Fill Gaps in the Capital Stack
Alternative financing options for small-balance investors
are gaining traction
Written By Noah Miller, Vice President of Gelt Financial LLC
Featured article in Scotsman Guide February 2022
With life beginning to return to some form of post-pandemic normal and businesses reopening their offices nationwide, demand for commercial real estate has been on the rise. Mortgage brokers can see evidence of this trend from a variety of data sources.
Real Capital Analytics recently reported that a record level of commercial real estate — including multifamily housing, office buildings, retail centers, e-commerce distribution centers, and more — was purchased in third-quarter 2021. Commercial property sales for the first nine months of 2021 rose to $462 billion, up 10% compared to the same period in 2019 and the highest sales volume in history for this nine-month period.
As the U.S. economy continues to recover from the shock waves of COVID-19, commercial mortgage lenders and investors of all stripes are looking for a piece of the emerging real estate market. Unfortunately, the playing field is heavily tipped in favor of institutional investors that have almost unlimited access to funds to complete their capital stacks, particularly in regard to preferred equity and mezzanine debt financing. But this may be changing.
The key to democratizing the commercial real estate market is to educate borrowers and brokers who work in the sub-$5 million space. Commercial mortgage brokers and borrowers need to learn about the market for small-balance versions of preferred equity and mezzanine funding. They should know about the myriad capital options they can tap into, including preferred equity and mezzanine debt, which small-balance investors can use to complete their capital stacks. Small-balance lenders also need to understand these products to be able to provide the right services for their borrowers.
Understand the basics
It is important for lenders, brokers and borrowers to understand the differences between preferred equity and mezzanine debt before diving into this area. Preferred equity is usually structured as an investment in the ownership entity, where the preferred equity is senior to the common equity. In this structure, the preferred equity may have certain control rights and gets paid before the common equity. On the other hand, mezzanine financing, which is debt, is typically structured as a pledge of the ownership entity. In certain cases, a lien also may be recorded against the property.
In terms of pay structure, preferred equity and mezzanine financing each hold senior positions to common equity and are subordinate to the first-mortgage debt. The reason that these two financing tools are combined into one concept is because both are used to increase leverage on the property and to reduce the owner’s capital requirements.
The benefits and drawbacks of both types of financing tend to be one and the same — additional leverage. One main incentive is that property owners don’t have to invest as much of their own equity by using these types of financing tools. As less equity is invested in the deal, the yield will be increasingly higher. Additionally, owners can pull out equity from their existing properties and use it for new investments.
“The key to democratizing the commercial real estate market is to educate borrowers and brokers who work in the sub-$5 million space.”
Like any type of leverage, however, these types of financing are strategic tools. Lenders should be cautious and ensure that property owners only take on leverage that they can comfortably service. Since capital providers have rights and remedies if they are not repaid, owners and operators can actually go into default and, in a worst-case scenario, be forced into foreclosure.
Complete the stack
Traditional commercial real estate loans often provide about 70% of the total amount needed to purchase an asset, leaving it up to the borrower to come up with the additional 30%. For those who don’t have enough cash or want to increase their yields, preferred equity or mezzanine debt can provide buyers with additional financing.
As mentioned, such financing is a mix of debt and equity. It sits in a subordinate position to the first mortgage but is senior to the common equity contributed by the owner. In terms of repayment structure, while the first mortgage debt is often priced with interest of 4% to 7% and equity usually earns 18% to 25% returns, preferred equity and mezzanine debt financing typically have returns in the 10% to 15% range. This structure can be negotiated but is often split between a current portion and an accrued portion.
This type of financing is useful in several situations, such as when buyers cannot write the entire equity check themselves. These options also can be used when borrowers want to spread their capital across multiple deals or when they want to take cash out of their existing properties.
Take the following acquisition scenario as an example of how this type of financing can be used. Nancy is under contract to purchase a neighborhood shopping center for $2 million and has a lender lined up to provide $1.4 million (70%) for the first mortgage. For Nancy to complete the purchase, she will need $600,000 (the remaining 30%) in cash.
Alternatively, Nancy may want to consider bringing in a preferred equity or mezzanine debt provider to help her bridge the gap. Assuming that this source is comfortable going up to 85% of the purchase price, they would be willing to provide her with a $300,000 capital investment. This would mean that Nancy now has leverage of $1.7 million ($1.4 million from the first mortgage and $300,000 from the preferred equity or mezzanine debt). Nancy now only has to come to closing with $300,000 of her own money.
In a refinance scenario, Jim purchased an apartment building for $1 million and spent the past year renovating the property. He successfully increased the net operating income and now the asset has a value of $1.5 million. Jim has increased his equity in the property and can use preferred equity or mezzanine debt financing in much the same way that someone would use a home equity line of credit to pull cash out of their primary residence.
Let’s assume that Jim has an existing loan balance of $700,000 after purchasing the property for $1 million, or 70% of the original value. Now a lender might be comfortable providing Jim with preferred equity or mezzanine debt that would boost his leverage to 85% of the new value for a total loan of $1,275,000. This would allow Jim to cash out $575,000.
These types of financing tools have been used for decades by institutional investors but haven’t yet trickled down to Main Street. This is because most providers have a $5 million minimum loan amount and stand to gain greater returns by writing larger checks. The result is that they often disregard the needs of small-balance investors.
But times are changing. There are lenders that offer small-balance financing of this type. There are even a few that specifically operate in the sub-$5 million space. Some examples of recent closings include a $1.6 million mezzanine loan on an office building in Houston, a $400,000 mezzanine loan on an apartment building in Tampa and a $150,000 preferred equity investment on an apartment building in Miami.
When mortgage brokers go in search of the appropriate lender, ask for referrals from local real estate brokers and industry colleagues, read online reviews and testimonials, and make sure to speak directly to the lender. Debt and equity providers involved in this sector should be ready to share information about their deal structures, pay rates and due-diligence processes. They need to make sure that borrowers understand all the nuances of this type of financing. They should be prepared to explain their time frame for closing and, importantly, what happens if things don’t turn out as planned.
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The potential for private investors in the commercial real estate market is growing now that such loans are available in small-balance sizes. Ultimately, the key to making commercial asset purchases accessible to all types of investors lies in educating borrowers on how to use these types of financing and where to find them.