Commercial Loans and Fun Blog

Who makes land loans today?  Where is the best place to find a good land loan?  Will you or your borrower qualify for a land loan?  How large of a land loan can you get?  Today we answer these questions, as well as discuss inadequately capitalized developers.

In the years leading up to the Great Recession, real estate developers were making a fortune  developing raw land.  They would buy farmland or scrub land, get it re-zoned, complete the horizontal improvements, and then quickly sell off the individual home-site lots for a small fortune to home builders.  Horizontal improvements are defined as grading the property, bringing utilities to each lot, and putting in streets, sidewalks, curbs, and gutters.

At the time, commercial banks were making lots and lots of land loans and A&D loans.  An A&D loan is defined as an acquisition and development loan structured like a construction loan, where the construction budget includes the purchase price of the raw land, the hard costs of the horizontal improvements, the soft costs - including an interest reserve and sales commissions, and a contingency reserve of around 5% of hard and soft costs.

During the bubble in real estate prices leading up to the Great Recession, commercial banks were drinking the Kool-Aid and making A&D loans up to 70% of Total Cost.  Sometimes commercial banks were even going as high as 80% of Total Cost!  Insane.  No wonder there was a bubble.

You can guess how this story turned out.  The Great Recession destroyed the housing market, and land prices plummeted.  The banks foreclosed, the banks took huge loss, and Federal banking regulators slapped the snot out the banking industry for being so stupid.  Truly folks, the losses in land development lending were often 80% to 90%.

Why do we care?  Regulators have a long memory, and the absolute last loan that banking regulators want commercial banks to make today are land loans.  Therefore, unless a developer is as rich as Donald Trump and has a banking history with a particular local bank going back for 15 years, he is probably NOT going to be able to get a land loan or a land development loan from a commercial bank.

So who is making land loans today?  Answer:  Hard money lenders, like Blackburne & Sons.  Hard money lenders are true capitalists.  We'll make hard money loans, even when blood is running in the streets.  In fact, Blackburne & Sons was in the market making commercial loans every day of the Great Recession.

But you don't have to apply strictly to Blackburne & Sons.  On C-Loans.com there are at least 75 different commercial and land loan hard money lenders.  You fill out one short mini-app, check off six suggested lenders, and then press, "Submit."

Will you qualify for a land loan?  How large of a land loan will you be able to get?  During an average market, hard money lenders will typically only advance up to around 40% loan-to-value on raw land.  In a rising market like today, Blackburne & Sons, for example, is pretty bullish on land loans.  We'll lend up to 50% loan-to-value on land to a good-credit borrower, and perhaps up to 60% of the land purchase price on a land development deal to a well-capitalized, experienced, and good-credit borrower. We're probably not unique among hard money lenders in terms of our bullishness on land today (12/13/15).

Now we FINALLY get to the point of today's training article.  I would like my own executives and loan officers (Ed!!) to pay special attention to the point that I am about to make.  We at Blackburne & Sons often see developers applying for a land.  They want a loan of 50% loan-to-value, and their exit strategy is to pay us off with a construction loan.

But wait a minute.  In my last blog article I pointed out that real estate developers are usually required to cover at least 20% of the Total Cost of the project.  They usually do this by bringing the land to the closing table (almost) free and clear.  If a developer has a big mortgage on his land, he won't be able to bring the land to the closing table free and clear.  He will never qualify for a construction loan to pay off his ballooning land loan!

Now, of course, if the developer has a BIG net worth, he can sell off some property to come up with the equity required by the construction lender.  Many developers also have a stable of passive investors who invest the equity in their deals in return for a share of the profits.  Other developers are very experienced at issuing private placements in order to raise their required equity.

But absent one of these three potential sources of equity, the land loan underwriter needs to be very careful about making a big land loan to a developer who claims that his exit strategy is a construction loan.  In order to qualify for a construction loan, most developers are supposed to bring the land to the construction loan closing table pretty much free and clear.

Do you enjoy my down to earth style of instruction?  Now is the time to become a commercial mortgage broker.  More commercial loans are ballooning in the next 12 months than in any similar period in history.

Keep looking for a business card from a banker making commercial loans.  We'll trade you a list of 2,000 commercial lenders for the contents of that one business card.  We solicit these bankers to refer their turndowns to C-Loans.com.

Have you registered on C-Loans.com yet?  I am just talking about inputting your name, company, address, etc.  If you are pre-registered, you are far more likely to enter your next commercial loan into C-Loans.com.  If you pre-register, we'll give you a free $199 commercial mortgage underwriting manual.

