- Discuss the types of capital structure and provide an example of each.
- Define a joint venture partner and provide examples of JV partners.
- Compare and contrast the joint venture equity partnership and the fund structure.
- Explain how to form a “good” partnership.
There are three types of properties. The first type is Stabilized Properties. Permanent financing is for stabilized properties. Stabilized properties are fully leased with rents at market rate and current cash flow within the properties. With these properties, there is no more work to be done to “grow or groom” the NOI. Finally, in regards to risk, the lenders are betting that nothing “bad” will happen to the project cash flows in the future.
The second type is Unstabilized or Value-Added Properties. Shorter term or floating rate financing, is typically more appropriate for value added properties. These properties are not fully leased, and/or rents are not at market. In addition, there is usually substantial work to be done before the property becomes stabilized. Finally, in terms of risk, something “good” needs to happen to the property cash flow in order to stabilize the property and achieve the business plan objectives.
The third type is Opportunistic Properties. These properties normally require “specialized” financing. With these properties, there are several exit strategies to consider.
- The exit strategies for these properties require one of the following:
- Residential sale exits: Typically relates back to the strength of the consumer (i.e. residential land and condominiums).
- Commercial sale exits: Usually relates to commercial land that has an exit strategy of sales to commercial developers.
- Development/construction: The property needs to be built and leased (which creates construction risk and lease-up risk).
- Extensive renovation or change of use: The property has no cash flow in the beginning and may need to go through a change of use (i.e. office to apartments).
- The risk: Numerous “good” things need to happen.
Commercial real estate capital structure is often misunderstood and misused by many, but this can be avoided by understanding how the capital structure works in commercial real estate finance. There are six different capital structure products that we will discuss in this course.
First Trust Debt is included in the “ascending level of risk” structure that you can view in the matrix below. With this type of structure, the typical Loan-to-Value (LTV) is 60% to 75%. This type of structure is secured by a first trust deed. When the lender provides the funds for the project, they will require a security interest in your property that takes priority over all others. This is important because if for any reason the borrower does not pay back the loan, the lender has the ability to foreclose on the property and would be “paid” first after selling the property. In order to make sure the lender has seniority, they will obtain a first deed on the property. If the borrower defaults on the loan, the first trust deed will ensure the lender has priority during the foreclosure action even if junior liens exist on the property.
Mezzanine loans are also known as “junior mortgages” and “participating debt/equity.” Mezzanine financing is considered a hybrid of debt and equity financing. This type of financing is also included in the ascending level of risk. The mezzanine debt is paid after the first trust debt is repaid, but before the equity is repaid. The typical mezzanine financing deal has a LTV of 50 percent to 90 percent, depending on the deal. Mezzanine financing creates a unique resolution if the loan is not paid back in time or in full. The lender would have the right to convert to an ownership or equity interest in the company. The lender would be able to “step into the shoes” of the General Partner or managing member in order to make decisions for the company going forward. This equity is usually subordinated to debt provided by senior lenders at banks and venture capital companies.
Mezzanine financing is often done quickly, so very little due diligence is completed by the lender and little or no collateral is provided by the borrower. This type of capital structure is aggressively priced and the lender will seek a return of 20-30 percent. If a default does occur, the traditional remedy is to pay off the first trust loan and the mezzanine lender would become the senior lender. The mezzanine lender would assume the first trust loan keep the senior in place.
The preferred Equity Mezzanine is similar to the Mezzanine financing, but the biggest difference is that mezzanine debt is usually structured as a loan that is secured by placing a lien on the property while the preferred equity financer takes an equity investment in the property-owning entity. The typical LTV percentage is 80 percent to 100 percent. Preferred equity can be a positive financing tool because it provides the borrower with higher levels of leverage at a lower cost than common equity. Investors also benefit because they have a more secured position relative to the equity, but a higher yield because of their risk since they are subordinated to the senior loan.
In reality, the preferred equity investor is making an unsecured loan and the investor is relying on the partnership agreement to determine his/her rights and benefits, if needed. In terms of repayment, the current or accrued “pay rate” must be totally repaid (principal and interest) to the investor first, prior to the return of capital.
If the borrower does not pay the loan, the investor’s remedy is to the General Partner and not to the property. The typical remedy is dilution of the General Partnership’s economic interests and/or their ability to manage or control the property.
The next type of capital structure includes Hard Money, Bridge Loans, Distressed Loans, and Value-Added Financing. These are all similar types of financing that represents our second category of capital structures as being Super/Senior Debt.
This financing category is often considered the “last resort” or short-term loan. This type of financing is different because the lenders are more concerned with the value of property versus the credit worthiness of the borrower. Borrowers for this type of financing usually have credit issues, such as low credit scores or even past issues with repaying credit. The interest rates are also usually higher and higher loan fees are likely to be charged. The property itself is used as the main protection against default, so the LTV ratios are lower than the other capital structures discussed above. The typical LTV range is 60 percent or less.
For security or collateral, the lender will take a first trust deed and will obtain the first priority in terms of preference of repayment. If the borrower does default, the typical remedy is to foreclose on the collateral. This would also include any and all additional cross-collateralized assets.
Debtor-in-Possession Loans (DIP)
Debtor-in-Possession Loans (DIP) is financing that is arranged by a company while in Chapter 11 bankruptcy process. DIP financing is unique from the other capital structure financing we have discussed because it has priority over existing debt, equity, and other claims. The reason for this is because absolute first priority is mandated by the Bankruptcy Court. Similar to the Hard Money loans, the property itself is used as the main protection against default, so the LTV ratios are lower than the other capital structures discussed above. The typical LTV range is 60 percent or less.
In terms of collateral and security, DIP has super priority first trust deed. This is senior to any mezzanine financing and any senior trust deeds in the capital structure. In case of a default, the traditional remedy is to foreclose on the collateral and wipe out any mezzanine and senior trust deeds.
Super Collateralized Loans (Super C)
Super Collateralized Loans (Super C) are also very low in LTV and are typically less than 30 percent. This type of financing is also known as a Triage Loan. For security and collateral, first priority is required. If the borrower defaults, the lender will foreclose on the collateral and include any additionally cross-collateralized assets.
Commercial real estate capital structure is often misunderstood and misused by many, but this can be avoided by understanding how the capital structure works in commercial real estate finance. There are six different capital structure products that we discussed in this course.
For this assignment, please list the six capital structure products and provide your own definition of the product and an example of who would offer the product.