In commercial real estate, return on investment is the name of the game. Whether the pressure stems from personal ambition, partners or Wall Street, it's what every real estate principal is striving to maximize. The most commonly used method of increasing returns is leverage. With the addition of first-mortgage debt, the principal's equity contribution to a project can be reduced to a fraction of the project's costs. Theoretically, returns on equity will rise as long as the project's rate of return is higher than the rate paid on the debt.
However, a first-mortgage lender will typically only lend up to 70% to 80% of a project's costs, which leaves an additional 20% to 30% of the costs for the principal to procure on its own. Subordinate project-level debt and additional equity may be available to fill the principal's equity shortfall (or “gap”), but only at rates much higher than those of the first-mortgage loan.
Not only is the first-mortgage lender's capital the largest component of a project's capital stack, it is also the cheapest component. Since first-mortgage lenders require lower returns, it is worth considering this type of institution as a source of additional debt. Specifically, commercial banks can be a source of credit products that can be applied to the underfunded project.
This practice is generally acceptable to the project's first-mortgage lender, as long as the borrower provides at least some cash investment, and the additional debt is not project-level (i.e., the credit is not secured by any of the project's assets or equity interests). This option should be explored before resorting to the more expensive sources of investment capital described below.
Subordinate Project-Level Debt
The two most common forms of subordinate project-level debt are mezzanine and second-mortgage loans. Mezzanine debt (or “mezz”) typically is secured by an assignment of equity interests in the mortgage borrower, and has no security interest in the first-mortgage lender's real property collateral. First-mortgage lenders are often skeptical of additional lenders secured by their collateral, due in part to complications in the event of foreclosure, and thereby often prefer mezz to second mortgages.
However, first-mortgage lenders generally prefer that principals seek additional equity rather than incur additional project-level debt. Both forms of debt can cost 10% to 15% based on a project's leverage, product type and risk profile.
In cases where the first-mortgage lender prohibits any subordinate project-level debt, additional equity is an attractive option. However, while subordinate project-level debt can be expensive, equity investors require even higher returns, typically 20% to 30%.
A Cheaper Alternative
Principals with strong balance sheets, but without the necessary liquidity, are often able to fill the gap by tapping into banking relationships. Lines of credit, additional loans or even letters of credit, are all options, which the first-mortgage lender will generally tolerate as long as these debt instruments are not secured by project-level assets. While these options are available only to the more creditworthy individuals and companies, their costs are typically less than those of subordinate project-level debt and additional equity.
For example, in the current interest rate environment, with LIBOR floating just above 1%, applying proceeds from an additional bank loan, or line of credit, to a project may only cost an incremental 3% to 5% annually on a floating-rate basis.
If a principal would rather keep the appearance of additional debt off its balance sheet, it could apply for an unconditional, stand-by letter of credit with the first mortgage lender as the beneficiary. This so-called “suicide” letter of credit can be drawn upon without documentation, and can be considered cash equity by the first-mortgage lender. As a result, the first-mortgage lender can increase its mortgage loan by the amount of the letter of credit (without an increase to its security interest), and may draw upon the letter of credit at any time.
This increase in the first-mortgage loan amount can be enough to bridge the gap — and can bridge it more cheaply than subordinate project-level debt or additional equity. The issuing bank would likely charge 1% to 2% annually, and additional interest would be paid because of the increase in the first-mortgage loan. The incremental cost of this structure (costs of the letter of credit and additional first-mortgage debt) would likely remain under 5% to 7% today.
This arrangement compares favorably to the double-digit rates required by subordinate project-level debt or additional equity. The benefits from such a wide differential in rates can be significant. Even a 1% difference would cost an additional $10,000 annually on each $1 million.
A costly or inflexible addition to the capital stack can haunt a project for years. Analyzing every reasonable option for financing the gap represents a prudent strategy, leading to fewer headaches and higher returns.
Jake Little is in the real estate syndications group at Bank of the West. He may be reached at [email protected].
Shervin I. Gabayan is an attorney and founder of Gabayan & Associates focusing on real estate transactions. He may be reached at [email protected].