Developers, now is the time to apply for a commercial construction loan.  Mortgage brokers, now is the time to resume brokering commercial construction loans.  The economy is pretty healthy, and commercial banks are hungry to put their $2.7 trillion in excess reserves to work.  By the way, if you want a commercial construction loan, you will want to apply to a commercial bank, rather than to a mortgage company.  Commercial banks make 98% of all commercial construction loans.  However, developers, you need to have some skin in the game.

One of my commercial construction loan officers called me yesterday.  He had a developer who is building a $33 million apartment building in Florida.  The developer is buying the land for $2.7 million, and he has a term sheet for a purchase money first mortgage for $1.7 million.  He wanted a second mortgage on his purchase of the land for $800,000.  Who out there immediately spotted this as a goofy loan request?

A term sheet is defined as a loan proposal or conditional commitment letter (same thing) from a commercial real estate lender.  Appraisals and toxic reports are so expensive in commercial real estate finance that borrowers want at least a moral commitment from the bank before shelling out $4,500 to $8,000 for these third party reports.  A term sheet is legally worthless, but in real ife it means that the borrower is probably going to get the loan at the proposed terms, as long as the third party reports come back okay.

Now back to my story.  Why was this a goofy loan request?  Answer:

1. No one makes second mortgages on land (other than sellers carrying back part of the purchase price).
   
   
2. The bank is going to insist that the developer contribute at least 20% of the total cost of the project.  Normally - but not always - this means that the developer has to bring the land to closing table (almost) free and clear.  More on this below.

Before we go any further, let's define a few terms.  The Total Cost of a commercial construction project is defined as the sum of the land costs, the hard costs, the soft costs, and the contingency reserve (normally equal to 5% of hard and soft costs).

Total Cost = Land Cost + Hard Costs + Soft Costs + Contingency Reserve

The Loan-to-Cost Ratio is the most important ratio in commercial construction loan underwriting.  The Loan-to-Cost Ratio is defined as the Construction Loan Amount divided by the Total Cost, times 100%.

Loan-to-Cost Ratio = (Construction Loan Amount / Total Cost) x 100%

Example:  Let's suppose a developer wants to build a three-unit industrial center in Austin, Texas.  He needs a $3.2 million construction loan, and his total cost is $3.8 million.  What is his Loan-To-Cost Ratio?

Loan-to-Cost Ratio = ($3,200,000 / $3,800,000) x 100% = 84.2%

This ratio is too high.  Unless the developer can raise more equity, the loan will be turned down.

For most commercial construction lenders, the Loan-to-Cost Ratio must not exceed 80.0%.  In other words, the developer must cover at least 20% of the Total Cost of the project.  This kind of makes sense.  The bank doesn't want to take all of the risk.  The developer must stand to lose some serious dough if the project goes South.  The developer must have some skin in the game.

Okay, now let's go back to the goofy commercial construction loan request I cited at the very beginning of this training article.  You will recall that it was a $33 million apartment construction loan request.  Well, we know that the developer and his investors are probably going to be required to contribute 20% of the $33 million Total Cost; i.e., $6.6 million. 

Now the developer is buying the land for $2.7 million.  He has a term sheet for a $1.7 million new first mortgage, and on top of that, he wanted an $800,000 second mortgage.  In other words, he was only contributing a $200,000 downpayment on a $33 million project.  His Loan-to-Cost Ratio was 99.4%!  Somebody has been partaking of that Colorado medicinal tobacco.  Ha-ha!

Remember, most commercial construction lenders want the developer to bring the land to the deal free and clear, or at least pretty close to free and clear.  In most commercial construction deals, the land represents between 20% to 25% of the Total Cost, and that, along with architectural and engineering fees, is where most developers have spent their required equity.

Do you know a banker who is making commercial real estate loans?  We'll trade you the contents of one banker's business card for a list of 2,000 commercial real estate lenders.  We solicit these guys to refer their turndowns to C-Loans.

The vast majority of all large commercial real estate loans today are made to single asset, bankruptcy remote entities.  This article will explain why.

About 30 years ago a lowlife scumbag was climbing on the roof of a retail building in New York City, looking for a way to break in and steal some of the inventory.  The roof was old, and this poor-poor lowlife scumbag fell through the roof and was severely injured.  This lowlife scumbag then had the audacity to sue the property owner for $6 million for negligently having an older roof and not warning him of the danger of collapse.  The brain dead jury found for the the lowlife scumbag!

