Commercial Loans and Fun Blog

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.

This is the fifth article in my series on commercial second mortgages, and it will be the hardest article in the series to understand.  Just try to get through it.

Rest assured that I am leading you to a warm, profitable place; but first you have to understand commercial second mortgages (done), mezzanine loans (done), structured finance (today's subject), preferred equity, and finally equity.  I promise that you will be well-rewarded for following along.

What is structured finance?  According to Wikipedia, structured finance is a broad term used to describe a sector of finance that was created to help transfer risk and avoid laws using complex legal and corporate entities.  In commercial real estate finance, the risk to be avoided is any default risk, and the law to be avoided is any income taxes.  Are your eyes glossing over?  Perhaps an example will help.

Wall Street investment bankers are considered to be using structured finance when they securitize credit card debt, scratch-and-dent home loans, auto loans, and sub-prime commercial mortgages into mixed pools.  These pools are a real hodge-podge of assets.  The loans in this giant pool are held by a pass-through trust (a special kind of trust that doesn't have to pay income taxes).

The trust then issues bonds backed by the loans in the pool.  These bonds are called asset-backed securities (ABS) or collateralized debt obligations (CDO's).  Please don't give up on me.  All we are doing is making soup.  We have a great, big pool of water, and we are sprinkling in some car loans, some credit card loans, and some poorer-quality home loans and commercial loans.  We are calling the soup a C.D.O., and the bonds that will be issued by the pool are simply called asset-backed securities.

Different classes of bonds would have different levels of risk, called tranches.  The entire CDO would be rated by some rating agency, and each tranche would be assigned its own risk-rating and yield.  Investors could then choose the tranche that they wanted to invest in, according to how much risk they were willing to accept.  The more risk they accepted, the higher the yield they could earn.

By breaking a debt offering into tranches and giving investors the chance to choose their risk level, investment bankers discovered that they could get far more money for the pool of loans.  A single buyer of the entire pool of loans might only pay $250 million; but if the bonds were broken up into tranches and rated, the investment bankers might get a whopping $290 million for the same pool of loans.  (CDO pools are typically much smaller than CMBS pools.)

"Gee, George, these fancy structured finance securitizations you described above sound just like garden-variety mortgage-backed securities."  Fannie Mae and Freddie Mac have been securitizing residential mortgages for forty years.  Conduits have been securitizing commercial mortgage-backed securities (CMBS) for over a decade.  Tell me something I didn't know."

Asset-backed securities (ABS) are very similar to mortgage-backed securities, except that some of the loans in the pool are not mortgages.  Remember, we have lots of auto loans and credit card loans in the pool.

Hey, we're almost done for the day, and the following is possibly the most important point:

When investment bankers, commercial bankers, and mortgage originators use the term, structured finance, in the context of commercial real estate finance, they usually just mean the making of mezzanine loans, preferred equity investments, and equity investments.

"Geez, George, couldn't you have just said that in the first place?  My brain feels like its gonna explode!"  :-)

This article is the fourth in my series on commercial second mortgages.  In my first article I pointed out that commercial second mortgages are rare because most commercial second mortgage lenders got wiped out in the real estate depression of 1987 to 1991.

In my second article I pointed out that most bank commercial first mortgage loans have a due-on-the encumbrance clause, making it very risky for commercial lenders to make commercial second mortgages.  In my third article I pointed out even mezzanine loans were difficult because modernly most bank commercial loan documents contained an alienation clause, which forbids even mezzanine loans.

In this article we will talk about the relative size of the second mortgage compared to the first mortgage.  For the reasons I will outline here, it is imprudent for a commercial lender to make a second mortgage that is too much smaller than the underlying first mortgage. 

The New-Money-to-Old-Money Ratio holds that the ratio of the second mortgage to the first mortgage should never be smaller than 1:3.  In this ratio, the new second mortgage is the "new money", and the existing first mortgage is the "old money".

Why?  Suppose a second mortgage lender made a $200,000 commercial second mortgage behind a $1.5 million first mortgage.  Remember, if a borrower defaults on his first mortgage, the second mortgage holder has to keep the first mortgage current while he forecloses; otherwise, the second mortgage holder risks being wiped out by a foreclosure of the underlying first mortgage.

Now suppose the borrower defaults on both the first and second mortgages.  The second mortgage lender would have to keep the first mortgage current.  For this example, let's suppose the monthly payments on the underlying first mortgage were $15,000 per month.  If the foreclosure took 18 months*, the second mortgage holder would have to advance 18 monthly payments of $15,000 or a whopping $270,000 - just to protect a tiny $200,000 second mortgage.  Yikes!  In real life, most second mortgage lenders would just walk away.

So what would be a more reasonable second mortgage?  The New-Money-to-Old-Money Ratio suggests that the first mortgage should never be more than three times larger than the proposed first mortgage.  In our example, the first mortgage is $1.5 million.  Therefore the smallest second mortgage that would be economically justifiable would be $500,000.  Most lenders would advance $270,000 to protect $500,000.

*  Above I mentioned that the foreclosure might take 18 months.  Many states use mortgages, rather than deeds of trust.  In a mortgage foreclosure, the process has to take place in court.  Courts can often be backed up and extremely slow.  If the subject property is located in a trust deed state - like California or Arizona - the foreclosure process does not involve the courts and is usually much faster.

In addition, many times a second mortgage lender doesn't realize that the borrower has defaulted on the underlying first mortgage until the borrower is four to five months behind on the first mortgage.  The second mortgage holder would have to cure the first mortgage before he even starts his foreclosure, if he wants to keep the first mortgage lender's late charges, default interest, and legal fees to a minimum.  Yikes!

