Commercial Loans and Fun Blog

If you are a conventional buyer of commercial real estate, or if you are a commercial broker, this article is VERY important to you.  The reason is because you are about to discover a BIG problem with your next commercial real estate loan.

It is very hard these days for a buyer or a commercial broker to put together a conventional purchase of an investment property, like an office building or a shopping center.  Banks today will only make commercial mortgage loans up to around 58% to 63% loan-to-value.  This means the buyer of a commercial property - assuming he can't get an SBA loan - has to put 37% to 42% down in cash.  Who has that kind of money?

The good news is that Blackburne & Sons has a wonderful new commercial loan product - more precisely a preferred equity investment - that will solve this problem for you.

Why are the banks so conservative when underwriting commercial real estate loans today?  Many commercial banks lost a ton of money in commercial real estate loans during the Great Recession.  These banks watched in horror as commercial real estate fell in value by 45%.  In addition, the portfolios of many commercial banks are too heavily invested in commercial loans today.  Why?  They can't get these legacy loans (loans written before the Great Recession) off the books.  Although the vast majority of these legacy loans are current, a great many of them are past maturity, and they exceed 85% loan-to-value, based on today's lower values.  Yikes!

To make matter worse, not only will few banks make commercial loans that exceed 58% to 63% loan-to-value, these banks will NOT allow junior financing (a second mortgage).  In other words, the seller cannot carry back a second mortgage.  The banks don't want to see these commercial properties over-burdened with debt.

"Okay, George, you promised me the cure for this problem.  Let's hear it."

Blackburne & Sons will add its dough to the buyer's downpayment to come up with the 37% to 42% required by the bank.  Typically the buyer will come up with the first 20% to 25%, and we'll come up with the rest.  In return, Blackburne & Sons will take a preferred equity investment in the property.

A preferred equity investment is NOT a second mortgage or even a mezzanine loan.  It's an equity investment.  The buyer of the property is not promising to pay any interest rate to the preferred equity investor, nor is he promising to even repay the preferred equity investor's original investment.  Repayment is dependent on the success of the real estate venture.

If the real estate venture is successful, however, the first equity investor to be repaid is the preferred equity investor.  He's special (said in the voice of the Church Lady from Saturday Night Live).  The original buyer of the property - who owns what is known as the common equity - only gets paid any profit after the preferred equity investor gets repaid his original investment, plus the agreed-upon preferred return.

An example will make this more clear.  Let's suppose that Robert Buyer teams up with Blackburne & Sons to buy for $1 million a small row retail building in downtown Palo Alto, California.  Mr. Buyer puts up $250,000 and Blackburne & Sons puts up $120,000 in a preferred equity position.  The bank makes a new commercial loan of $630,000.  The agreed-upon preferred equity return is 17%.

Just weeks after we buy the property, Apple Computer decides to buy this entire block in Palo Alto as part of their campus.  Apple agrees to pay a ridiculous sum, a whopping $2 million.  The all-cash deal closes just 30 days later.  The equity holders get to split a cool $1 million profit.  But who gets what?

The profit distribution plan of an equity venture is called a waterfall.  In this case, the first equity investor to be repaid its $120,000 principal investment is Blackburne & Sons.  Is there any more left over?  Yup, there's TONS of money left over.  Okay, so Robert Buyer gets back his $250,000 principal investment.  Is there any money left over?  Yes.

Therefore, Blackburne & Sons earns its preferred return of 17% annually (prorated for 37 days), so we earn a whopping $397.  The balance of the $1 million profit ($999,603) goes to Robert Buyer!

An important and very favorable point to notice here is that Blackburne & Sons can be bought out at any time for our original principal, plus its preferred return (17% annually in this example) since inception, compounded, with no prepayment penalty!

Let's look at another example.  Let's suppose we buy together a multi-tenant office building.  Unfortunately two of the seven tenants move out.  Therefore the property is not bringing in the kind of income that we projected.  Fortunately the property is making enough money to service the first mortgage, plus there is enough to pay the preferred equity investors a 5% return, but not the agreed 17% preferred return.

What happens?  Can Blackburne & Sons sue Robert Buyer?  No!  Remember, Mr. Buyer never promised Blackburne & Sons any sort of return, not even a return of its $120,000 principal investment.  All Blackburne & Sons can do legally is fire Mr. Buyer and bring in a more competent property manager.

What happens to the unpaid preferred return?  It accrues, defers, and compounds at 17%.  When the property sells, any profit will first be applied towards these arrearages.

"Okay, George, what you're describing is pretty garden-variety preferred equity.  What's so special about your program?"

The unique thing about Blackburne & Sons' Preferred Equity Program is that we will make TINY deals.  Most preferred equity providers have a $3 million minimum.  Blackburne & Sons will only make preferred equity investments of between $100,000 and $600,000.