The property was not sufficiently insured for this kind of personal injury, and the older couple who owned the building held title in their personal names.  The lowlife scumbag was therefore able to seize the life's savings of this honest, hard-working, older couple.

After this astounding case, most commercial real estate investors transferred title to their properties into some sort of entity that had a corporate shield, initially a Subchapter-S corporation and later, after the limited liability company was adopted by the states in 1978, an LLC.

However, it wasn't enough to have title vested in an entity with a corporate shield, as the following imaginary story will explain.

Peter Printer owned the world's largest illustrated Bible printing business in the world.  His Bibles contained scores of full color illustrations, far more pictures than his nearest competitor.  Customers loved his Bibles, especially parents who read the Bible to their young children at night.  For thirty years Peter Printer made a wonderful income, and he invested his millions into a series of office buildings in Los Angeles.  He held title to both his successful printing business and his latest office building (he sold his smaller buildings and traded up) in the name Peter Printer Enterprises, LLC.

In 2017 Amazon came out with the Kindle VII, which allowed book printers to embed numerous short videos right into their e-books.  Clever Printing, LLC was the first Bible printer to embed short videos, scenes culled from scores of old Biblical movies, into their Bibles.  Their new Bibles were a smash hit, and Peter Printer's Bible sales plummeted.  Suffering from immense losses, Peter was even forced to use the rents from his investment property, the big office building, to prop up his Bible printing business.  He stopped making payments on his $8 million first mortgage from Statewide Regional Bank.

When Statewide Regional Bank stopped receiving payments, it filed foreclosure.  Ten days before the foreclosure sale, Peter Printer Enterprises, LLC filed a Chapter 11 (Reorganization) Bankruptcy.  For sixty days, Statewide Regional Bank was not allowed by the automatic stay of bankruptcy to do anything; but when the sixty days had run, the bank immediately filed a motion for relief of stay or, in the alternative, for the immediate appointment of a receiver to collect the $75,000 in rent generated by the beautiful, big office building.

To the bank's absolute horror, Peter's bankruptcy attorney was able to convince the bankruptcy court that the $75,000 per month in rent generated by the big office building was absolutely essential to Peter's plan of reorganization.  The company needed that $75,000 per month to pay the salaries of the printing company's employees while the company developed its own video-embedded Bible.  

For three years the bankruptcy court forbade the bank from foreclosing, during which time the leases of 70% of the tenants came up for renewal.  With no money to pay for repairs and upgrades to the office suites and no money to pay for leasing commissions, a Biblical Exodus of tenants ensued.  By the time the bank was finally granted relief from the stay, the building was severely rundown and almost empty.  The bank had originally made an $8 million loan.  It lost all of its interest income and limped home with just $5.25 million of its original principal.

Are you learning anything today?  This is how I teach commercial real estate finance.  I try to use lots and lots of "real-life" stories.  In the 200-year history of the industry, this year is the single best year to becomes a commercial mortgage broker.  More commercial loans are ballooning this year than any year in history.

What mistake did Statewide Regional Bank make?  They made a large commercial loan to an entity that that owned more than one asset.  They got caught up in the bankruptcy troubles of Peter's printing business.  The bank did not make a loan to a single asset, bankruptcy remote entity.  Had Peter, as a condition of the loan, transferred title to the large office building into a stand-alone LLC with no other assets, the troubles of Peter's printing business would not have delayed the bank's foreclosure.  The bank would not have taken a financial bath.

It amazes me that more people don't take advantage of the following offer.  Give us the contact info of a banker making commercial loans, and we'll give you a list of 2,000+ commercial real estate lenders.  2,000+ for one.  Helloooo?

Life insurance companies offer by far the lowest interest rates on large commercial permanent loans. You will recall that a permanent loan is just a garden variety first mortgage on a commercial property, with a term of at least 5 years and with at least some amortization, typically 25 years.

Interest rates on commercial real estate loans from life insurance companies are typically 25 to 37.5 basis points lower than those offered by conduits, and they are often only 25 basis points higher than the prime residential mortgage rate.  In other words, if an A-quality borrower can obtain a conforming, 30-year, fixed rate loan of 3.5% on his home today, a life company might make a 10-year, fixed rate, commercial permanent loan at around 3.75%.

In most cases, a borrower will NOT be able to obtain a new permanent loan from a life insurance company by applying directly to the life insurance company.

