Commercial Loans and Fun Blog

Historically credit companies were a major source of commercial loans.  The big credit companies - commercial real estate lenders like GE Capital and CIT Financial - are fairly quiet right now, but mark my words.  If you believe in capitalism, these credit companies should be coming back in the market very aggressively before long.

What is a credit company?  A credit company is an old, well-capitalized lending company with an excellent reputation for borrowing, lending, and repaying its unsecured bond holders.  The following credit companies no longer exist in their most recognized form, but they were once household names:  Beneficial Finance, Ford Motor Credit, and Household Finance.

A credit company has a such a superb repuation for managing credit that it can walk up to the bond market and simply shout out, "Who wants to loan us money on an unsecured basis?  Okay, okay, just line up here please.  No pushing.  No shoving.  Okay, what interest rate do you want?  Three percent?  You're dreaming.  Step out of line please.  What interest rate do you want?  You'll loan us money at 1.50%?  Okay, that works.  Please give your dough to the clerk.  Who's next?  No pushing.  No shoving!"

So a credit company might be able to borrow money in a market like today at just 1.25% to 1.75% and then lend it out at a whopping 5% to 7%.

Many of the largest credit companies took a terrible beating during the Great Recession.  In September of 2008, during the darkest days of the slump, money market funds were facing massive withdrawals.  Even well-run companies, like GE Capital and CIT, were having trouble rolling over their commercial paper.  Commercial paper is defined as an unsecured, short-term debt instrument issued by a corporation, typically for the financing of accounts receivable, inventories and meeting short-term liabilities.

Ben Bernanke, the Chairman of the Federal Reserve and my personal hero, saved the day by guaranteeing the deposits of money market funds.  Investors stopped withdrawing funds, the run on the money market funds ended, and the money market funds went back to buying commercial paper and short-term corporate bonds.

However, most credit companies were sorely wounded during near-collapse of the corporate bond market, and they have largely withdrawn from active participation in commercial real estate lending in recent years.  But I'm a betting man, and I am betting on capitalism.  They will soon be back.  Why?

Last year was the best year in the 33-year history of Blackburne & Sons.  My private money commercial mortgage company faced very little competition for commercial loans.  Bank-quality borrowers and near-bank-quality borrowers were forced to pay our soft-money rates if they wanted to take advantage of a discounted pay-off ("DPO") from their bank.  The same thing was true of commercial mortgage borrowers with balloon payments coming due.  Where else could they go?  As a result, Blackburne & Sons had a very good year.  We made good money, and we booked some terrific loans too.

However, it is a basic tenet of capitalism that "excess profits breeds competition."  You can absolutely bet that all across Wall Street and the board rooms of credit companies, capitalists are rubbing their hands together and saying, "There's gold in them 'thar hills!  It's time to get back into commercial real estate lending."

This is how a commercial mortgage market recovers.  There is a certain order to things.  First the private money lenders - who use the funds of very wealthy private investors with a large tolerance for risk - return to the market.  They make a big profit.  This attracts the credit companies and the finance companies.  A finance company is a company which borrows money from a commercial bank at a low rate then lends it out a higher rate.  The credit companies and the finance companies then make the big profits.

Eventually the regional banks and the community banks see the big profits being made by the credit companies and the finance companies, and then they return to the market.

Is this absolutely sure to happen?  As Mark Twain once said, “History doesn't repeat itself, but it does rhyme.”

Commercial loan brokers and commercial real estate lenders converged this week in Las Vegas for the California Mortgage Bankers Association's Western States Commercial Real Estate Finance Conference.  The Western States Conference is always the big Kahuna of trade shows in commercial real estate finance.  I have some interesting news for you from that conference.

My first observation was that the show was quite small, at least compared to 2005.  Fewer than 20 commercial banks and commercial lenders had exhibit booths.  In 2005, there were 150 to 200 commercial lenders exhibiting.  Clearly the number of hungry commercial real estate lenders is tiny compared to pre-crash times.