"How much does your equity cost?"

Each deal is individually priced, so a lot depends on the deal.  Deals in California are much cheaper.  Attractive properties are cheaper.  In these equity investment deals, the CV (curriculum vitae or the business resume) of the buyer matters a lot.

That being said, most deals will cost between 16% and 22% annually and eight origination points.  Keep in mind that these preferred equity investments are tiny-tiny amounts, especially when compared to the bank's new first mortgage.  If he can borrow $630,000 at only 4.75% and $120,000 at 17%, the buyer's weighted average cost of funds is dirt cheap (6.71%).   Also remember that the buyer can buy out Blackburne & Sons at any time.

"How do we get started?

Just call your Blackburne & Sons loan officer or call Angela Vannucci, Vice President and Equity Division Manager, at 916-338-3232.

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.

Mezzanine Loans Are More Expensive Than Mortgage Debt But They Are Much Cheaper Than Equity

This is another blog article that was written in late 2005, long before the Great Recession. Since the financial crisis started, mezzanine financing has declined by 85%; but it has not disappeared. The pricing of mezzanine loans has surely changed since late 2005, but this article should give you a starting point.

There are two main types of mezzanine loans - mezzanine loans on standing property and mezzanine loans on construction projects. We shall use the terms standing mezz and construction mezz.

Let's suppose an investor bought an office building 8 years ago for $10 million, and the building is now worth $18 million. He originally obtained a $7.5 million permanent loan from a CMBS lender that is paid down to $7 million. Therefore he owes just $7 million on an $18 million property, and he wants to pull out some cash to buy another building.

CMBS lenders do not permit second mortgages, and their prepayment penalties are ghastly. Therefore the investor will need to get a mezzanine loan to pull out his equity. Today mezzanine lenders are very agressive, so he should be able to easily obtain a standing mezz loan of $7.4 million (80% LTV).

What would this loan cost him? He has two options. One option would be to get a floating rate, standing mezz loan. The other option would be a fixed rate loan.

A floating rate deal would probably cost him one-month LIBOR plus 400 to 500 basis points (bps). Lenders sometimes use the expression, "400 to 500 bips over". In structured finance, one-month LIBOR is so common that lenders don't even have to make reference to the name of the index. Today one-month LIBOR is around 4.4%, so the cost of his loan would be 8.4% to 9.4%.

The typical loan fee would be one point, plus maybe an exit fee of one point.

The term of the standing mezz loan would be coterminous with the first mortgage; i.e., they would mature on the same date. Since the original CMBS loan had a term of ten years, and since the CMBS loan was originated eight years ago, the standing mezz loan would have a term of two years.

Standing mezz loans typically have a term of one to three years, but extention options are often available. Some mezzanine lenders are even willing to go out five to ten years.

In our earlier example, the total debt stack on the office building was 80% loan-to-value. The debt stack includes all of the mortgages, mezzanine loans, and preferred equity investments directly or indirectly secured by the property. Did you know on some very large commercial projects that there will be a first mortgage piece, a senior mezz piece, a junior mezz piece, and a preferred equity piece? That pie is sliced and diced every which way from Sunday.

If a new buyer wanted to buy the office building and assume the $7 million first mortgage loan, he might want a mezzanine loan up to 90% of the purchase price. This way he would only have to put 10% down.

A mezzanine loan of 90% loan-to-value is more risky than one that is 80% LTV. Mezzanine lenders will often use the term loan-to-cost here because appraisals are mistrusted and the building is actually costing the buyer $18 million. A mezzanine loan of 90% LTC might cost 500 to 700 bips over. In this case the cost to the buyer would be 9.4% to 11.4%.

Fixed rate standing mezz deals are typically priced at 450 to 550 basis points over ten-year Treasuries. Ten year Treasuries today are around 4.5%, so fixed rate mezzanine loans up to 85% LTV might cost the borrower 9% to 10% interest. If a buyer needed 90% LTC financing, a fixed rate mezzanine loan might cost 550 to 750 bips over 10-year Treasuries, or 10% to 12% interest.

Construction mezz is typically priced on a floating rate basis with some sort of profit participation. The developer almost always needs at least 90% LTC financing. Therefore a typical deal might be priced at 600 to 700 bips over with a 10% to 25% participation. Since one-month LIBOR is 4.4%, the interest rate might be around 10.4% to 11.4%, plus the profit participation.

Sometimes mezzanine lenders may even go up to 93% to 95% of cost, but these loans are so risky that they are almost joint ventures. As a result, they are very costly. The developer will pay at least 11% to 13% interest plus up to 50% of the profits.

Equity investments from partners and merchant bankers usually cost in the range 18% to 30% annually; therefore in most cases mezzanine debt is much cheaper than equity.

You can apply to scores of mezzanine lenders on C-Loans.com.

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.