When you are the prettiest girl at the dance, lots and lots of guys want to ask you to dance. Screening twenty loan requests per day takes a lot of time. In addition, it doesn't make sense for most life insurance companies to open regional offices throughout the country, especially when the typical life company makes fewer than 30 loans per year.  Please note, however, that when a life insurance does make a new commercial permanent loan, it is usually a very large loan.

Therefore most life companies employ correspondents. A correspondent is a commercial mortgage company that has the exclusive right to make commercial loans in a given region for a particular life company. The correspondent does all of the site inspections for prospective loans in that region for that life company.

The correspondent then services the loan (collects the payments and handles any foreclosures) for that life company.  The amount of the loan servicing fee is tiny - typically just 12.5 basis points per year - but life insurance company loans are typically huge.  For example, 12.5 basis points on a $20 million loan is a healthy $25,000 per year.

As I mentioned in another recent blog article about life insurance companies, most borrowers and brokers could live three life times and never have a commercial loan attractive enough for a life insurance company.  Life insurance companies are looking for the following types of commercial loans:

1. The commercial loan must be secured by one of the four major food groups - which is just commercial mortgage lingo for (1) Multifamily; (2) Office; (3) Retail; or (4) Industrial.
   
   
2. The property should be either brand new or in pristine condition.
   
   
3. The property needs to be located in a primary location.  A primary location is one of the very best locations in a gateway city in terms of traffic count, accessibility, and affluence of the neighborhood.  In other words, a lot of Lexus'es, Mercedes, and BMW's need to be driving by.  You will rarely find a life company lending in a city of less than 400,000 residents.
   
   
4. The loan amount must usually exceed $5 million.  You will occassionally see life companies making commercial real estate loans as small as $3 million, but these small deals are usually made on properties leased on a triple net basis to some incredibly strong tenant, like Walgreens, CVS, Rite Aid, or some other national credit tenant.  A national credit tenant is a company rated BBB or better by Standard & Poor's.
   
   
5. Life company loans rarely exceed 55% to 58% loan-to-value.  They are designed for deals where the buyer is exchanging into the property with an enormous down payment.

Remember, if you were to call a life insurance company directly, the company receptionist will usually ask you for the location of the property and then refer you to the appropriate correspondent. Don't get a broken nose over this.  This is just how life companies originate their commercial loans.  They almost always use exclusive correspondents.

You can apply to a dozen different life company correspondents using C-Loans.com.

Commercial loans from life insurance companies typically offer the lowest interest rates and the best terms in all of commercial real estate finance.  Most commercial real estate loans from life insurance companies have a fixed rate, and these wonderful loans typically have a term of either 5, 7, or 10 years.  The interest rate is usually 25 to 37.5 basis points cheaper than those from any CMBS lender (conduit) or major bank.

Pop Quiz:  What is a basis point?  Answer:  A basis point is 1/100th of 1%.  Therefore 25 basis points is one-quarter of one percent.

By the way, in the lingo of commercial real estate finance, a life insurance company is known as a life company.

Life insurance companies insist on fixed rate loans because they need to know exactly what they will earn during the term of the investment.  They need these precise numbers because they need to be sure they can meet the death benefits promised in their life insurance policies, based on their actuarial projections.

Therefore most life company loans have a lock-out clause for the first half of the loan (the first five years of a ten-year loan).  A lock-out clause is defined as an absolute prohibition against prepayment.  Suppose you win the lottery.  You walk into the life insurance company's office, overturn a wheelbarrow containing $5.2 million in cash, and then proudly march out.  Three days later you get a certified check in the mail for $5.2 million (less this month's payment).  "Sorry, sir, but you are NOT allowed to pay this loan off early."

For the remaining half of the loan term almost all life company loans have a defeasance prepayment penalty.  A defeasance prepayment penalty is defined as one where the borrower is required to go out and buy a series of Treasury bills and bonds that will provide the lender with the exact same stream of incoming payments, plus any balloon payment.  There are defeasance companies which will buy and assemble these securities for you.  The thing to remember about defeasance prepayment penalties is that they are HUGE.  Think of the largest prepayment penalty that you have ever encountered and then multiply by twenty.  Ouch!!!

Life insurance companies are looking for the following types of commercial loans:

1. The commercial loan must be secured by one of the four major food groups - which is just commercial mortgage lingo for (1) Multifamily; (2) Office; (3) Retail; or (4) Industrial.
   
   
2. The property should be either brand new or in pristine condition.
   
   
3. The property needs to be located in a primary location.  A primary location is one of the very best locations in a gateway city in terms of traffic count, accessibility, and affluence of the neighborhood.  You will rarely find a life company lending in a city of less than 200,000 residents.
   