Nevertheless, I learned some things.  First of all, the money center banks (Wells Fargo, Bank of America, JP Morgan Chase) are crushing the life companies and conduits.  One speaker from HFF (formerly Holiday, Fenoglio, Fowler, the largerst independent commercial mortgage company in the country) described how his office was writing a 7-year permanent loan that was less than 3% interest for the first two years.  The rate floated with some annual rate increase caps thereafter.

There is no way that CMBS lenders and life companies can compete against such low, floating rate loans.  In fact, there was a lot of discussion about how the large, money center banks were buying up all of the independent commercial mortgage companies.  Could an independent commercial real estate lender even surivive in the face of competition from the money center banks?  As one panelist pointed out, "The commercial banks are essentially getting their deposits for free!"

I was amazed to hear that loan-to-deposit ratio of most commercial banks nationwide is just 52%!  In 2005 this same loan-to-deposit ratio was close to 90%.  Clearly the banks have an immense capacity to fund commercial loans.

That being said, the darth of banks exhibiting at the show was an unmistakable signal that, while the banks have the capacity to fund an immense number of commercial loans, they simply lack the courage and confidence to do so.

Even though few commercial banks seemed hungry for commercial loans, there appeared to be TONS of money from structured finance lenders - mezzanine lenders, preferred equity lenders, and equity providers.

One formerly traditional life insurance company has stopped making conventional permanent loans.  Now all this life company wants to do is high-yield mezzanine, preferred equity, and JV equity deals.  It's insane.  Their crystal ball must be VERY bullish on commercial real estate.  (At Blackburne & Sons, we are equally bullish on commercial real estate.)

An enormous volume of commercial real estate loans are multifamily loans being originated modernly for "the Agencies" (Fannie Mae and Freddie Mac) and FHA.   Note to self:  Get more Agency lenders added onto C-Loans!

As a commercial loan hard money lender, I was greatly disturbed to learn that the first sub-prime commercial loan ABS offering is currently being assembled.  Already this commercial sub-prime lender has booked $200 million in commercial loans at rates of less than 7%.  (Think of a lender like the old BayView Financial, but this time the lender has to carefully document their sub-prime loans.)

This lender is not a CMBS lender.  Instead they are an ABS lender.  ABS stands for Asset-Backed Securities.  ABS securitizations typically involve a multitude of different collateral, like scratch-and-dent residential loans, car loans, credit card loans, and sub-prime commercial loans.  Bonds issured by ABS securitizations typically offer much higher rates than CMBS offerings, in some cases as much as 150 bps. (1.5%) higher yields.

This new commercial loan sub-prime lender could really kill lenders like my own, Blackburne & Sons.   It's very disappointing because we just had our best year ever.  I don't welcome the competition.  The good news is that they have agreed to join C-Loans.com.  You will see them listed on our commercial mortgage portal shortly.

This is my second article for commercial loan brokers and commercial investors about cap rates.  In my last article we described how a Cap Rate is simply the return (think of it like "interest") that an investor would earn if he bought a commercial property for all cash.

Algebraically, the Cap Rate is the property's Net Operating Income (NOI) divided by the Purchase Price, multiplied by 100%.  Let's use a simple example to solidify this ratio in your mind.   Let's suppose an investor bought a small, average-quality, office building with a NOI of $50,000, and he paid $700,000 for the property.  Fifty thousand dollars divided by $700,000 is 0.071.  (Remember that Cap Rates are computed without regard to any commercial loan placed on the property.)

Multiplied by 100%, we have a Cap Rate of 7.1%.  Cap Rates are commonly expressed as percentages, to one digit.  Therefore Cap Rates look like this:  8.2% or 5.6% or 11.8%.

Not every investor will be satisfied with the same Cap Rate.  Let's go back to the above example, and now let's assume that a wealthy business owner is leasing one of the six office suites in the building.  In addition to partially-occupying the building, this wealthy business owner lives just five minutes away.  He likes the short commute, and he fears that he might someday be forced to move.  When he hears that the office building has been listed for sale and that an offer to buy the property has already been made, the wealthy business owner submits a competing offer for $740,000.

