This is an immensely important blog article for you. If you can make the leap from just arranging commercial real estate loans (debt) to arranging both commercial real estate debt and real estate equity, you will have truly become a commercial real estate financier.
The first step to becoming a true financier is to understand the concept of equity. The link above is an article that you should read first before going any further. I please mean it. Equity has about a dozen different definitions, depending on the situation. Please read this article first before going any further.
Okay, now that we understand the concept of equity, let's talk about the cost of equity.
Equity is the first-loss piece. It's kind of like that old joke: What do a divorce and a tornado have in common? Answer: Somebody is going to lose a trailer. If anyone is going to take a loss in a real estate deal, its going to be the holder or the contributor of the equity.
For example, let's suppose four yuppies pool their savings to buy a rental duplex in Council Bluffs, Iowa. Between the four yuppies, they put 30% down on a $200,000 purchase price. Crop prices suddenly fall, over-leveraged farmers across the country start losing their farms in foreclosure, and John Deere closes the nearby manufacturing plant. Ten thousand workers are laid off in Council Bluffs, and rents plummet.
The yuppies can no longer find tenants for their rental duplex, they fall behind in their mortgage payments, and eventually the house sells at the foreclosure sale for $150,000. After the $10,000 selling costs (foreclosure trustee, title policy, closing costs, etc.), the bank nets $140,000 - enough money to be repaid in full.
All is well, right? Not if you contributed the equity! The first people - and in this case, the only people - to lose money in this failed investment were the contributers of the equity. They lost their entire $60,000 downpayment. Equity is always the first-loss piece.
Remember, we're talking about the cost of equity. Investing in equity is very, very risky, and in order to attract investors, the potential return has to be higher than what they can receive in competing real estate investments.
Well, banks are making commercial first mortgages at around 5.5%. Their loans are pretty safe, typically just 65% LTV to good credit borrowers. Hard money lenders are offering investments in commercial first and second mortgages at rates of between 10% and 14% (and they charge their borrowers 3 to 5 points as well). Even hard money second mortgage investments are far safer than equity investments.
Therefore, you should not be surprised to learn that equity investors want to earn at least 16% to 20%. In addition, the broker syndicating the investors is going to charge at least 6 to 10 points. This isn't just what Blackburne & Sons is charging. This is the market. Equity is expensive.
Equity money is also very difficult to raise because of the risk. Therefore, Blackburne & Sons can only raise equity for commercial real estate projects in amounts of between $150,000 and $600,000. In other words, we play only in the minnow pond when it comes to equity.
Here are some sample scenarios:
- The owner of a company has a balloon payment coming due on his industrial building. He owes $2 million. The property was once worth $3 million, but after the Great Recession it has fallen to just $1.9 million. The bank has offered to accept a discounted pay-off (DPO) of just $1.35 million, but the largest new mortgage he can find is $1.1 million. He is $250,000 short, and he doesn't have the dough to make up the difference. Blackburne & Sons may be able to raise the $250,000 short-fall.
- An experienced commercial real estate investor spots the deal of a lifetime - a partially leased office building in an affluent part of town that would cost $3 million to rebuild. The seller has accepted a $2 million purchase offer, and the buyer has 25% ($500,000) to put down. The buyer approaches every bank in town, but none of them (the big sissies) will lend more than $1.1 million because of the vacancies. Blackburne & Sons may be able to raise the $400,000 short-fall for him.
We will pay referring brokers a finder's fee of 2 points on the net amount ($250,000 and $400,000 in the examples above) of the equity we raise.
Got a potential equity deal? Please call or write Angela Vannucci, Vice President and the General Manager of our Equity Department, at 916-338-3232 or email her at firstname.lastname@example.org.
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