Commercial Loans Blog

Preferred Equity and Commercial Second Mortgage Lenders Do Exist

Posted by George Blackburne on Mon, Feb 12, 2018

Preferred Equity.pngI have a real treat for you today.  A buddy of mine, Yoni Miller of QuickLiquidity.com, makes preferred equity investments and second mortgage loans on commercial property.  He has generously agreed to write today's fascinating blog article about all of the unique types of preferred equity investments and commercial second mortgages that junior commercial lenders can make.

 

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Before we get into Yoni's wonderful article, I first just want to give you a quick refresher course on preferred equity investments.  Preferred equity is similar to a second mortgage on a commercial property.  You own a $6 million shopping center, and you owe just $2.5 million against it.  You need $1 million to convert a former K-Mart space into self-storage space.

You just can't go out and refinance the building because you have a defeasance prepayment penalty.  You would have to pay a prepayment penalty of $850,000 just to borrow $1 million.  The first mortgage loan documents prohibits second mortgages.  You can't even put a mezzanine loan on the property because the first mortgage loan documents prohibit mezzanine loans too.  The trust that bought the first mortgage does not want the owner to take on any additional loan payments.

 

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A preferred equity investment is NOT a loan.  Therefore it does NOT have any loan payments.  A preferred equity investment is a purchase of some of the membership interests (think of shares of stock) in the limited liability company (think of a corporation) that owns the commercial property.

The preferred equity investor only gets paid if the property is generating enough cash flow.  Because the investment is preferred, the preferred equity investor gets a paid its return first, right after the first mortgage payment, but before any of the other owners of the property can pull out a dime.

Now on to Yoni's insightful article.  Who knew such unique financing and liquidity strategies actually existed?

 

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Commercial real estate owners strive to create additional equity in their investment properties.  (George: By renovating the property, leasing out vacant units, replacing existing tenants with higher paying tenants, and paying down on the first mortgage.)  Once they have created a significant amount of equity, they unfortunately have few ways to monetize it.  (George:  Pay attention here folks.  Lots of investors have tons of equity, but they don't know how to monetize it!)

The most common way to monetize equity in a commercial real estate investment is a cash-out refinance, but some borrowers' existing first mortgages have hefty prepayment penalties, meaning if they were to refinance and payoff their existing mortgage, they have to pay extra fees, which can vary greatly.  In many cases these prepayment penalties make it costly to do a cash-out refinance with a new lender, making them look for alternative options for them to monetize their equity.

 

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Two of the most popular options are second mortgages and equity recapitalizations, which may allow them to monetize their equity without disturbing their existing first mortgage. Let’s discuss what each of those are and then provide a few real life examples.


What is a “Second Mortgage”?

Investopedia answers the questions for us.  “A second mortgage is a type of subordinate mortgage, made while an original mortgage is still in effect. In the event of default, the original mortgage would receive all proceeds from the liquidation of the property until it is all paid off.  Since the second mortgage would receive repayments only when the first mortgage has been paid off, the interest rate charged for the second mortgage tends to be higher and the amount borrowed will be lower than that of the first mortgage.”

 

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What is a “Equity Recapitalization”?


An equity recapitalization in commercial real estate is changing the mix of the capital that creates the real estate capital stack (George: On $100 million office building purchases in New York City, the capital stack often gets very, very layered.  For example, there's the first mortgage, then mezzanine loan #1, then mezzanine loan #2, then the senior preferred equity, then the junior preferred equity, then the venture equity, and finally the developer's or borrower's cash contribution.)

An equity recapitalization is often done to buy out existing partners, create liquidity for new investment opportunities, or for capital needed for tenant improvements. A common way to achieve this is by bringing in a new capital partner or preferred equity investor. This helps an owner create the liquidity they need without giving up management control or majority ownership of the property.

 

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Here are four examples of how QuickLiquidity, a direct lender and preferred equity investor recently helped commercial real estate owners and limited partners monetize their existing equity.