Just for practice, let's compute the wealthy business owner's new Cap Rate.  Fifty thousand dollars in Net Operating Income divided by the higher, $740,000 purchase price gives us 0.67.  Multiplied by 100% gives us a 6.7% Cap Rate.  Obviously the second guy's Cap Rate is lower because he paid $40,000 more for the same $50,000 worth of Net Operating Income.

So what are some common Cap Rates on average-quality buildings in middle-income areas?

Multi-family

6.0% to 8.0%

Office

7.5% to 9.5%

Retail

7.5% to 9.5%

Industrial

8.25% to 10.25%

Hospitality

9.5% to 11.5%

Here are some general rules about Cap Rates:

1. The nicer the area, the lower the Cap Rate.  Average-quality buildings in the wealthiest part of town commonly sell at Cap Rates of 6.5% or lower.
2. The more reliable the income stream, the lower the Cap Rate.  For example, an office building with a 20-year lease from Apple Computer might sell at just a 4.5% Cap Rate.
3. The more vacant land surrounding or close to the property, the higher the Cap Rate.  The reason why is because if rents ever increase too high, some developer will quickly throw up a competing building.
4. Buildings in successful downtown areas sell for absurdly low Cap Rates - sometimes as low as 3.5%.
5. The younger the building, the lower the Cap Rate.

We can therefore tell a lot about a building, just by its cap rate.  For example, if you tell me that I can buy an apartment building at a 14% Cap Rate, I would pretty much bet that the area suffers from pervasive drug use, a high crime rate, and gang violence.

If you tell me that an industrial building just sold for a 7.0% Cap Rate, I would bet that the property is less than seven years old, has tall ceilings (important to a modern warehouser, who stack pallets very high), and a stronger-than-average tenant.

If you tell me that an office building just sold at a 5.0% Cap Rate, my bet is that the office building is located in an upper-income downtown area with virtually no vacant land within a mile (prevents competing buildings from being built).

You can subscribe to this free training blog in commercial real estate finance (CREF) by typing in your email address under my ugly picture above.

This is the first in a new series of articles on cap rates.  If you are going to invest in commercial real estate, or if you are going to work as a commercial loan broker, you simply must be very comfortable with cap rates.  Watch me make this an easy subject:

Let's suppose you have just inherited $200,000 from your grandmother.  (Sorry for your imaginary loss.)  You could take this money down to your neighborhood commercial bank and buy a certificate of deposit.  Interest rates are low today, so the return on your investment might only be 1.0% annually; but at least your principal would be safe.

Alternatively, you could buy a junk bond through your securities broker and perhaps earn a return on your investment of 3.5% annually; however, this is a riskier investment.  The company issuing the junk bonds could go bankrupt, and you could possibly lose your entire investment.

Or, you could buy for $200,000 a little commercially-zoned house that is currently leased out to a chiropractor as his office.  (Important note:  There is no commercial loan involved here.)  He pays you $1,400 per month in rent, and he pays for his own utilities and landscaping.  You're responsible for real estate taxes, insurance, and repairs.  Because you hate late-night phone calls, you decide to also hire a property manager for $155 per month to manage the property for you.

Therefore, after real estate taxes, insurance, repairs, and management, you net $1,000 per month.  That's $12,000 in net rental income per year on an investment of $200,000.  In other words, the return on your investment is 6%.  (Once again, please note that there is no commercial loan here.)

A cap rate is simply the return on your investment if you buy a commercial property for all cash.  In other words, think of a cap rate as the "interest" you would earn if you bought a commercial building for all cash.

Every commercial property is different.  Some commercial buildings are so attractive and are so well-located that most investors would "lust" to own them.  Other commercial properties are more bread-and-butter properties, with no distinguishing appeal.  Finally, some commercial properties look terrible, are in need of repair, and are located in crumby neighborhoods.  Yuck.  Therefore when you go to sell commercial properties, the cap rate will be different for each one.

For example, let's suppose a commercial property - we'll call it Property 1 - generates $50,000 per year in net rental income.  If its an average-looking office building in a middle-income neighborhood, and the tenant is of average quality, most investors might need a cap rate (remember, think of a cap rate just like an interest rate) of around 8% before they would buy the property.  Fifty thousand dollars divided by an 8% cap rate produces a likely sales price of around $625,000.

