This is the tenth blog article in my series on commercial second mortgages. By now it should be clear that commercial second mortgages, in real life, are just not getting made. The only "commercial loans" that work in their place today are mezzanine loans, preferred equity, and equity.
Please note that I placed the expression, commercial loans, above in quotation marks. Preferred equity and equity are technically are not loans at all, but rather equity investments.
Please also remember that equity has no required monthly payments. That's so huge that I am going to say it again. The difference between debt and equity is that equity has no required monthly payments.
Equity is going to be new hot product in commercial real estate lending for the next decade. Already you're seeing a hint of it. Just think about the Blackstone Group and their all-cash purchases of thousands of rental houses all across the country. They're buying theses houses because they can fix them up, rent them out, and earn 6% to 8% cash-on-cash. In other words, they can buy a rental house for $80,000, fix it up for another $20,000, and earn $6,000 to $8,000 in positive cash flow thereafter. It's a great business model. Where else can you earn 6% to 8% on your money, secured by a valuable hard asset?
So that's one way that equity investors get paid: Equity investors earn their return from the net postive cash flow on their real estate holdings. In addition, the yield earned by equity investors includes any property appreciation they can capture when they sell. Please note that there is no interest income to include because equity is not debt.
Careful: The time when commercial real estate reliably appreciated by 3% to 5% annually may be long gone. Equity investors need to be mindful of the fact that we are in an era of low inflation. That being said, commercial real estate, in my humble oppinion, may be poised for a little bit of a Dead Cat Bounce after the Great Recession. Dead Cat Bounce? Yeah, they say even a dead cat will bounce if it falls from a high enough building. Eeeuuuu! Hey, don't blame me. No cats were hurt in the making of this blog article. (My wife and I are owned by six cats.) It's a Wall Street term.
We here at Blackburne & Sons are working on our standard Private Placement Memorandum for equity deals. As I was writing to my attorney today, explaining how I wanted the waterfall to work, I thought a part of my email to him might help you to understand.
What a minute. What on earth is a waterfall? Please think of a fairly-steep mountain side. At the top edge of the cliff is a bathtube, into which a garden hose feeds water. As the top bathtub fills, the bathtub overflows. Fortunately there is another bath tub on the mountain side almost right below the top bathtub, strategically placed to catch the overflow. As the second bathtub overflows, the overflow is caught by a third, lower bathtub on the mountain side. And so on.
Now maybe the hose feeding into the top bathtub is only producing a tiny dribble of water. Maybe the top bathtub, during the investment term, never quite gets filled to the point of an overflow. However, if it does overflow, the extra water flows to the second bathtub, and so on.
This is a waterfall. The water in the hose is the net positive cash flow from the commercial property and the profit, if any, upon the sale of the commercial property. When it comes to getting paid, you definitely want to be in the top bathtub.
Okay, so here is what I wrote to my attorney today:
"The Private Placement Memorandum and the Operating Agreement should provide for a Preference to our equity investors in the form of a waterfall. Any net positive cash flow and the proceeds of the sale of the property shall be distributed as follows:
Wait a minute, George. Earlier you said that equity is not debt. Who is this "Borrower" that you are talking about above? You're right. You caught me. There is no borrower because equity is not debt. It does not have to be repaid. If the entire project blows up, the commercial property owner who received the equity injection would NOT have to repay it. Really? Yup. Equity is not debt.
However, I used the term "Borrower" above to help our mortgage brokers be able to identify the players. "Programs! Programs! You can't tell the Christians from the lions without a program!" The "Borrower" is the above paragraph is the commercial investor who was buying a property and needed a little more down payment money. Or the "Borrower" in the above example was the commercial property owner who had a balloon payment coming due that was too large to refinance. He needed an equity injection to reduce the amount of debt that he had to refinance.
So if there is any money to distribute, our equity investors get paid an 8% return first. Then our equity investors get paid back their original investment. Then the "borrower" gets paid back his original downpayment or his original equity in the property. Then our equity investors earn the rest of their desired 16% to 22% yield. Then the "borrower" gets to keep the rest.
Remember, because equity is the first loss piece, equity is always far more expensive than debt. If your "borrower" can raise the money from his friends and family, he should do so.