Commercial Loans Blog

Mezzanine Loans, Preferred Equity, and Venture Equity - Part II

Posted by George Blackburne on Mon, Jun 6, 2016

Office_tower.jpgThis whole subject of mezzanine loans, preferred equity, venture equity, capital stacks, senior stretch financing, A/B Notes, and syndicated loans is called structured financing.  Relax.  I am going to give you a quick refresher course about each of these fancy terms.

Most of us human (as opposed to god-like) commercial mortgage brokers will seldom dwell in the lofty palaces of structured financing; but we don't want to look like complete newbies if the subject ever comes up at a commercial lending conference or in a conversation with a very wealthy commercial borrower.

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Think of a mezzanine loan as sort of like a second mortgage, but its a type of second mortgage that a lender can foreclose in six weeks rather than six months.  A mezzanine loan is always junior to some huge first mortgage (typically $10+ million), and a mezzanine loan is secured, not by a mortgage, but rather by the stock of the corporation* that owns some trophy office building or huge shopping center.  If you foreclose on the stock, you then own the corporation as well as the property!  And since stock in a corporation is personal property (pay attention - this is on the test), normal mortgage laws don't apply.  Just like a finance company can repossess your car in just a few days if you miss a payment, so can a mezzanine lender foreclose on a billion dollar office tower in New York City.

*  More precisely, everyone uses LLC's these days, and the stock equivalent in LLC's is a membership interest. If you foreclose on 100% of the membership interests, you own the LLC and the $500 million shopping center.

 

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Think of preferred equity as if it was a second mortgage as well, but technically preferred equity is not a loan.  It does not have regular monthly payments.  It's an investment in the ownership of the property; however, the most a preferred equity investor can earn is some agreed upon yield - typically 12% to 14%.  The bad news is that the preferred equity investor is not guaranteed to earn, say, 13%; but the good news is that if the owners of the property earn anything, those earnings go first to pay the preferred equity investors.  They're preferred.  Mother always loved them best.  As the Church Lady might say, they're special.

 

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In my last blog article, I explained venture equity.  It's joint venture money.  The bank wants the developer to have invested 20% of the total cost of the project; but on the really huge deals, no one has $10 million in cash to put into a single deal.  Opportunity funds (think of them as go-go funds or the play money of the super rich)  will contribute 70% to 90% of the required equity in return for a preferred yield of, say, 8%, and 50% of the profit in the deal.

"Geez, George, my eyes are glazing over.  Do I really need to know this stuff?  I'm just doing $500,000 to $5 million commercial loans."

If you don't completely understand everything today, don't freak out.  I will try to review structured finance every few months; but yes, eventually you will want to master this stuff.  If not, then you will always lack confidence when negotiating larger commercial loans.

This verbal proof story will help you to understand.  My hard money mortgage company once made a loan on an office building in New York.  It tooks 18 months to foreclose!  That's how slow the courts were there.  Arghh!  Now, can you imagine if my loan had been a $200,000 second mortgage behind a $1 million first mortgage with monthly payments of $10,000 per month?  In order to keep my $200,000 second mortgage from being cut off by a foreclosure of the first mortgage, I would have needed to advance a whopping $180,000 to cover the first mortgage payments during that 18-month foreclosure process.  

Now think about a $50 million first mortgage on some office tower with payments of $290,000 per month.  If you made a $5 million second mortgage on this building worth $1 billion, and the borrower defaulted, you might have to make $290,000 monthly payments for 18 months while you foreclosed! In other words, you would have been required to advance another $5.2 million in order to protect your original $5MM loan.  Ouch!!!

This is why smart investment bankers invented the mezzanine loan.  They needed a way to foreclose FAST!  Some first mortgage documents forbid mezzanine loans.  This is why preferred equity was created.

 

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Almost done for the day.  You may recall that I blogged last year on senior stretch financing.  It's when a single lender blends the rate of a conventional first mortgage with the rate of a mezzanine loan to come up with a single first mortgage loan with a higher blended rate and a higher LTV.  

The next to the last subject is A/B notes.  To prepare to write today's article, I had to go onto Google and search for "A/B notes and C-Loans".  I found a great blog article on A/B notes written by... me!  Remember this trick.  Suppose you wanted to understand hypothecations, but you like the way that I explain things.  You could simply go onto Google and type, "hypothecations and C-Loans".  [Sons, when I move on to that great party boat in the sky, remember this trick.]

An A/B note is when a lender spits up a giant first mortgage into a larger "A" portion and a smaller "B" portion.  The "A" portion has priority.  The "A" portion gets paid first.  The two different portions are then sold off to different investors. 

Last subject:  When fancy New York investment bankers finance the huge office towers, you might have a capital stack that looks like this in terms of priority:

 

$200 million first mortgage at 4.75%
$50 million mezzanine loan Piece A at 8.2%
$20 million mezzanine loan Piece B at 9.5%
$12 million preferred equity Piece A yielding 12.0%
$8 million preferred equity Piece B yielding 14.0%
$18 million venture equity investment with a yield expectation of 20%
$4 million buyer's downpayment

And all I want is a lousy 2 points of the entire $312 million in financing.  Am I asking so much?  :-)

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Final funny:  Many pessimists got that way by financing optimists.

 

Topics: structured finance