Capital Structure Mastery Lesson 02

Lesson Two: Capital Structure Overview

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.

2.1 Types of Capital (Capital Structure)

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

First Trust Debt is included in the “ascending level of risk” structure that you can view in the matrix below. We will not spend much time on this debt, as we are concerned mainly with everything “after the senior debt.” With this type of structure, the typical Loan-to-Value (LTV) is 60–75%. This type of structure is secured by a first trust deed. When the lender provides the funds for the project, the lender 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 they will then be “paid” first after selling the property. In order to make sure the lender has the 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

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 and before the equity is repaid. The typical mezzanine financing deal has a LTV of 50–90%, depending on the deal. Mezzanine financing creates a unique resolution if the loan is not paid back in time or in the full. The lender will 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 lends at banks and venture capital companies.

Mezzanine financing is often done quickly; thus, very little due diligence is required from 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%. If a default does occur, the traditional remedy is to pay off the first trust loan, and the mezzanine lender becomes the senior lender. The mezzanine lender then assumes the first trust loan and maintain seniority.

Equity High Leverage Mezzanine Preferred Equity

The preferred Equity Mezzanine is similar to the Mezzanine financing, but the biggest difference is that mezzanine debt is usually structured as a loan, which 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 80–100%. 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, and 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 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.

Hard Money/Bridge Loans/Distressed/Value-Added Financing

The next type of capital structure includes Hard Money, Bridge Loans, Distressed Loans, and Value-Added Financing. These are all similar types of financing and represent our second category of capital structures with Super/Senior Debt.

This financing category is often considered the “last resort”, or the short-term loan. This type of financing is different because the lenders are more concerned with the value of property, as opposed to the credit worthiness of the borrower. Borrowers for this type of financing usually have credit issues, such as low credit scores or past issues with repaying credit. The interest rates are also usually higher, and larger 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% or less.

For security or collateral, the lender will take a first trust deed and 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) are arranged by a company while in the Chapter 11 bankruptcy process. DIP financing is unique among the other capital structure financing types we have discussed because it has priority over existing debt, equity, and other claims. This is because absolute first priority is mandated by the Bankruptcy Court. Similar to 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% or less.

In terms of collateral and security, DIP has the super priority first trust deed. This is senior to any mezzanine financing and senior trust deeds within 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%. 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.

2.2 Capital Stack

All investors need to be experienced in making correct and informed choices when it comes to making sound real estate decisions. One of the first items that the investor must understand in bridge lending is the proposed capital structure. This is what we refer to as the capital stack. The capital stack is the different layers of financing, stacked on top of one another to show the entire risk profile of the transaction. Your investors will want to know where they are in the capital stack so they can know where they want to be. The capital structure drives the debt and equity structure that will determine the financial risk for all involved. The capital stack is the total cost to buy and improve the property. Let’s take a look at a simple and a complex capital stack example.

Real estate investors cannot make an intelligent decision until they understand the sources and uses of funds involved in the transaction, including all capital needed to bring the property to completion or stabilization. Sources and uses must be equivalent to one another, and the capital structure should total the amount of sources and uses.

Typical sources of cash are equity, mezzanine debt, and first-trust debt. Typical uses of cash include acquisition, capital improvements, interest reserves, soft costs, tenant improvements, lending fees, and financing costs. Below is an example of sources and uses of cash:

Sources and Uses of Cash
2.3 Continuum of Capital Providers

Real estate risk can be viewed on a continuum, going from left (least risk) to right (most risk).

  1. Life insurance companies: Generally, the most conservative underwriters.
  2. Banks: Includes local banks (community banks), regional banks and money center banks. Note: most banks will no longer portfolio 10-year loans.
  3. Conduit lenders: Also known as securitized lenders. These lenders aggregate loans and then repackage them as rated bonds or securities.
  4. Opportunistic lenders: Typically, lenders who hold whole loans on a balance sheet. Can include opportunity funds, finance companies, mezzanine lenders and mortgage REITs.
  5. Equity investors: Have the “first loss piece” of the transaction, but also has an uncapped upside.

Assignment:

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.

This assignment is your study guide to ensure you have learned these materials before you take the required quiz.

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