This is the ninth article in my series on commercial second mortgages. My private money commercial mortgage company, Blackburne & Sons, is a C-corporation (the garden-variety kind of corporation that we saw everywhere before LLC's became legal). If Blackburne & Sons makes a profit, my corporation has to pay income taxes on that profit. Individuals, C-corp's, and many trusts all have to pay income taxes.
When commercial mortgages are syndicated, you will recall that a huge pool of commercial loans are assigned to a trust. The trust then issues bonds, secured by the loans in this trust. As payments come in, the payments are first applied to the safest tranches of bonds. If there is any money left over, the bonds in the second safest tranche get paid; and so on. Many large securitizations ($1+ billion) of commercial mortgage-backed securites (CMBS) have more than ten different tranches.
But what about income taxes? The trust is a business entity. The trust is making gobs and gobs of interest income. Doesn't the trust have to pay income taxes? And what about the investors in those mortgage-backed bonds? Do they effectively get taxed twice - once when the trust pays income taxes and again when these bond investors receive their interest payments?
Absent direct action by Congress, the answer would have been, "Yes, the trust has to pay its own income taxes, and later the bond holders have pay income taxes again." Fortunately, Congress wanted to increase the flow of capital to the commercial mortgage market. Congress therefore created a special kind of trust - the real estate mortgage investment conduit (REMIC). This is where the term, conduit lender, comes from.
A REMIC does not have to pay income taxes, as long as it does not act like a "for profit" company. A REMIC is sort of like a mindless computer, programmed with certain rules dictated by the trust agreement. [Said in a mechanical, lifeless voice:] "I am an automotron. I am not allowed to think. I must always follow the rules outlined in the trust agreement, even if this results in millions of dollars in unnecessary losses for the trust. I am an automotron."
As long as the REMIC acts like an automotron, the trust does NOT have to pay income taxes. It is a pass-through entity. The income from the commercial loans in the pool pass through to the bond holders without any additional tax liability.
However, if the trust ever starts making business decisions of any kind - even reasonable, common sense decisions designed to save the bond holders millions of dollars - the REMIC loses its tax-free status!
Now we started out two weeks ago talking about how the loan documents of most commercial mortgage lenders modernly contain a strict prohibition against second mortgages, mezzanine loans, and many preferred equity investments. Even if there is tons of equity in the commercial property, you cannot go back to a conduit lender later and obtain permission to place a mezzanine loan on the property. Why? Because that would involve business judgment. You would be asking the REMIC to make a business decision. If the REMIC starts making business decisions, it become a for-profit entity and loses its tax-free status.
There is only one time when a conduit can agree to allow a mezzanine loan. A conduit lender can agree to allow a mezzanine loan when the loan is first originated. How is this possible? Permission to allow the mezzanine loan is effectively written right into the original trust agreement. The automotron therefore has to obey the trust agreement and allow the existence of the mezzanine loan.
As a result, most mezzanine loans these days are recorded simultaneously with the first mortgage. In fact, these is one company of which I have heard whose entire business model is to record small mezzanine loans - sometimes as small as $750,000 - in cooperation with their stable of regular conduit lenders. Mezzanine loans this small are highly unusual because most mezzanine loan lenders have a minimum loan of $5 million.
As I recall, this mezzanine lender won't even take calls from the public. They work exclusively with their conduit lender buddies. If a borrower approaches one of their conduit loan buddies, and the borrower is seeking 75% financing, the conduit makes a 60% LTV new first mortgage, and this mezzanine loan lender simultaneously records a mezzanine loan equal to 15% loan-to-value.
Finally I can get to the point of today's article. As you know, Blackburne & Sons is now making small equity investments of $150,000 to $600,000 in California commercial properties. Our new equity investments must be made at the same time the new first mortgage is recorded by the bank. We are doing two kinds of deals - purchase money deals where the sponsor needs a little more downpayment and refinances of ballooning loans where the bank will not refinance their entire prior balance.