Commercial Loans and Fun Blog

This is the fifth article in my series on commercial second mortgages, and it will be the hardest article in the series to understand.  Just try to get through it.

Rest assured that I am leading you to a warm, profitable place; but first you have to understand commercial second mortgages (done), mezzanine loans (done), structured finance (today's subject), preferred equity, and finally equity.  I promise that you will be well-rewarded for following along.

What is structured finance?  According to Wikipedia, structured finance is a broad term used to describe a sector of finance that was created to help transfer risk and avoid laws using complex legal and corporate entities.  In commercial real estate finance, the risk to be avoided is any default risk, and the law to be avoided is any income taxes.  Are your eyes glossing over?  Perhaps an example will help.

Wall Street investment bankers are considered to be using structured finance when they securitize credit card debt, scratch-and-dent home loans, auto loans, and sub-prime commercial mortgages into mixed pools.  These pools are a real hodge-podge of assets.  The loans in this giant pool are held by a pass-through trust (a special kind of trust that doesn't have to pay income taxes).

The trust then issues bonds backed by the loans in the pool.  These bonds are called asset-backed securities (ABS) or collateralized debt obligations (CDO's).  Please don't give up on me.  All we are doing is making soup.  We have a great, big pool of water, and we are sprinkling in some car loans, some credit card loans, and some poorer-quality home loans and commercial loans.  We are calling the soup a C.D.O., and the bonds that will be issued by the pool are simply called asset-backed securities.

Different classes of bonds would have different levels of risk, called tranches.  The entire CDO would be rated by some rating agency, and each tranche would be assigned its own risk-rating and yield.  Investors could then choose the tranche that they wanted to invest in, according to how much risk they were willing to accept.  The more risk they accepted, the higher the yield they could earn.

By breaking a debt offering into tranches and giving investors the chance to choose their risk level, investment bankers discovered that they could get far more money for the pool of loans.  A single buyer of the entire pool of loans might only pay $250 million; but if the bonds were broken up into tranches and rated, the investment bankers might get a whopping $290 million for the same pool of loans.  (CDO pools are typically much smaller than CMBS pools.)

"Gee, George, these fancy structured finance securitizations you described above sound just like garden-variety mortgage-backed securities."  Fannie Mae and Freddie Mac have been securitizing residential mortgages for forty years.  Conduits have been securitizing commercial mortgage-backed securities (CMBS) for over a decade.  Tell me something I didn't know."

Asset-backed securities (ABS) are very similar to mortgage-backed securities, except that some of the loans in the pool are not mortgages.  Remember, we have lots of auto loans and credit card loans in the pool.

Hey, we're almost done for the day, and the following is possibly the most important point:

When investment bankers, commercial bankers, and mortgage originators use the term, structured finance, in the context of commercial real estate finance, they usually just mean the making of mezzanine loans, preferred equity investments, and equity investments.

"Geez, George, couldn't you have just said that in the first place?  My brain feels like its gonna explode!"  :-)

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.

I just finished recording a ten-minute primer on structured finance - including mezzanine loans, preferred equity, and venture equity.  If you have ever wondered, "What on earth is a mezzanine loan?" or "What is preferred equity?", this short video will explain in layman's terms what they are about.