Property 2 also generates $50,000 in net rental income.  Unfortunately Property 2 is a huge, old, rusting, steel-skinned industrial building located in the flatlands of Oakland, where drive-by shootings are an almost nightly occurance.  To get to the property to collect the rent, the property owner is literally taking his life in his own hands.  It might take a cap rate of 12% to sell this property.  Fifty thousand dollars divided by a 12% cap rate produces a likely sales price of just $417,000.

Property 3 is a cute, little five-plex in the Chinatown area of San Francisco.  Demand for apartments within walking distance of Chinatown (many Chinese immigrants do not own cars) is immense.  If there were ever a vacancy, a new tenant could be found in twenty minutes or less.  Such a commercial property is highly desirable, and an investor might be satisfied with a 3.5% cap rate (3.5% "interest") in order to own this building.  Fifty thousand dollars in net rental income divided by a 3.5% cap rate produces a likely selling price $1,428,000.

Therefore we have three different commercial properties, each producing exactly $50,000 per year in net rental income ("interest" on the buyer's investment), with three greatly different sales prices.  The yucky industrial building might only be worth $417,000.  The average office building was worth $625,000.   The nice, well-located apartment building was worth a whopping $1,428,000 - more than $1 million more than the ugly industrial building producing the same amount of net rental income!  

We'll explore cap rates further tomorrow.

Brick Building Photo Attribution: Joe Mabel

It can be very tricky for a commercial lender to foreclose on a blanket commercial loan.  If he doesn't bid exactly the right amount at each foreclosure sale, even an over-secured commercial lender can still take a painful loss.  An example will make this clearer.

Suppose a commercial lender has a $9 million blanket loan on an $11 million apartment building in Nevada and a $6 million office building in Pennsylvania.  Suppose further that this lender is based in Nevada, and he is not terribly familiar with the Pennsylvania commercial real estate market.

The borrower bitterly contests and delays the Nevada foreclosure, but he offers no resistance on the Pennsylvania foreclosure.  The commercial lender therefore completes his foreclosure on Pennsylvania building first.  Local Pennsylvania foreclosure law states that a foreclosing commercial lender must make a reasonable foreclosure bid, absent specific contractual language to the contrary.  At the foreclosure sale the commercial lender therefore bids $5 million.  No one outbids him at the sale.

Important note:  It is very rare, but not totally unheard of, for bidders to actively bid at commercial foreclosure sales.  The reason why is because any bidder must pay all-cash, and commercial properties are usually far more expensive than homes.  For example, five million dollars is a lot of cash (actually bidders use cashier's checks) to bring to a foreclosure sale.

Okay, so now the commercial lender owns the Pennsylvania office building for $5 million.  This leaves just $4 million remaining on the $11 million Nevada apartment building.  The commercial lender bids his $4 million at the foreclosure sale.  When an $11 million apartment building goes to sale for just $4 million, this is one of those rare times when the Big Boys whip out their cashier's checks and outbid the commercial lender.  Therefore the commercial lender only receives $4 million for his security interest on the nice, Nevada apartment building.

Now the trouble begins.  The commercial lender discovers friable aesbestos in the Pennsylvania office building that costs $600,000 to remediate.  Then the commercial lender's commercial broker drops a bomb.  A local chemical company - the city's largest emplyer - is moving its nearby national headquarters to another state.  Demand for office space in the area plummets, as the local economy tanks.  The lender is only able to sell the office building for $3 million, and this formerly over-secured commercial lender ends up taking a whooping $2.6 million loss!

Okay, so what went wrong?  The commercial lender foreclosed on the out-of-state property first, in a market that he did not know.  Had he been based in Pennsylvania, he might have read about Orkin Chemical Company moving out of town.  He would have known to have bid far less on the Pennsylvania office building.

The borrower also forced the commercial lender to foreclose on the Pennsylvania property first.  If only the commercial lender had a choice of where he wanted to foreclose first, he could have foreclosed on the Navada property first, a real estate market that he knows.  His foreclosure bid would have been far more precise.

