Even though I have been in the commercial mortgage business for 35 years now, I still learn new commercial real estate finance (CREF) terms every month. Here are some CREF terms that I've learned recently:
Dequity - Typically the maximum loan-to-value for commercial mortgage loans is 75% (80% LTV for multifamily). Typically the maximum loan-to-cost ratio for commercial construction loans is 80%. If the sponsor / borrower / developer needs more capital than that, he has to raise equity. Equity is typically very expensive - in the range of 12% to 24% annually. Dequity is slightly cheaper equity that is structured as debt. I'll explain this in more detail below.
Equity is the the cash downpayment, prepaid costs (for example, architectural and engineering fees), cash contribution, and/or the equity in the land that the sponsor contributes to satisfy the lender that there is enough of a cushion in the deal to protect the lender from loss. The equity investor is the first guy to lose money if the deal goes South. The equity owner is therefore known as the first-loss piece.
Carried Interest or Promote: In the hedge fund* world, the sponsor is the guy who raises the dough and manages the fund. He typically earns a management fee of 1% to 2% annually, plus a piece (often around 20%) of the investors' profit. This piece of the the profit is known as the carried interest or promote.
*Hedge Fund - A hedge fund is an investment fund that is exempt from many of the legal requirements and heavy costs of registration with the SEC because ALL of the investors are accredited investors (filthy rich guys). I put an asterik (*) in front of the word, "hedge fund", because the experienced commercial mortgage broker will be very leery about working with any commercial mortgage company that calls itself a hedge fund. A big percentage of the time, they will either be rookie-blowhards or flat-out advance fee scammers. Guys claiming to be merchant bankers are equally suspect. Ignore my warnings at your own peril.
Above I described dequity as equity that is structured as debt. Let me give you an example. Suppose a developer wants to build a speculative or "spec" office building. A construction project is considered speculative or spec if there is no pre-leasing.
The total cost of the project is $10 milllion, and construction lender - almost always a bank - will only go 80% loan-to-cost. The bank will make an $8 million construction loan.
The developer therefore will have to contribute $2 million in equity. He paid $400,000 cash for the land, but he got it rezoned from agricultural to office use (an amazing feat of politics). Everyone agrees that with this zoning change - a real value-added accomplishment - the land is now worth $850,000. The developer paid $50,000 to the structural engineer and $100,000 to the architect (prepaid expenses), so he has $1 million in total equity in the project ($850,000 + $50,000 + $100,000).
But he needs another $1 million in equity, so he approaches a broker-dealer that specializes in raising equity dollars for developers. The broker-dealer agrees to raise the $1 million for him, but the broker-dealer warns the developer that the money will be very costly - around 22% annually.
For legal reasons (less reporting requirements), the broker-dealer structures the deal as a mezzanine loan. You will recall that a mezzanine loan is similar to a second mortgage, except that the security for the loan is not a mortgage on the property, but rather a security interest (think of a security interest like a lien or mortgage on personal property - aka - chattel mortgage) on the membership interests of the LLC that owns the property.
Phew! Lost? Don't give up. A mezzanine loan is simply like a loan against the stock of a corporation that owns a property. If you own the 100% of the stock of the corporation, then you own the building.
Why go through the agony of all these fancy terms and exotic instruments? Because it can take 18 months to foreclose a mortgage on a property in many states. On the other hand, the finance company can repossess your car in a week, if you miss a payment. Why? Because the car is personal property, not real estate. Miss a payment - bam! You pull into a McDonald's. When you come back six minutes later with your burger, your car is gone-girl.
This is why the Big Boys making loans at the top of the capital stack make mezzanine loans. Late on a payment? Bam! Gone, girl.
Remember, we are melting your brain with all of these fancy terms, just to define dequity. Now normally mezzanine loans on standing properties (much less risky deals) only cost around 8% to 10% interest. Here the broker-dealer is charging us on the order of 22% interest. Now the coupon rate (note rate) might only be 8%, but the lender is also charging an 8 point exit fee, plus a profit participation (share of the profits) of 20%. Put them all together, and the lender earns his required 22% internal rate of return (IRR). Ouch.
By the way, an exit fee is merely a "prepayment penalty" that is owed, whether the loan is paid off early, exactly on time, or late. There is no escaping it.
Okay, okay, don't melt. We're finally there. You cursed child. I'm melting.
Dequity is equity money that is structured as incredibly-expensive debt.
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