   
4. The loan amount must usually exceed $5 million.  You will occassionally see life companies making commercial real estate loans as small as $3 million, but these small deals are usually made on properties leased on a triple net basis to some incredibly strong tenant, like Walgreens, CVS, Rite Aid, or some other national credit tenant.  A national credit tenant is a company rated BBB or better by Standard & Poor's.
   
   
5. Life company loans rarely exceed 55% to 58% loan-to-value.  They are designed for deals where the buyer is exchanging into the property with an enormous down payment.

"Gee, George, those are some pretty tough requirements to meet."

Most of us could live three lifetimes and never run across a commercial real estate deal suitable for a life company.

But don't panic.  If you use C-Loans.com to apply for a commercial real estate loan, you can apply to a dozen conduits and banks at the same time you apply to a half-dozen life insurance companies.  If the life companies all turn you down, the conduits will probably do your deal at just a slightly higher rate.

A bank is never going to finance a gentlemen's club, which is just a fancy term for a nudie bar.  Nor would a bank finance an adult bookstore or a lingerie and marital aid store.  Can you just visualize the headlines?  First Neighborhood Bank Forecloses on the Pink Feather Lounge!  Bank Vice President seen collecting the cover charge at the door.  This is NOT gonna happen.  Ha-ha!

The owners of such establishments, along with the owners of medicinal marijuana facilities, will usually be forced to borrow from private money (hard money) lending companies.

For those of you who think that I am some depraved sinner, it is important you appreciate that over the past 35 years, we have financed six churches.  Every one of these loans defaulted, and we took a huge loss on each one.  Actually that's incorrect.  We once made a $1.5 million loan on a free and clear church in a nice area of Texas.  When this loan defaulted as well, it turned out that the pastor had stolen the money to originally buy the church from his former church in Detroit.  Our private investors were in litigation for three years, but they eventually came out whole.  Needless to say, we are not a big fan of church loans.

At Blackburne & Sons, we actually prefer loans secured by gentlemen's clubs, adult bookstores, and other politically incorrect properties.  We have made twenty such loans over the years, and we have never taken a loss on one of them.  Usually they are cash cows.

We are actively looking for new loans on politically-incorrect properties right now.  We just put a $1.1 million loan on a gentlemen's club in Detroit (scary area) out for sale to our private investors, and the entire loan sold out in a day and a half.  Our private investors understood the concept that boys will probably always enjoy looking at pretty girls.  They absolutely ate this loan up.

Now if you were reading carefully, you probably noticed something.  Blackburne & Sons does NOT use a mortgage fund to fund its deals.  Instead, we syndicate every loan.  On a $1.1 million loan, we might have as many as 30 different private investors, and the group of private investors in each deal will be different.

"But George, if you have to syndicate every loan, doesn't that mean you will take longer to fund a new loan than a competing hard money lender?"

Yes, it does.  It might take us a week longer to fund our loans because each participating private investor has to send in his check.  It can be a pain in the tail sometimes.

Blackburne & Sons actually has its own mortgage fund, but I absolutely hate the concept.  Huh?  Why?  Every ten to fifteen years commercial real estate is hit by a depression, where commercial real estate falls by 45%.  When commercial real estate values are crashing, every hard money mortgage fund in the country is absolutely swamped with withdrawals.  They are forced to stop making new loans because they have no liquidity.  Every penny of liquidity is spent returning money to panicky investors.  They are completely out of the market.

Sons, please remember this.  During commercial real estate depressions, real estate falls by almost exactly 45%.  Certainly it has every time in my lifetime.  (Confused?  I write this blog to teach my two sons everything I have learned in my 35 years in the business.  I have a bad heart, and I was in the cardiac intensive care unit of the hospital twice in the past two weeks.  These wonderful blog training articles cannot continue forever.  I'm just sayin'...)

Everyone, here is why this matters to you.  Here is why you want to be the best friend of my two sons.  Blackburne & Sons was the ONLY commercial hard money lender to be in the market to make new commercial loans every day of every year of the Great Recession.

We can always find first mortgage money from our filthy rich private investors - even when blood is running in the streets.  It's just a matter or price.  And if you can find commercial mortgage money during a horrible depression, you can charge a huge loan brokerage fee.

So if you are a surviving veteran of the commercial mortgage brokerage industry, you definitely want to develop a relationship with Alicia Gandy (our biggest producer who is affectionately known as the Loan Goddess), my son George IV, or my son Tom.