The moral of the story is this:  If a commercial lender is going to make blanket commercial loans, he needs to add a clause to his deed of trust or mortgage that allows him to foreclose on any property, in any order he wants, and to bid any amount he wants.

I want to thank my old mentor and good friend, Bill Owens of Owens Financial Group for his help with this blog article.  Bill taught me the commercial mortgage business over thirty years ago.  Owens Financial Group just successfully converted its private mortgage fund into a commercial mortgage REIT listed on the New York Stock Exchange.  Wow!!!

Bill Owens reports that his REIT has plenty of dough with which to make new commercial mortgage bridge loans.  He is looking for commercial bridge loans requests from $1 million to $10 million in the western states.  You can reach Bill Owens at (925) 935 - 3840.

A long-time blog subscriber asked, "Why would the lender, who already put a $9M mortgage on the two properties, have to bid at the foreclosure sale?"

When a commercial lender forecloses, the commercial lender is required by each state's foreclosure law to bid an amount that he will accept in lieu of keeping the property.  The maximum amount the commercial lender can bid at the foreclosure sale is everything that is owed to him - principal, interest, late charges, past due interest, default interest (which is just like regular interest but at a higher rate - say, 20% per annun rather than 11% per annum), trustee's fees, legal fees, and legal costs.  A bid where a foreclosing commercial lender bids everything that he is owed is called a full credit bid.

Remember, its a foreclosure sale, not a foreclosure seizure.  This is easy to forget because almost no one ever bids at commercial property foreclosure sales.  If you are going to offer something for sale, there has to be some price that you will accept.  That price is the lender's bid at the foreclosure sale.

By the way, did you know that many states will allow the agent of the foreclosing commercial lender to increase his credit bid at the foreclosure sale?  For example, the commercial lender above could have started the bidding out at just $2 million.  The foreclosing commercial lender will normally instruct his foreclosure agent as to a starting bid and a maximum bid.  "Start the bidding at $2 million, Mr. Trustee, but if anyone is bidding against us, keep increasing your bid by an extra $10,000, up to a maximum of $5 million."

A legal, non-conforming property is a commercial property that was legally built years ago, but it could not be newly built today on the land, as the land is currently zoned.  A couple of examples will make this more clear.

Let's suppose that fifty years ago a developer built a 60-unit apartment building in downtown San Francisco with no on-site parking.  Since then the City of San Francisco enacted a municipal ordinance that says every two-bedroom apartment building must have at least one on-site parking space, and every three-bedroom unit must have at least two on-site parking spaces.

This apartment building - the old one with no on-site parking spaces - does not have to be torn down.  It's was legal when it was first constructed, and it is therefore still legal.  However, it no longer conforms to the current city ordinances.  It is non-conforming.

Here's another example of a legal, conforming building.  Suppose that Florida city planners observe that stick-built apartment building adjoining the Atlantic Ocean fared particularly poorly during hurricanes.  After seeing countless such apartment buildings destroyed along the coast, the city planners for most coastal Florida cities adopt an ordinance forbidding the construction of multi-family dwellings within a half-mile of the coast.  Does that mean that all of the apartment building buildings along the Florida coast have to be torn down?  No.  It just means that they are legal, conforming buildings.

Legal, non-conforming buildings can be repaired; but if such a building is substantially damaged - say, in an earthquake or a fire - it cannot legally be rebuild.

Okay, so what?  The lender will insist on a fire insurance policy, right?  If the building burns down, the lender simply gets paid off by the fire insurance proceeds.

Many times this is true; but sometimes a legal, non-conforming commercial building is worth far more than its replacement cost.  Absent a special endorsement to the fire insurance policy, the fire insurer will only pay for the replacement cost of the building!  What if your commercial loan is much larger than the replacement cost?  Yikes!

For example, this 60-unit apartment building might only cost $2.8 million to rebuild, but it might be worth $6 million (before the damage).  Based on the cash flow, a reasonable commercial lender might have placed a $3.9 million commercial loan on the property.  The building burns down.  The insurance company hands the commercial lender a check for just $2.8 million, the building's replacement cost, because the building cannot be rebuilt.  The lender has just eaten a $1.1 million loss.  Ouch!