Lastly, if the property enjoys protective equity, a great many borrowers will file a Chapter 11 Bankruptcy to delay the foreclosure sale.  This means even more months of keeping the first mortgage current.

Later in the week we will talk about preferred equity and then later equity, a fairly sophisicated subject.

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My private money commercial mortgage company, Blackburne & Sons, once had to foreclose on a commercial first mortgage loan on an office building in the State of New York.   Even though the borrower didn't fight us very much, because New York is a mortgage state, as opposed to a trust deed state, it still took us well over 18 months.  The process through the New York courts was very, very slow.

Now imagine if we had a made a $200,000 commercial second mortgage behind a $1.5 million first mortgage.  Remember, if a borrower defaults on his first mortgage, the second mortgage holder has to keep the first mortgage current while he forecloses; otherwise, the second mortgage holder risks being wiped out by a foreclosure of the underlying first mortgage.

It doesn't really matter how much equity the property enjoys.  The property in the above example could have been worth $4 million, and the second mortgage holder would still be wiped out 99% of the time.  Why?  In real life almost no one ever bids at commercial foreclosure sales.

The reason why is because the bidder has to show up at the foreclosure sale with enough cash to pay off the entire foreclosing first mortgage.  If the first mortgage was was originally $1.5 million, with accrued interest, late charges, penalties, legal fees, and foreclosure costs, the bidder would probably have to bring a cashier's check to the foreclosure sale of almost $2 million!  This just doesn't happen in real life.

Okay, so in our example, we made a $200,000 second mortgage behind a $1.5 million first mortgage.  We have to keep the first mortgage current, and let's suppose the monthly payments on the underlying first mortgage were $15,000 per month.  If the foreclosure took 18 months, the second mortgage holder would have to advance 18 payments of $15,000 or $270,000 - just to protect a tiny $200,000 second mortgage.  Yikes!

Clearly commercial second mortgages behind large first mortgages are darned risky.  Therefore smart financiers came up with the idea of mezzanine loans.

You will recall that a mezzanine loan is loan secured by the stock of the corporation that owns the property.  (More precisely, since most real estate investors use LLC's, rather than corporations, a mezzanine loan is a loan secured by the membership interests of the LLC that owns the property.  For ease of understanding throughout this article, however, I will continue to use stock and corporations, rather than membership interests and LLC's.)  If you own all of the stock of the corporation that owns the commercial property, you own the commercial property.

What's the big advantage of a mezzanine loan over a commercial second mortgage loan?  Stock is personal property, not real property.  A foreclosing lender does not have to go through the long mortgage foreclosure process.  Instead, he can simply advertise the foreclosure sale of the stock in a commercially reasonable way and then hold the sale in some attorney's office.  Since no courts are involved, a mezzanine loan foreclosure can happen in just 60 to 70 days!

So far, so good.  But there is a problem.  The alienation clauses of most standard commercial first mortgages prohibit the hypothecation (the pledging of an asset as security for a loan) of the stock of the corporation that owns the property and which borrowed the underlying mortgage loan.  Banks and conduits do this because they don't want some idiot-rookie taking over the management and control of a some multi-million-dollar commercial property.

So how then are mezzanine loans ever made?  The mezzanine lender signs an intercreditor agreement with the underlying first mortgage holder, whereby the first mortgage holder agrees not to disturb the mezzanine lender, if the mezzanine lender forecloses, as long as the mezzanine lender keeps the first mortgage current.

But good luck ever getting a bank to sign an intercreditor agreement.  The vast majority of the time, the bank will refuse to sign an intercreditor agreement; and if they ever do agree to sign one, it takes months of negotiations and thousands of dollars in legal fees.

Commercial second mortgage loans and mezzanine loans are therefore very, very rare.  Monday we will talk about the ratio of new money to old money and preferred equity.

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Yesterday I explained that the most important reason why commercial second mortgages are so rare these days is because all of the commercial second mortgage lenders got wiped out in the commercial real estate depression of 1987 to 1991.  Today I will explain a number of legal barriers facing commercial lenders wishing to make commercial second mortgages.

Most modern commercial mortgages contain a due-on-encumbrance clause.  This means that if the borrower places any junior financing on the property, the underlying first mortgage lender has the right to declare the borrower in default and to accelerate his loan; i.e., demand that the borrower immediately repay the loan in full.

It gets worse.  Most modern commercial mortgages also contain a provision whereby any alienation of title without the first mortgage lender's permission is grounds to accelerate the mortgage.  Alienation of title means the transfer of any legal or equitable ownership right in the property.  In this context the word "alienation" means "to make foreign" or "to send away".  When you alienate your wife's affection by yelling at her, you send her love for you to a foreign planet.

Okay, let's not forget where we are.  We are talking about the legal obstacles to making commercial second mortgages.  Placing a second mortgage on a commercial property constitutes a form of alienation of title.  You better get the lender's permission first because further encumbering the property is grounds for accelerating the bank's first mortgage.

"Mr. Borrower, this is Bob Smith, the loan officer at the bank.  I see that you recently placed a $200,000 second mortgage on your apartment building.  It is my duty to tell you, Mr. Borrower, that because you did not first get our permission, you are now in default on our $3.4 million first mortgage.  We are hereby accelerating it.  Would you please pay off our entire $3.4 million commercial loan by 5:00 p.m. tomorrow?  If you fail to do so, we will be forced to start seizing your assets (like all of the cash in your checking and savings account).  Have a pleasant day."

Have a pleasant day?

Tomorrow we'll talk about prohibitions against mezzanine loans, preferred equity, and springing personal guarantees.