example if assets are held in separate bank loans. If investors sells one asset they can repay the bank that lend against the asset only and use the equity proceeds for another opportunity.
If assets are cross collateralized, then the lender could require the borrower to use all of the proceeds to reduce the total loan outstanding. If the intention is always to reduce debt then both cases will result in the same outcome.
However if the investors are looking for flexibility in withdrawing equity then cross collateralization complicates the process.
To recap all the points above. The key impact from cross collateralization is increasing the complexity and liming flexibility at a potential lower interest rate. It is up to each investor to judge if the trade off is worth in the medium and long run.
For individual rental property owners which the property is held in their own name. It is important to check and understand that only because the loans are under separate accounts within the same bank such as credit card and mortgages means that all accounts are linked together through the “all money” clause.
Any asset can be called to repay anytime which in means that they can even force sale your home to repay a credit card debt or in our example force sale of first asset to repay total debt outstanding. While this is the extreme and unlikely unless the borrower is grossly negligent, nonetheless it is an interesting fact to know.
If loans are separated across multiple banks then one property could be sold and pay out the loan without involving the other properties.