Okay, so how does a commercial lender protect himself?  He obtains a special endorsment to the owner's fire insurance policy, called a ________________ (anyone know?), that pays more than the commercial property's replacement cost if the building burns down or is otherwise destroyed.  This special endorement to the fire insurance policy costs around 15% to 20% more than a guaranteed replacement cost policy.

My own private money commercial mortgage company, Blackburne & Sons, will gladly finance legal, non-conforming commercial properties.

This is the tenth blog article in my series on commercial second mortgages.  By now it should be clear that commercial second mortgages, in real life, are just not getting made.  The only "commercial loans" that work in their place today are mezzanine loans, preferred equity, and equity.

Please note that I placed the expression, commercial loans, above in quotation marks.  Preferred equity and equity are technically are not loans at all, but rather equity investments.

Please also remember that equity has no required monthly payments.  That's so huge that I am going to say it again.  The difference between debt and equity is that equity has no required monthly payments.

Equity is going to be new hot product in commercial real estate lending for the next decade.  Already you're seeing a hint of it.  Just think about the Blackstone Group and their all-cash purchases of thousands of rental houses all across the country.  They're buying theses houses because they can fix them up, rent them out, and earn 6% to 8% cash-on-cash.  In other words, they can buy a rental house for $80,000, fix it up for another $20,000, and earn $6,000 to $8,000 in positive cash flow thereafter.  It's a great business model.  Where else can you earn 6% to 8% on your money, secured by a valuable hard asset?

So that's one way that equity investors get paid:  Equity investors earn their return from the net postive cash flow on their real estate holdings.  In addition, the yield earned by equity investors includes any property appreciation they can capture when they sell.  Please note that there is no interest income to include because equity is not debt.

Careful: The time when commercial real estate reliably appreciated by 3% to 5% annually may be long gone.  Equity investors need to be mindful of the fact that we are in an era of low inflation.  That being said, commercial real estate, in my humble oppinion, may be poised for a little bit of a Dead Cat Bounce after the Great Recession.  Dead Cat Bounce?  Yeah, they say even a dead cat will bounce if it falls from a high enough building.  Eeeuuuu!  Hey, don't blame me.  No cats were hurt in the making of this blog article.  (My wife and I are owned by six cats.)  It's a Wall Street term.

We here at Blackburne & Sons are working on our standard Private Placement Memorandum for equity deals.  As I was writing to my attorney today, explaining how I wanted the waterfall to work, I thought a part of my email to him might help you to understand.

What a minute.  What on earth is a waterfall?  Please think of a fairly-steep mountain side.  At the top edge of the cliff is a bathtube, into which a garden hose feeds water.  As the top bathtub fills, the bathtub overflows.  Fortunately there is another bath tub on the mountain side almost right below the top bathtub, strategically placed to catch the overflow.  As the second bathtub overflows, the overflow is caught by a third, lower bathtub on the mountain side.  And so on.

Now maybe the hose feeding into the top bathtub is only producing a tiny dribble of water.  Maybe the top bathtub, during the investment term, never quite gets filled to the point of an overflow.  However, if it does overflow, the extra water flows to the second bathtub, and so on.

This is a waterfall.  The water in the hose is the net positive cash flow from the commercial property and the profit, if any, upon the sale of the commercial property.  When it comes to getting paid, you definitely want to be in the top bathtub.

Okay, so here is what I wrote to my attorney today:

"The Private Placement Memorandum and the Operating Agreement should provide for a Preference to our equity investors in the form of a waterfall.  Any net positive cash flow and the proceeds of the sale of the property shall be distributed as follows:

Wait a minute, George.  Earlier you said that equity is not debt.  Who is this "Borrower" that you are talking about above?  You're right.  You caught me.  There is no borrower because equity is not debt.  It does not have to be repaid.  If the entire project blows up, the commercial property owner who received the equity injection would NOT have to repay it.  Really?  Yup.  Equity is not debt.

However, I used the term "Borrower" above to help our mortgage brokers be able to identify the players.  "Programs!  Programs!  You can't tell the Christians from the lions without a program!"  The "Borrower" is the above paragraph is the commercial investor who was buying a property and needed a little more down payment money.  Or the "Borrower" in the above example was the commercial property owner who had a balloon payment coming due that was too large to refinance.  He needed an equity injection to reduce the amount of debt that he had to refinance.

