Commercial Loans Blog

Commercial Second Mortgages VI and Preferred Equity

Posted by George Blackburne on Fri, Aug 23, 2013

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.

Submit Your Loan to 750 Commercial   Lenders Using  It's Free!

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.

Free List of 3,159 Commercial Lenders  Sort By Your Own Criteria

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.

Click me

Apply For a Commercial Loan to Blackburne & Sons 


Topics: preferred equity