Commercial Loans and Fun Blog

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 an immensely important blog article for you.  If you can make the leap from just arranging commercial real estate loans (debt) to arranging both commercial real estate debt and real estate equity, you will have truly become a commercial real estate financier.

The first step to becoming a true financier is to understand the concept of equity.   The link above is an article that you should read first before going any further.  I please mean it.  Equity has about a dozen different definitions, depending on the situation.  Please read this article first before going any further.

Okay, now that we understand the concept of equity, let's talk about the cost of equity.

Equity is the first-loss piece.  It's kind of like that old joke:  What do a divorce and a tornado have in common?  Answer:  Somebody is going to lose a trailer.  If anyone is going to take a loss in a real estate deal, its going to be the holder or the contributor of the equity.

For example, let's suppose four yuppies pool their savings to buy a rental duplex in Council Bluffs, Iowa.  Between the four yuppies, they put 30% down on a $200,000 purchase price.  Crop prices suddenly fall, over-leveraged farmers across the country start losing their farms in foreclosure, and John Deere closes the nearby manufacturing plant.  Ten thousand workers are laid off in Council Bluffs, and rents plummet.

The yuppies can no longer find tenants for their rental duplex, they fall behind in their mortgage payments, and eventually the house sells at the foreclosure sale for $150,000.  After the $10,000 selling costs (foreclosure trustee, title policy, closing costs, etc.), the bank nets $140,000 - enough money to be repaid in full.

All is well, right?  Not if you contributed the equity!  The first people - and in this case, the only people - to lose money in this failed investment were the contributers of the equity.  They lost their entire $60,000 downpayment.  Equity is always the first-loss piece.

Remember, we're talking about the cost of equity.  Investing in equity is very, very risky, and in order to attract investors, the potential return has to be higher than what they can receive in competing real estate investments.

Well, banks are making commercial first mortgages at around 5.5%.  Their loans are pretty safe, typically just 65% LTV to good credit borrowers.  Hard money lenders are offering investments in commercial first and second mortgages at rates of between 10% and 14% (and they charge their borrowers 3 to 5 points as well).  Even hard money second mortgage investments are far safer than equity investments.

Therefore, you should not be surprised to learn that equity investors want to earn at least 16% to 20%.  In addition, the broker syndicating the investors is going to charge at least 6 to 10 points.  This isn't just what Blackburne & Sons is charging.  This is the market.  Equity is expensive.

Equity money is also very difficult to raise because of the risk.  Therefore, Blackburne & Sons can only raise equity for commercial real estate projects in amounts of between $150,000 and $600,000.  In other words, we play only in the minnow pond when it comes to equity.

Here are some sample scenarios:

1. The owner of a company has a balloon payment coming due on his industrial building.  He owes $2 million.  The property was once worth $3 million, but after the Great Recession it has fallen to just $1.9 million.  The bank has offered to accept a discounted pay-off (DPO) of just $1.35 million, but the largest new mortgage he can find is $1.1 million.  He is $250,000 short, and he doesn't have the dough to make up the difference.  Blackburne & Sons may be able to raise the $250,000 short-fall.
2. An experienced commercial real estate investor spots the deal of a lifetime - a partially leased office building in an affluent part of town that would cost $3 million to rebuild.  The seller has accepted a $2 million purchase offer, and the buyer has 25% ($500,000) to put down.  The buyer approaches every bank in town, but none of them (the big sissies) will lend more than $1.1 million because of the vacancies.  Blackburne & Sons may be able to raise the $400,000 short-fall for him.

We will pay referring brokers a finder's fee of 2 points on the net amount ($250,000 and $400,000 in the examples above) of the equity we raise.

Got a potential equity deal?  Please call or write Angela Vannucci, Vice President and the General Manager of our Equity Department, at 916-338-3232 or email her at angelav@blackburne.com.

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The concept of equity is far more complicated than you probably think; but if you want to play in the big leagues of commercial mortgage finance and structured finance, you need to be able to understand the dozen or so different meanings of the word, equity.

Let's take an easy example first - the equity in your home.   Your house is worth $400,000.  You have a $250,000 mortgage against it.  The difference between the value of your house and what you owe against it is your equity - or $150,000 in this case.

Can a business have equity?  Let's say your mortgage business is worth $2 million because you have a huge book of repeat clients.  The company owes $30,000 on a car loan, $75,000 on your furniture loan, and another $95,000 to the bank on its line of credit.   The difference between the value of company ($2 million) and the debt against the company ($200,000) is the owner's equity in the company ($1,800,000).  So you can have equity in a company, just as you can have equity in real estate.

In fact, investment bankers (think: stockbrokers) are in business of raising both debt (think: loans) and equity (think:  investments by outsiders) for corporations.  In order to raise equity dollars for a corporation, an investment banker will find buyers for the corporation's stock.  The difference between the assets of a corporation and its liabilities is called the stockholder's equity.

Now the wonderful thing about equity is that equity has no required payments.  If you borrow from the bank to grow your company, you might have to make payments of, say, $9,000 per month.  If the economy goes into a severe recession, you may not be able to make your $9,000 monthly payments.  The bank might foreclose and wipe you out.  You could lose your company.

But if you were able to raise the money to expand your business or to renovate your apartment building by selling equity, you would be far better off in a recession.  There are no required payments on equity investments.  You do not have to declare a dividend to the stockholders if the company is struggling.  The investors in common stock cannot foreclose on your company if you cannot afford to pay them a dividend.  They just have to wait until better times to get a return on their investments.

Equity investments are risky because the equity investors are the last to be paid if the company or project fails and the assets are sold off to pay the creditors.

Suppose you cannot afford to make the monthly payments on your house.  You can't even afford repairs.  The house deteriorates, so it is now only worth $360,000.  The mortgage has been unpaid for months, and with interest and penalties, the balance grows to $290,000.  The house sells at the foreclosure sale for only $300,000 because hardly anyone ever bids at foreclosure sales in real life.  Guess what?  The bank gets their entire $290,000 and the owner - the equity investor - only gets $10,000.

The equity investors are the last to be paid when a business or a piece of real estate is sold off to pay the debt.  The equity investors take the biggest risk.

Equity also is an important concept in construction financing.  Suppose a project will cost $10 million to build.  The bank will usually insist that the owner of the project (the developer) must put up 20% of the total cost of the project, or $2 million in this case.  This $2 million is the developer's equity contribution and can consist of his equity in the land, any costs he has pre-paid (architectural fees, engineering fees, etc.), and the cash he can bring to the loan closing.

What if the developer doesn't have enough equity dollars in the project?  The developer can sell part-ownership of the project to some rich doctors that he knows in order to raise more equity.

Another alternative would be to get a mezzanine loan (sort of like a second mortgage) behind the construction loan.

Finally, the developer can go to a company that specializes in raising equity dollars for real estate projects.  You can think of real estate equity investors as venture capitalists who help provide the equity required by construction lenders.  In return for their equity investments, these investors typically require a preferred return (they get paid before the developer gets paid anything), as well as a large share of the ownership of the project.

As you can see, equity means a lot of different things, depending on the context.  But the important concept to understand is that equity provides a protective buffer for the  lender, and from the lender's point of view, the more equity, the better.