So if there is any money to distribute, our equity investors get paid an 8% return first.  Then our equity investors get paid back their original investment.  Then the "borrower" gets paid back his original downpayment or his original equity in the property.  Then our equity investors earn the rest of their desired 16% to 22% yield.  Then the "borrower" gets to keep the rest.

Remember, because equity is the first loss piece, equity is always far more expensive than debt.  If your "borrower" can raise the money from his friends and family, he should do so.

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.

This is the 8th article in my series on commercial second mortgages.  So far we've discussed commercial second mortgages, mezzanine loans, and preferred equity.  Today we'll discuss equity, as it pertains to commercial real estate finance.

Equity has a dozen different meanings, depending on the context.  In finance, equity is difference between what an asset is worth and how much is owed against it.  Think about your own house.  It's worth $200,000, and you owe just $267,000 against it.  Therefore your equity is ... hey, wait a minute!  You're upside down.  Just having fun here.  :-)

In the context of a company, the owner's equity in a company is the difference between the assets owned by that company and what that company owes.  For example, let's suppose a linen cleaning company owns ten washers, four dryers and six delivery trucks - worth a total of $1 million.  The company owes $400,000 to the bank and various trade creditors.  Therefore, the owner's equity in the company is $600,000.

Now let's suppose our linen cleaning company is incorporated and the stock is publicly traded.  The owner's equity would therefore be evidenced by shares of stock.  If there were 600 outstanding shares of stock, each share of stock would be "worth" $1,000.  This is why the talking heads on Wall Street often use the term, equities.  Shares of common stock are often referred to as equities.

In commercial real estate finance, equity could mean the buyer's downpayment.  Equity could mean the developer's contribution to a construction project.  In the case of an existing commercial building, equity could mean the difference between what the building is worth and what the owner owes against it.

In commercial real estate finance, you will often hear the term, capital.  Capital is defined as wealth, in the form of money or other assets, owned by a person or organization or available or contributed for a particular purpose, such as starting a company or investing.

There are two main forms of capital - debt and equity.  The following point is huge:  The difference between debt and equity is that equity has no required interest payments.

Forgive me while I drive this important point home.  When you bought your house for $300,000, you put down $60,000 in cash (equity) and took out a new first mortgage loan for $240,000 (debt).  You have to make payments on your debt, but not your equity.

Your capital stack is the various layers of debt and equity that you used to raise the entire purchase price.  Here's an example of a capital stack.  You are buying that same house for $300,000.  Your take out a $240,000 first mortgage (debt), the seller carries back a $30,000 second mortgage (debt), and you put $30,000 down (equity).  Your capital stack consists of a first mortgage, a second mortgage, and your downpayment (equity).

Sometimes when those huge office towers in New York City get financed, the capital stack will look like this:  $60 million first mortgage, a $10 senior mezzanine loan, a $7 million junior mezzanine loan, a $10 million senior preferred equity investment, an $8 million junior preferred equity investment, and a $5 million downpayment (common equity).

Earlier we mentioned that equity could mean a developer's contribution to a development project.  Building income properties is a risky business.  There could be cost overruns.  The property could sit vacant for years.  Even when a tenant is finally found, the rent obtained might be 40% lower than projected.  The entire commercial property market could collapse in value by 45%, like it did during the Great Recession.

Clearly, if you are trying to construct a new commercial building, the bank is not going to lend you 100% of the total cost.  Even duing the best of times, the bank is going to want you to have enough skin in the game to make sure you stick around to to complete the building.  That skin in the game is your equity.

In commercial development, your equity will come from several sources.  Your first source will be the cash you spent for the land.  Then there is the cash you spent on the architectural plans, engineering work, and permits.  Then there is value-added equity, an increase in value of the land because you got the zoning changed or you purchased adjacent parcels from different owners and assembled them all into one larger, more developable parcel (assemblage).

Banks modernly will want the commercial developer's equity to total at least 30% of the cost of the entire project.