Why are relationships so important?  The most important lesson about commercial real estate finance that I ever taught my sons was that commercial lenders make loans for their friends.

In late 2014 I wrote a blog article suggesting that industrial real estate was heating up, and I gave my reasons.  Apartments have enjoyed sensational appreciation for the past several years, but an investor looking to invest in commercial real estate in 2015 doesn't want last year's winner.  He wants to invest in that type of commercial real estate which is going to perform the best in the next 12 months.

This week I flew to Las Vegas for the California Mortgage Association's semi-annual training session for hard money mortgage companies.  The conference had a number of speakers, but by far the most entertaining and informative speaker was Luis A. Belmonte, the gentleman who gave the economic outlook for the upcoming year.  Mr. Belmonte is a former partner in Lincoln Properties and formerly the Executive Vice President of AMB Institutional Realty Advisors, the asset manager for 15,000,000 square feet of industrial property throughout the United States.

Mr. Belmonte made some very interesting points.  First of all, he remains bullish on multifamily due to the fact that leading edge of the children of the Echo Boom generation - the grandsons and granddaughters of the Baby Boomers - have reached the age of sixteen.  Soon these 80 million Americans will be forming new households, and they will need apartments.

Office space, in his opinion, is still greatly overbuilt.  The office space vacancy rate in most cities remains in the mid-teens.  Rents are going nowhere.  Retail space - he wouldn't touch it with a ten foot pole.  Amazon.com is eating retail's lunch.

But then he got to industrial space.  "Industrial space is the best type of commercial real estate in which to be invested today."  He gave a number of reasons:

1. There has been almost no new construction of industrial space for eight years.
   
   
2. Absorption of industrial space is outpacing new construction in almost every major city.
   
   
3. Wages in China have increased dramatically in recent years.  It's not that much cheaper to manufacture goods in China anymore.  [George's note:  The Boston Consulting Group maintains a cost index for the various counties, and China is only 4.5% cheaper than the U.S. right now, mainly because our natural gas / energy costs are tiny compared to the rest of the world.]
   
   
4. But then he gave a reason that rocked my world.  "For every two square feet of retail space that the internet makes unnecessary, the U.S. needs one square foot of warehouse space" (for internet retailers to store their products).

End of article.

If a potential commercial mortgage borrower or broker is pre-registered on C-Loans, he is far more likely to enter a commercial loan request into the portal.  Therefore we are going to bribe you to pre-register (fill in your name, address, etc.).

Need a commercial mortgage loan?  Submit your mini-app to 750 different commercial lenders in just four minutes for free.  C-Loans is paid by its participating lenders.

Do you know one banker making commercial real estate loans?  We'll trade his contact information for our list of 2,000 commercial lenders.

Do you enjoy my "everyman's language" style of teaching commercial real estate finance, where I use lots of examples and war stories?  Why not become a near-expert in commercial real estate finance? 

A joint venture is a sort of a "partnership" between a developer and one or more passive investors to build a commercial property.  The developer brings to the partnership the project; his expertise, as described in detail in his CV or curriculum vitae; and some prepaid expenses, such as architectural fees, engineering fees, and his down payment on the land.  The investor brings to the "partnership" the majority of the equity required by the construction lender.  I've used the term "partnership" throughout this article, but these business entities are almost always set up as limited liability companies ("LLC's").

Almost all commercial construction loans are made by banks.  Banks today are not going to take all of the risk of a construction project by loaning to the developer 100% of the total cost of the project.  Usually the bank will only cover part of the total cost of construction, and the developer will have to cover the rest.  How much of the total cost of the project that the bank will cover is determined by their loan-to-cost ratio.

Example:

Doug Developer wants to build six town homes.  The total cost of the project - including land costs, hard costs, soft costs, and the contingency reserve - is $2,500,000.  This is a relatively small project, so his construction loan request will be small.  He therefore wisely applies to a small bank located close to the subject property.  (George's note:  Doug did two smart things here.  First he matched the size of the loan to the size of the bank to which he applied.  Secondly, he applied to a bank with a branch located just down the street.  Construction lenders greatly prefer local projects.)

Nearby Neighborhood Bank NT&SA has a bank policy that it will only make commercial construction loans today up to 70% loan-to-cost.  Remember, the total cost of the project is $2.5 million.  Seventy percent of $2.5 million is $1,750,000.  This is the largest construction loan that Nearby Neighborhood Bank will make.  Doug Developer will be expected to come up with the remaining $750,000.

