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Wednesday, February 12, 2014

Can Preferred Equity Save Investors?

It's now the year 2014.  You have a $1,950,000 first mortgage ballooning, and you suddenly realize that you have a problem.  During the trough of the Great Recession, your $2.6 million strip center had fallen in value to just $2 million.  Fortunately, with the recovery, your strip center is now worth $2.5 million; but that's still not enough.

The big problem is that few commercial banks will make commercial real estate loans in excess of 58% to 63% loan-to-value today.  Even if you could convince a bank to make you a loan of $1,575,000 (63% of $2.5 million), the proceeds of the loan won't be enough to pay off your $1,950,000 existing first mortgage. Not good...!! 

Even forgetting about points and closing costs, that leaves you short $375,000.  The bank will expect you to bring the shortfall to the closing; but you don't have $375,000 in cash!  You barely survived the Great Recession without losing any property.  To make matters worse, you personally guaranteed the loan from the bank. 

You're in deep trouble.  Your dog could leave you, and your wife could bite you.

You sit down with your banker, and you ask him, "What if I could find a hard money lender to make a $375,000 second mortgage?"  The banker replies, "Commercial banks won't allow second mortgages behind their commercial first mortgages these days.  They don't want the property overburdened with debt.  The danger is that if the owner's cash flow gets tight, he might be tempted to use the money earmarked for repairs and maintenance to make the payments on the second mortgage.  The property will fall into disrepair, the tenants will move out, and the bank will end up foreclosing on a run-down, vacant strip center with a leaking roof and mold all over it."

"So, what can I do?" you ask the banker.  He replies, "You need to find a partner to contribute $375,000 in cash to the deal, in return for a partial ownership of the building."  

Forget going to your brother-in-law, begging for cash, he is as impoverished as you are.

Luckily for you, we are the only realty capital provider in the country that make small preferred equity investments (its easier to think of them as preferred equity loans), from $100,000 to $600,000.  Most preferred equity providers won't even look at deals smaller than $3 million.

We agree to invest $300,000 in preferred equity into your property, bringing the preferred equity capital stack (the sum of the first mortgage plus the preferred equity) up to 75% of value.  This means that you still have to bring to the closing table $75,000 in cash, but this smaller amount is far more manageable.  It sure beats defaulting on your balloon payment and getting sued for the deficiency.

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