1)    QuickLiquidity funded a $1.4 million second mortgage on a $50 million shopping center located in a suburb of Kansas City, MO. The borrower, who is an experienced developer, needed to monetize his equity in a 235,000-square-foot shopping center without refinancing their existing first mortgage. The borrower had recently created significant equity in the shopping center by redeveloping it and securing new long-term leases with national tenants. The borrower's existing first mortgage lender would not increase their loan for the purposes of a cash-out, leaving the borrower with a limited amount of financially feasible options to quickly monetize their equity. If the borrower were to refinance their first mortgage with a new lender, the closing costs and fees to replace the large first mortgage would be significant compared to the relatively small $1.4 million cash-out amount. QuickLiquidity offered a solution by providing the borrower with a second mortgage on the property. This saved the borrower a ton of money in fees and provided them with the capital they needed in the time frame they needed.

 

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2)    QuickLiquidity purchased a 2.53% partial interest for $460,000 in a real estate partnership that owns a 199-unit apartment community in Fairfax, VA. (George: Pay attention here.  QuickLiquidity actually purchased a tiny interest in the LLC that owned the property.  This was NOT a preferred equity investment.  After the purchase, the interest that QuickLiquidty purchased was pari passou with that of the other investors in the project.  In the words of the Church Lady, QuickLiquidity was NOT special.)  The seller inherited the partial interest over 30 years ago and was seeking an immediate exit strategy from their illiquid and non-controlling interest. By QuickLiquidity coming in as a new passive investor, the seller was able to receive immediate liquidity without having to wait until the partnership decides to sell the property, which might not occur for many years.

3)    QuickLiquidity provided $1 million of post-petition debtor-in-possession (DIP) financing to a commercial real estate investment fund in Chapter 11 bankruptcy. The DIP financing is secured by a priority lien against the funds ownership interests in 5 properties totaling almost 500,000-square-feet, between three office buildings and two retail shopping centers. This loan provided the necessary capital to allow the fund to operate while pursuing a confirmable plan of reorganization.

 

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4)    QuickLiquidity made a $500,000 loan secured by a 9.39% illiquid and non-controlling ownership interest in a $30 million shopping center located near Cincinnati, OH. The property is 320,000-square-feet.  The shopping center is 100 percent occupied, with its anchor tenants being The Home Depot, Kroger, and Kohl’s, who have leases that continue until 2024 and 2025. The borrower looked to monetize its illiquid and non-controlling ownership interest to access capital in order to invest in a time sensitive real estate development deal. By bringing in QuickLiquidity as the lender, the borrower was able to receive the capital he needed, while maintaining complete ownership of his interest. (George:  Note, unlike example 2 above, QuickLiquidity did NOT buy the borrower's membership interest in the LLC that owned the shopping center.  Instead, they made a loan against it.  This is incredibly rare and invaluable to know.)  This allows the borrower to receive the property’s future appreciation and upside, while leveraging his existing investment.

Yoni Miller.jpgQuickLiquidity is a direct lender and preferred equity investor providing equity recapitalizations, subordinated debt and partner buyouts on commercial real estate nationwide. QuickLiquidity allows real estate owners to monetize their existing equity while maintaining majority ownership and control of their property without disturbing their existing first mortgage or triggering any prepayment penalties. For more information you can visit www.quickliquidity.com/recapitalizations.html or call Yoni Miller 561-221-0881.

 

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Topics: preferred equity

Commercial Second Mortgages and the New-Money-to-Old-Money Ratio

Posted by George Blackburne on Thu, Feb 8, 2018

Second mortgage-1.jpgYou don't see many new second mortgages on commercial properties these days.  The reason why is because most modern first mortgage loan documents contain an outright prohibition against any sort of junior financing.  It's not just conduits that prohibit junior financing.  Commercial banks now also prohibit junior financing.

The section of a first mortgage that prohibits junior financing is called the alienation clause.  An alienation clause is one that says that the alienation (transfer) of any interest in the property, without the permission of the lender, is grounds to accelerate the loan and to demand that the loan be immediately paid in full.  The really sucky part of such an acceleration is that the payoff demand will contain the full prepayment penalty!  Ouch.

 

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"But George, what if there is tons of equity in the property?"