Banks are still stinging from the losses they took in commercial real estate during the Great Recession.  If an investor wants to buy a garden-variety, multi-tenant office building, he can no longer do so by putting down a mere 25% of the purchase price (his equity).  Nervous banks now often require the buyer to put a whopping 35% down.  Who has 35% to put down?  That's a lot of equity.

It's too bad that there isn't a place where you could go to get a little bit of extra equity.  Or is there?  Blackburne & Sons now provides equity for small commercial projects in California.
 

This is my sixth article on commercial second mortgages and structured finance.  First we said that commercial second mortgages are rare because most commercial second mortgage lenders were wiped out between 1989 and 1991.  Then we said that most bank loan documents prohibit second mortgages behind commercial first mortgages.

Then we described mezzanine loans and the expensive need (huge legal fees) for an intercreditor agreement.  Next we described the New-Money-to-Old-Money Ratio (needs to be larger than 1:3) and the danger of making a small second mortgage behind a much larger first mortgage.  In my last article we said that structured finance includes mezzanine loans, preferred equity, and equity.

Along this long journey I promised to eventually bring you to a warm, profitable place.

Today's topic is preferred equity.  

First let's define a preference.  A preference is a debtor's or investor's right to get paid back first.  Let's suppose you're the richest kid on the block.  Your parents give you a huge weekly allowance of $30.  I come up with the idea of setting up a lemonade and snack stand near the parking lot during Friday night high school football games.  For the card table, lemonade mix, sugar, red Solo cups, cookies, etc. we'll need $30.  You agree to put up the $30 ... BUT, you insist that you get the first $40 of sales receipts.  We agree to split anything over $40 equally.  In this example, that first $40 is a preference.  You negotiated the right to get paid back first.  Got it?

For ease of understanding, I want you to think of preferred equity as being very similar to a mezzanine loan.  A wealthy investor buys a huge office tower in Brooklyn in late-2008 for $12 million at the very bottom of the Great Recession.  He practically steals it at this distressed and deeply-discounted price.  He finances it with an $8 million, 10-year, new conduit loan that has an enormous prepayment penalty (defeasance).

During the next five years the New York City office market recovers.  Brooklyn, in particular, has been greatly gentrified.  Now this Brooklyn office tower is easily worth $22 million.  The investor wants to pull out some of his equity, but he doesn't want to pay a $1.3 million defeasance prepayment penalty.

Therefore he approaches a mezzanine lender for a $5 million mezzanine lender.  The mezz lender looks at the loan documents and breaks the news to him that his conduit first mortgage loan documents forbid not only a second mortgage, but also any mezzanine financing.

All is not lost, however, the mezz lender informs him.  For a 1.5% higher interest rate, the mezzanine lender will made a $5 million preferred equity investment in the property.  The "lender" (actually the mezz lender has become an "investor" at this point because preferred equity is not debt, but rather an agreement to share in the profits and losses) wants a preferred return of 12.5%.

I mentioned above that preferred equity is not technically a form of debt.  Instead, its an agreement to share in the profits and losses.  But there sure better be enough profits to yield the preferred equity investor his yield of 12.5%!  If the preferred equity investor does not get his preferred return, the new Operating Agreement of the "partnership" (actually its an LLC) says that the preferred equity investor can take over the management of the property!

"But George, I thought you said in an earlier article that most conduit and bank loan documents nowadays forbid any transfer of even an equitable interest in the LLC that owns property?"

More precisely most conduit and bank loan documents prohibit the transfer of a 50% or higher equitable interest in the LLC that owns the property.  Therefore, when a preferred equity investor makes a preferred equity investment in a commercial property, they are assigned only a 49% equitable interest in the LLC that owns it.  Fancy lawyer stuff.

Very wealthy investors can pull equity out of their very large commercial properties.  That's the good news.  The bad news is that the legal fees associated with preferred equity investments are so huge that very few preferred equity investments ever get made that are smaller than $5 million (maybe $3 million).  This is a game only played by the polo crowd in New York City, not mere mortals like you and me.

I promised to lead you to a warm, profitable place.  We are almost 85% of the way to our destination.