Doug paid $500,000 for the land, and he put down $125,000.  The seller carried back a short term first mortgage of $375,000.  Doug also paid $65,000 for all of the architectural plans and another $22,000 for the engineering work.  He therefore has $212,000 in equity into the project.  He is short $538,000.  

$750,000 required equity - $212,000 in developer contributions = $538,000 shortfall

Where is Doug going to come up with the missing $538,000 in cash?

Doug approaches Dr. Dan Deeppockets, a retired neurosurgeon, and invited Dr. Dan to enter into a joint venture with him.  Doug Developer and Dr. Dan negotiate the following deal:

Dr. Dan will contribute the needed $538,000 in additional equity.  If the project is successful and the condo's are sold off, Dr. Dan first gets his $538,000 investment back.  Then, if there is any money left over, Doug Developer gets back his $212,000 cash contribution.  If there any money left over, Dr. Dan gets a preferred return (before Doug Developer) of 15%.  If there is still any money left over, Doug Developer earns a 15% return on his $212,000 cash contribution to the project.  Any money left over?  Dr. Dan and Doug developer agree to split any remaining profit 50-50.  This repayment schedule is known as a waterfall.

End of example.

Who can qualify for a joint venture?  In order to qualify for a joint venture, a developer needs one heck of a curriculum vitae (construction experience resume).  After all, the developer is saying, "With my brains and your money, we are going to make a fortune together."  I don't know about you, but if I were the guy putting up the dough, that developer's brain would have to be pretty darned impressive.

In real life, almost no one ever qualifies for an institutional joint venture - a JV with some huge fund.  If you are an average commercial mortgage broker, I strongly urge you never to work on a joint venture.  You'll never get paid.  Personally I have come to the conclusion that the only developers who can convince a life insurance company, a REIT, or some wealth fund to JV with them are developers who are rich enough to build the project for cash using their own dough.  You and I, as commercial mortgage brokers, will never get to represent one of these guys.  Helloooo?  You will never get paid.  The guys we as brokers get are the developers who spend their last dimes on the architectural and engineering fees.

But what about private joint ventures - joint ventures with wealthy private investors?  Many years ago, scores of broker-dealers raised money for development deals.  Then the rolling commercial real estate depression hit in the early 1990's, and all of these broker-dealers were sued into oblivion.  For 25 years developers found it extremely difficult to raise equity dollars from private investors.

Then something changed.  During the Great Recession, President Obama signed the JOBS Act, which now allows real estate developers and entrepreneurs to publicly advertise to accredited investors for investments, just like hedge funds have been allowed to do for decades.  This is huge.  

Thirty years ago the syndication business was enormous, far larger than the hard money business nationwide.  The syndication industry is not back yet, but I predict that it will return over the next five to seven years.  My own hard money commercial mortgage company, Blackburne & Sons, is looking at a relatively tiny ($1.8 million) joint venture in California.  In fact, we just issued a  Letter of Interest.  Risky-risky-risky, but I remain very bullish (after 20 years of being a perma-bear) on the future of the U.S. economy.

A hypothecation is defined, at least in the context of commercial real estate finance, as a loan secured, not by a piece of commercial real estate, but rather by a mortgage note owned by the borrower, which is itself secured by a piece of commercial real estate.  In short, its a loan to a guy who owns a mortgage note.  He pledges his mortgage note receivable for a smaller loan.

It is normally far-far better for a note holder to hypothecate his mortgage note rather than to sell it at a huge discount.  Normally when an investor sells a mortgage note, he is forced to take an enormous haircut (loss).  If he simply borrows against his mortgage note receivable (hypothecates it), he can pay back the hypothecation loan and regain title to the full value of his mortgage note.  An example will make this much more clear.

Example:

Once upon a time Billy Whiteshoes (he wears plaid pants and a matching white belt) owned an 80-unit apartment building in Naples, Florida free and clear.  He was 68-years-old, and it was finally time for his bride of 55 years and him to retire.  He sold his apartment building for $4.2 million and carried back, for tax reasons, a $3,700,000 first mortgage at 6% interest for 20 years, a wonderful return considering that banks are only paying 0.50% for deposits right now.

Sadly his beloved bride is snatched by an alligator while feeding the ducks in a pond near their Florida retirement community.  Billy Whiteshoes is devastated and realizes that life is short.  He resolves to live his last remaining years with gusto.  That's when he meets Lola La Boom-Boom, a 42-year-old retired stripper, working as a bartender in a nearby watering hole.  It's love at first sight (of Billy's assets).  Lola convinces Billy to take her on an expensive cruise and to buy her an enormous diamond engagement ring ($120,000).