One way a big-time investor can pull equity out of an underleveraged commercial property is to obtain a mezzanine loan.  Unfortunately mezzanine loans and preferred equity investments are also considered junior financing and are usually prohibited.  In some cases, however, an intercreditor agreement can be negotiated.

 

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An intercreditor agreement is an agreement between a first mortgage holder and the provider of junior financing, which could be a second mortgage lender, a mezzanine lender, or a preferred equity investor.  The first mortgage lender looks at the junior lender for experience in actually operating the type of property involved and for his financial strength.  If the junior lender is a newbie with no financial strength, the first mortgage lender will say no.  If the junior lender is an old pro with deep pockets, the first mortgage lender will sometimes agree in writing to permit the junior financing.  There is often a provision that says that the first mortgage lender will notify the junior lender immediately in the event of a default.  The intercreditor agreement will also often allow the junior creditor to buy the first mortgage in the event of a default.

 

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Okay, with this long-winded background in mind, we finally get to the point of today's training lesson.  This week a buddy of mine who makes preferred equity investments (like a second mortgage but with no required monthly payments) sent out a tombstone.  He proudly announced that his company had just made a second mortgage of $1.4 million behind a $32 million first mortgage on a $50 million shopping center in Kansas City.

Holy crap!  A second mortgage of only $1.4 million behind a $32 million first mortgage???  So I wrote to him, "My friend, this loan grossly violates the New-Money-to-Old-Money Ratio."

 

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Back in the old days of hard money, second mortgage lenders learned the hard way never to make a small second mortgage behind a huge first mortgage.

Example:

Newbie Mortgage makes a $20,000 second mortgage behind a $500,000 first mortgage on a house worth $1 million.  There is tons of equity.  Then the borrower becomes a crack addict and stops making all payments.  By the time the second mortgage finds out, the first mortgage is behind 7 payments of $4,000.  Just to cure the loan, Newbie Mortgage has to come up with $28,000.

Then Newbie Mortgage is facing another nine-month ordeal to march to a trust deed sale and to obtain relief from the automatic stay of bankruptcy.  That’s another $36,000.  And then there are attorneys fees and foreclosure costs.  That’s an advance of over $54,000 - just to protect an original investment of $20,000.

Ninety percent of similar investors, in real life, end up just walking away from their $20,000 loan.

 

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The Irony: 

The first mortgage lender goes to a foreclosure sale.  No one bids, so the first mortgage investor ends up owning the property.  After a $15,000 clean-up and facelift, the lender ends up later selling the property for $1.3 million.  Arghh.

New-Money-To-Old-Money Ratio

New Money / Old Money > 33%

In plain English, the wise second mortgage investor will avoid making any second mortgage where this ratio is less than 33%.  In other words, the second mortgage should be at least one-third the size of the first mortgage for the reasons explain above.

 

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Now back to my buddy's deal:  Let's compute his New-Money-to-Old-Money Ratio.

($1.4 million / $32 million) x 100% = 4.3%

Holy crap!  This ratio is never supposed to be less than 33%.

Now my buddy is pretty sophisticated and he pointed out that his Fund had negotiated a very good Intercreditor Agreement.  The underlying first mortgage holder had agreed to notify them immediately in the event of a default.

 

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In addition, his Fund had the option to purchase the underlying first mortgage in the event of a default.  His Fund would love to own this $32 million first mortgage because it had an attractive default interest rate.  It would also love-love-love to own this gorgeous shopping center for a mere $32 million.

He had also gotten personal guarantees from the high net worth borrower and other high-equity LLC's.  Lastly, the shopping center had a number of long-term leases from credit tenants and near-credit tenants.

By the end, I agreed that his was a reasonably prudent investment, but only because his Fund had deep-deep pockets.

 

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Folks, I have done a pretty smart thing.  I have started to trade my wonderful video training courses  to mortgage brokers all across the country for a list of ten bankers making commercial loans.  We are adding these banks to CommercialMortgage.com ("CMDC") in huge handfuls.  Man, CMDC is getting soooo useful.  And its free!

 

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Topics: New Money to Old Money Ratio

Why Banks Dislike Commercial Real Estate Investors

Posted by George Blackburne on Mon, Feb 5, 2018

Tool and die.jpgIf you are a multifamily or commercial property investor yourself, today's training article is really going to open your eyes.  Banks dislike you just for breathing.

