one of the reasons Levin bought controlling interest in the Charlotte properties from Garfinkle was because improper management had created a high vacancy rate, threatening the flow of income from the property.
Another element which must be considered in valuing the wraparound is the requirement of a balloon payment on the Levin purchase-money mortgage. As noted above, for purposes of valuation, I am assuming that even if Levin were the holder of the wraparound, there would be a clause requiring a balloon payment on the Levin purchase-money mortgage. Levin's purchase-money mortgage was in the amount of $ 541,213. Although Levin would probably have agreed to strike this clause from the wraparound, because as holder of both mortgages it would be absurd for him to pay himself, I do not accept that the Garfinkle interests would have waived their right to a payment on their one-half share. Therefore, the holder of the wraparound, in its tenth year, would either have to make at least a $ 270,606 cash payment on the Levin mortgage, (representing the Garfinkle one-half interest), or would have to find new financing for that amount.
The balloon payment is required at the worst possible time for the holder of the wraparound, because after ten years the holder still has not realized any profit from the cash flow of the wraparound, as all of the money up to that point would have been paid out on the underlying mortgages. The requirement of a balloon payment scarcely makes the wraparound worthless, because the holder still stands to enjoy a substantial cash flow in the future. It does, however, have a depressing effect on its value.
Another clause in the wraparound provided that its holder could not foreclose on the property during the first three years of the mortgage if gross rental receipts from the property fell below debt service. Garfinkle's own expert projected gross rental income at over $ 650,000, whereas debt service even with the wraparound was only $ 385,000. Plainly, by the time gross rental receipts fell below $ 385,000, a senior lienholder would already have foreclosed on the property, and therefore the non-foreclosure clause would have little if any practical effect.
Taking these elements into account, I am persuaded that whatever may be true of wraparound mortgages generally, the wraparound offered to Levin was more in the nature of a conventional second mortgage than a first mortgage, and that it is unrealistic to discount the wraparound to present worth by a factor of only 7.25%.
Levin contends that the wraparound's subordinate position was reflected in the 7.25% interest rate, in that this rate was higher than several of the superior liens on the property. For purposes of considering market value, this is not a pertinent comparison to make. Rather, the relevant inquiry is what other comparable investments would have been available to an investor exploring the market in April of 1977. Evidence presented at trial by an officer of Continental Bank established that in any week of April, 1977, an investor could have invested in Federal National Mortgage Association ("Fannie Mae") bonds, which are not subject to any risk short of the collapse of the federal government, at rates higher than that of the wraparound: 7.69%, 7.56%, 7.42%, and 7.51%. Given the availability of risk-free investments like a Fannie Mae bond, relatively few investors would find the wraparound, with its much less secure position, to be an attractive investment at a rate of only 7.25%. Consequently, the present worth of the wraparound's hefty cash flow is much less than it first appears, and in calculating its market value according to a cash flow formula, I am convinced that a higher discount factor is appropriate.
Garfinkle's expert Block testified that the wraparound should be discounted by a factor of 15%, but that when the various clauses are taken into account, the mortgage has no value at all. I am not persuaded that the mortgage has no value. In Block's original evaluation of the wraparound, he did not identify the clauses unfavorable to its holder as making it completely devoid of value. It was only after counsel emphasized these clauses that Block came to this conclusion.
Moreover, Block conceded that the impact of the clauses and questions as to underlying value could not be quantified in terms of dollars. Plainly, if the property sustains itself, and there is no foreclosure in the early years, the holder of the wraparound has a valuable asset. The wraparound would prove to be worthless only if there were an early foreclosure, and although there is some risk of such an outcome, it is not so great as to make investment in the wraparound foolhardy. Likewise, the balloon payment is an undesirable feature, but by making the balloon payment, the holder of the wraparound secures the right to enjoy the hefty cash flow of the wraparound in its later years, and he need not make the payment until the tenth year, when he can evaluate his security and probably make a knowledgeable prediction as to whether the property will be able to sustain itself for the duration of the mortgage. Block himself conceded that certain types of investors could be found to "gamble" on such an investment.
Interest rates for conventional second mortgages in April, 1977, ranged from thirteen to fifteen percent. If I had no doubt about the underlying value of the Chatham Square property, and if there were no clauses in the wraparound which depressed its value, I would discount the cash flow at the lower end of the range of interest rates for second mortgages. Because of the particular characteristics of this wraparound, however, I am persuaded that a discount factor at the upper end of range for second mortgages is appropriate. Accordingly, I conclude that the market value of the wraparound mortgage offered to Levin should be derived by discounting the income stream by a factor of 15%. Applying this factor to the cash flow from the wraparound, the present value of the income generated by the wraparound mortgage, and its market value, is $ 264,214.
Judgment in that amount will be entered in favor of Levin, against defendant Howard Garfinkle for the value of the wraparound mortgage.