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.