Mezzanine loans made to entities that own commercial property loans, loans that all but dried up after the financial crisis, are resurfacing this year.
Mezzanine loans are equity loans based on the net equity in the market value of a commercial property owned by a limited liability company (LLC), limited partnership (LP) or corporation. These loans are secured by company stock, not real estate. They pose a higher risk than junior trust deed loans, as default on these pledged-stock loans require the lender to seize stock, take control of the entity and later management and liquidation of the property.
Mezzanine loans are typically used as short-term bridge financing when less risky (read, less expensive) junior trust deed financing cannot be obtained since the trust deed encumbering the entity’s real estate contains a due-on clause.
Current estimates by the New York Times put outstanding national mezzanine loans at $100 billion.
This year, somewhere around $364 million of mezzanine debt has been taken on by real estate companies around the county, trending much higher than the $210 million taken on in 2009, according to the commercial real estate firm Jones Lang LaSalle.
The Pembrook Group, a mezzanine lender, expects to originate $100 million in mezzanine loans nationally by the end of this year, including loans to companies owning real estate in California. This is compared to the $250 million in mezzanine loans originated nationally at the peak of the real estate market in 2006.
first tuesday take: High risk junior trust deed lenders seeking high rates of return on typically short term, one-year bridge loans to owners of large income properties dare not be secured by a junior trust deed on the very property that will indirectly serve as the collateral for the loan. The culprit interfering with this flow of real estate commerce in the junior lending arena is the existence of the due-on clause in the trust deed encumbering the income property.
Placing a second trust deed allows the existing trust deed holder to either call the loan, or possibly more profitably, simply demand a higher rate of interest and the exaction of an assumption fee for a loan modification given by the owner in exchange for a waiver of the lender’s right to call.
This due-on interference denies the owner of the right to alienation – to freely use his title – which Congress took away from California property owners at the beginning of lender deregulation in 1982. Lenders much prefer receiving a prepayment penalty than processing an assumption of any loan. On the origination of the new loan, lenders tack on points, garbage fees galore and adjust interest to the highest possible rates. All of this increases front end profits for the mortgage lending industry, rather preferable to handling an assumption for a loan they service but no longer own.
The mezzanine loan is the financial consequence impacting LLCs that own encumbered real estate with a positive equity and need to get around triggering the existing lender’s due-on clause. The entity vested with the real estate title pledges its stock and promises not to further encumber, sell or otherwise transfer the property interest it holds, which of course would trigger the due-on clause.
Thus, the entity has effectively, but not actually or in law, borrowed against its equity in the property. Some due-on clauses are worded so they are triggered by even a hypothecation of the LLC members’ ownership interest to borrow money – a financial jailhouse.
This mezzanine loan arrangement is a lending device that was extensively used in the late ‘60s and into the early ‘70s by banks lending to homeowners with equity in their home, as they were legally prohibited from holding a lien on the equity in a homeowner’s residence as security for a loan. At the time, a home was treated politically as the family’s nest and shelter, not as an ATM or an investment as Congress later permitted in 1986.
So when homeowners wanted equity loans, bankers recorded a document called an “agreement not to further sell or encumber.” It referenced the property by legal description, but contained only the homeowner’s promise not to sell or encumber the property. The agreement did not convey a security interest in the property to the lender. Thus, they creatively evaded the law so they could do what they are driven by their nature to do: make loans.
Further, the most important facet of the lender’s creativity was their quid pro quo arrangement with title companies: “don’t insure a second trust deed or conveyance if you see our recorded document, due to the ‘cloud’ it places on title. If you play our game, then we will send you title work for our loan originations.” The scheme worked, until the courts exposed the agreement for what it was – not a lien on the property which affected title, but merely the owner’s personal, unsecured obligation to pay a loan.
At least mezzanine lenders have a lien on the entity vested in title. From there it is but a few days in a court room before they have control of the underlying asset. It is better than foreclosing. But not so for the banker who makes a loan to an individual who is a positive-equity home owner, himself vested in title, and then does not get that recorded second trust deed lien. That second trust deed does not trigger the due-on clause since a homeowner’s equity loan is permitted for quick access to their wealth.
All this is just a case of history repeating as these games have been played by lenders many times before. It is part of what they will do every time they are able to gain from the commerce of real estate or interfere with the societal needs of a homeowner to treat the home as shelter. The reason for all this shifting of wealth to lenders: they are the selected institutions through which the Federal Reserve (the Fed) actually prints (digitally) and distributes the cash that we all need to consume and invest.
Lenders will try to manipulate how and when you can borrow money using your title, and will use the real estate industry’s collateral as a source of wealth for ever more loans with which to stoke the economy – the political justification for all this. These justifications were behind both the 1986 equity loan legislation and the mid-2000s Fed money supply action that opened up Pandora’s Box of insitutionalized creative real estate lending all severely damaging the long-term stability of the real estate market
Wall Street bankers, like a bad guest, always trash the real estate marketplace when you let them in, leaving the mess of their raucous party for everyone else to clean up. Those in the real estate market need to learn how to privatize profits and socialize losses – but isn’t that what underwater homeowners are now doing?
Re: “Loans That Vanished in a Property Bust Reappear” from the New York Times