Needing $150,000 in cash for the rock and the cruise, Billy contacts a mortgage note broker, who offers him just $2,250,000 for his $3.7 million first mortgage note.  "This is a 20-year mortgage, Billy, and while 6% may sound like a great yield today, in five years it may be well below market.  Then my investors will be stuck with a below-market yield for 15 more years.  In any case, we buy our mortgage notes discounted to yield at least 13%."  Outraged, Billy calls a half-dozen more mortgage note brokers, but the offers he receives are all about the same.

Billy is inflamed with desire for Lola, but he is not a complete idiot.  He keeps calling commercial mortgage brokers, until he reaches a subscriber to George's blog.  "You know, Billy," the wise commercial mortgage broker explains, "there is another way.  I can arrange for a $170,000 loan, secured by your first mortgage note receivable.  You don't have to sell the note at a discount.  You can just borrow against it.  This is a private money lender, so you are going to pay 12.9% and 4 points, plus my loan brokerage commission.  But when you pay off this hypothecation loan, you'll still own the entire $3.7 million first mortgage note.  Your cash flow from his mortgage note receivable is large, so I recommend that you triple up on your monthly payments.  Billy, you would be an idiot to sell your $3.7 million note for just $2.25 million!"

My private money commercial mortgage company, Blackburne & Sons, will hypothecate commercial first mortgage notes.

How much can you borrow against a commercial first mortgage note?  For how much can you hypothecate it?  Most lenders (there are very few of us) who hypothecate commercial first mortgage notes will lend up to 80% of the discounted present value of the note.  Without trying to teach a whole college-level course in business finance, most hypothecation lenders will discount the monthly payments and the balloon payment back to present value.  Blackburne and Sons will use a discount rate of 13%, the yield required by our private investors.  Since we charge a 4-point loan origination fee on hypothecations, we would use as our value of the note 96% of its discounted present value.  Just like we are not going to lend 100% of the value of a property, we will lend up to 80% of the value of that note (to us).

So how do you package a hypothecation loan?  If you are a commercial mortgage broker, what documents do you ask for?  One of our newer loan officers recently ran across a hypothecation loan request, and our brilliant EVP, Angelica Gardner, sent this to him:

Good Morning, (New Loan Officer),

I received your voicemail message regarding a hypothecation loan. I figured it would be better to send you the details so you can review (the deal) first, then we can discuss details or questions.

First, the definition of a hypothecation: The established practice of a borrower pledging an asset as collateral for a loan, while retaining ownership of the assets and enjoying the benefits therefrom. With a hypothecation, the lender has the right to seize the asset if the borrower cannot service the loan as stipulated by the terms in the loan agreement.

Below is a list of the documents that I would want to see. It is unlikely that you will be able to gather all of the documents listed below, but try to get as many of them as possible.

1. Color photos of the property.
   
   
2. Copy of Promissory Note and Mortgage*
   
   
3. Original title insurance policy (or fresh prelim)*
   
   
4. Something showing the payment history*
   
   
5. Closing statement from when note was created*
   
   
6. Financial statement on the maker/borrower (when the note was created)
   
   
7. Credit report on the maker/borrower (when the note was created)
   
   
8. Two years’ tax returns on the maker/borrower (when the note was created)
   
   
9. Appraisal - an old one is very helpful and a new one is blissful
   
   
10. Rent roll and/or commercial leases (when the note was created)
    
    
11. Current financial statement of the Maker (hypothecation borrower), current credit report on the Maker, last two years tax returns on the Maker, current Rent Roll, current commercial leases.

* Very, very important.

Find out early who has possession of the original Promissory Note and Mortgage. It is legally impossible to properly assign a note and mortgage to the assignee (buyer of, or lender against, the discounted commercial loan) without delivering the original promissory note.  In fact, if the assignee (buyer of, or lender against, a discounted commercial loan) fails to take physical delivery of the original promissory note, and if the assignor (the seller of, or borrower against, the discounted commercial loan) later files Chapter 7 bankruptcy, the promissory note becomes the asset of the bankruptcy estate!  (In real life) the intended assignee is completely wiped out.

Another important note: We will require that the underlying borrower makes his payments directly to us. We want to always make sure that the payment on our loan is covered by the payments from the underlying borrower. Please let me know if you have any questions.

Sincerely,

Angelica D. Gardner
Executive Vice President