My private money commercial mortgage company, Blackburne & Sons, once had to foreclose on a commercial first mortgage loan on an office building in the State of New York. Even though the borrower didn't fight us very much, because New York is a mortgage state, as opposed to a trust deed state, it still took us well over 18 months. The process through the New York courts was very, very slow.
Now imagine if we had a made a $200,000 commercial second mortgage behind a $1.5 million first mortgage. Remember, if a borrower defaults on his first mortgage, the second mortgage holder has to keep the first mortgage current while he forecloses; otherwise, the second mortgage holder risks being wiped out by a foreclosure of the underlying first mortgage.
It doesn't really matter how much equity the property enjoys. The property in the above example could have been worth $4 million, and the second mortgage holder would still be wiped out 99% of the time. Why? In real life almost no one ever bids at commercial foreclosure sales.
The reason why is because the bidder has to show up at the foreclosure sale with enough cash to pay off the entire foreclosing first mortgage. If the first mortgage was was originally $1.5 million, with accrued interest, late charges, penalties, legal fees, and foreclosure costs, the bidder would probably have to bring a cashier's check to the foreclosure sale of almost $2 million! This just doesn't happen in real life.
Okay, so in our example, we made a $200,000 second mortgage behind a $1.5 million first mortgage. We have to keep the first mortgage current, and let's suppose the monthly payments on the underlying first mortgage were $15,000 per month. If the foreclosure took 18 months, the second mortgage holder would have to advance 18 payments of $15,000 or $270,000 - just to protect a tiny $200,000 second mortgage. Yikes!
Clearly commercial second mortgages behind large first mortgages are darned risky. Therefore smart financiers came up with the idea of mezzanine loans.
You will recall that a mezzanine loan is loan secured by the stock of the corporation that owns the property. (More precisely, since most real estate investors use LLC's, rather than corporations, a mezzanine loan is a loan secured by the membership interests of the LLC that owns the property. For ease of understanding throughout this article, however, I will continue to use stock and corporations, rather than membership interests and LLC's.) If you own all of the stock of the corporation that owns the commercial property, you own the commercial property.
What's the big advantage of a mezzanine loan over a commercial second mortgage loan? Stock is personal property, not real property. A foreclosing lender does not have to go through the long mortgage foreclosure process. Instead, he can simply advertise the foreclosure sale of the stock in a commercially reasonable way and then hold the sale in some attorney's office. Since no courts are involved, a mezzanine loan foreclosure can happen in just 60 to 70 days!
So far, so good. But there is a problem. The alienation clauses of most standard commercial first mortgages prohibit the hypothecation (the pledging of an asset as security for a loan) of the stock of the corporation that owns the property and which borrowed the underlying mortgage loan. Banks and conduits do this because they don't want some idiot-rookie taking over the management and control of a some multi-million-dollar commercial property.
So how then are mezzanine loans ever made? The mezzanine lender signs an intercreditor agreement with the underlying first mortgage holder, whereby the first mortgage holder agrees not to disturb the mezzanine lender, if the mezzanine lender forecloses, as long as the mezzanine lender keeps the first mortgage current.
But good luck ever getting a bank to sign an intercreditor agreement. The vast majority of the time, the bank will refuse to sign an intercreditor agreement; and if they ever do agree to sign one, it takes months of negotiations and thousands of dollars in legal fees.
Commercial second mortgage loans and mezzanine loans are therefore very, very rare. Monday we will talk about the ratio of new money to old money and preferred equity.
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