Commercial Loans and Fun Blog

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.

Want to receive free commercial real estate finance training several times per week?  Remember, every chapter in every one of my expensive training courses started out first as a blog article.  Just find my ugly face in the upper-right-hand corner of this blog and fill in your email address below.

Mezzanine Loans Are a Way to Achieve Extraordinary Leverage on Huge Commercial Projects

This blog article was first written in late 2005, long before the start of the Great Recession. Mezzanine lending has not completely disappeared, but the volume of new mezzanine loans has declined by 85% since then. Nevertheless, this blog article was worth saving, as I rearrange articles on my blog.

Mezzanine loans are similar to second mortgages, except a mezzanine loan is secured by the stock of the company that owns the property, as opposed to the real estate.

If the company (usually a LLC) fails to make the payments, the mezzanine lender can foreclose on the stock in a matter of a few weeks, as opposed to the 18 months it often takes to foreclose a mortgage in many states. If you own the company that owns the property, you control the property.

Our own hard money company once had to foreclose a mortgage in New York, and it took almost two years. Yikes! In contrast, a mezzanine loan is secured by the stock of a company, which is personal property and can be seized much faster.

Mezzanine loans are also fairly big. It is hard too find a mezzanine lender who will slug through all of the required paperwork for a loan of less than $2 million. It is occasionally possible to obtain mezzanine loans as small as $1 million.

In addition, mezzanine lenders typically want big projects. If the property you are trying to finance is not worth close to $10 million, you may have a hard time attracting the interest of any mezzanine lenders.

There are three typical uses for a mezzanine loan. Suppose the owner of a $10 million shopping center has a $5 million first mortgage from a conduit. The owner wants to pull out some equity, but he cannot simply refinance the shopping center because the first mortgage has either a lock-out clause or a huge defeasance prepayment penalty. In this instance, he could probably obtain a $2.5 million mezzanine loan to free up some cash.

Suppose an experienced office building investor wanted to buy a partially-vacant office building in a fine location. Once again, assume that the purchase price is $10 million (when the office building is still partially-vacant) and that the conduit first mortgage is $5 million.

This may surprise you, but the right mezzanine lender might be willing to lend a whopping $4 million! But isn't that 90% loan-to-value? Yes, but when the vacant space is rented - remember, our buyer is a pro - the property will increase to $12 million in value. Suddenly the mezzanine lender is back to 75% loan-to-value and his rationale is obvious. This kind of deal is called a value-added deal.

The third and final use of mezzanine loans is for new construction. Suppose a developer wanted to build a 400 room hotel across the street from Disneyland. Hotels today are out of favor, and a commercial construction lender might only be willing to make a loan of 60% loan-to-cost. If the total cost was $20 million, the developer would ordinarily have to come up with 40% of $20 million or $8 million. That's a lot of dough.

A $3 million mezzanine loan solves the developer's problem. The commercial construction lender would advance $12 million, the mezzanine lender would make a $3 million mezzanine loan, and the developer would "only" have to come up with $5 million.

There are about 150 mezzanine lenders active in the country today, and you can apply to most of them by just clicking here.

A Mezzanine Loan is Personal Property, Not Real Property

This is really juicy gossip. A mezzanine lender is foreclosing on a $100 million mezzanine loan that is secured by the largest apartment complex in New York City.

You will recall that a mezzanine loan is not a real estate loan. Instead, a mezzanine loan is loan that is secured by the membership interests (think shares) of a LLC (think corporation) that owns a huge real estate project. If you own all of the company and the company owns all of the property, then you own all of the property.

Why would a lender make a mezzanine loan rather than just a normal mortgage loan? The answer is speed. It can take up to 18 months to foreclose a mortgage in New York. A lender can foreclose on the membership interests of a limited liability company in just 30 days because membership interests in an LLC are just chattel (personal property), not real estate.

The law merely requires that the lender seize the membership interests without breaching the peace and that it conduct the sale in a commercially reasonable manner; i.e., in a manner in which such property is usually sold.

Today I received the fascinating email below that details an upcoming UCC (personal property) foreclosure sale. This is GOOD STUFF.

Dear George,

I am writing to inform you of the upcoming opportunity to bid at public auction on the "Peter Cooper Village/Stuyvesant Town" Mezzanine Loans 1, 2 and 3 (with a face amount of $100 million each), which are indirectly secured by the Peter Cooper Village/Stuyvesant Town property located in Manhattan, New York. The public auction will be adjourned from August 25, 2010 until September 8, 2010 at 11:00 AM (for Mezzanine 3), 12PM (for Mezzanine 2) and 1PM (for Mezzanine 1) at the offices of Brown Rudnick LLP, located at Seven Times Square, 47th Floor, New York, NY 10036.

Peter Cooper Village/Stuyvesant Town, well known as a “City within a City”, was built for MetLife in 1947 and is considered Manhattan’s largest apartment complex. The complex is comprised of 56 buildings, situated on 80 acres and includes 11,227 residential apartments. In addition to the residential component, the complex contains approximately 100,000 square feet of retail space, approximately 20,000 square feet of professional office space, and 6 parking garages with 2,260 licensed spaces totaling approximately 400,000 square feet.

For additional information regarding the public UCC foreclosure sale, please execute the attached Confidentiality and Investment Agreement. Upon the execution and return of the Confidentiality and Investment Agreement in such form, you will be given a USER ID and Password to access the CONFIDENTIAL website located at ...

Thanks,

Joe Schmoe
Lender