Example #1:

Bob Tool opens a successful tool and die business.  He has a net worth of around $2 million, and he clears about $140,000 per year.  Bob hears about a competitor going out of business, and he has an opportunity to buy $3 million's worth of equipment for just $600,000.  Bob therefore applies to Steve Veteran, a very experienced commercial mortgage broker, for a $600,000 on his industrial building.

 

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Now Bob Tool's industrial building is not terribly pretty.  It is a 30-year-old steel building that is showing its age.  Old industrial equipment litters the yard.  Bob had approached a couple of banks on his own, but the answer was the same.  The banks just didn't like the collateral.

Now Steve Veteran has survived for twenty years in the business for a reason.  He understands banking.  Bob therefore does a Google search for small banks located close to Bob Tool's business. He find the First National Bank of Nearby.  Then Steve calls the bank president (branch manager), and sets up a meeting between the three of them.

 

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At the bank, Steve introduces Bob to the bank president and explains, "Mr. Banker, Bob owns a successful tool and die company near you.  He needs to borrow $600,000 for five years, but he is willing to change banks and move all of his corporate and personal accounts over to your bank."  

The banker's face breaks into a BIG smile.  "Welcome, Bob, you've come to the right place."  The banker knows that Bob may end up keeping his accounts at the bank for the next decade or two.  Because Bob's business is successful, he will probably maintain sizeable cash balances in those those accounts, money with which the banker can make loans to other customers.

This is The Banking Game, and Steve Veteran, the old-time commercial mortgage broker, played the game to perfection.

 

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Example #2:

John Investor does not own a company.  Instead, he owns and manages several apartment buildings.  Like Bob Tool, he has a net worth of aound $2 million, and he clears about $140,000 per year.  John Investor hears about a five-plex that was just forclosed upon by a hard money commercial lender.  The building is worth, once it is cleaned up and rented out again, on the order of $3 million.  He can buy this building from the hard money lender for $900,000.  John has the downpayment, but he needs a $600,000 loan from the bank.

John Investor therefore call the bank and sets up a meeting with the bank president.  At first the banker is all smiles, but as soon as the banker hears that John is a real estate investor, his attitude markedly changes.  "I'm sorry, Mr. Investor, but I know that apartment building.  It's pretty rundown.  This deal is not for us."

 

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Frustrated and sensing some distinct coldness from the banker, Steve argues, "But, Mr. Banker, I am going to be fixing up the building.  Within 18 months, the building will be pristine.  I'll even move my bank accounts over to your bank."  "I'm sorry," stonewalls the bank president, "but this deal is not for us."

Okay, so what happened?  Both borrowers were successful businessmen.  Both had good credit.  Both made good money.  Why did the banker dump all over the real estate investor, like he was some sort of low-life?

 

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Answer:

Real estate investors seldom leave large cash balances in their bank accounts.  As soon as they have amassed a decent grubstake, they go out and buy another building.  In addition, real estate investors like to use leverage, so most of them are paying on large real estate loans.  

Real estate invesors are not good bank customers; i.e., they don't maintain large cash balances in the bank.

 

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Much of the Above is No Longer True

Huh?  Not true?  Its pretty easy for banks these days to raise deposits.  All they have to do is to raise their interest rates a little higher than that of the competition, and new deposits will flow into the bank.  The problem, however, is that this is hot money, and hot money can flow out as quickly as it flowed in.

Money center banks and the big regional banks will seldom turn down a good real estate loan these days because of the lack of deposits.  These big banks are experts at matching their deposits with their loans.  By the way, a money center bank is a very large bank located in an economic hubs (large cities such as Los Angeles, New York, London, and Hong Kong) and earn revenue from transactions between themselves and governments, big businesses, and other banks, rather than the individual consumer.

 

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While money center banks and large regional banks typically have all of the desposits  they need, this is not true of community banks.  Community banks still have to play The Banking Game, using their ability to make short term loans to entice businesses to maintain large cash deposits in their bank.

 

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Topics: Banks dislike investors