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Underwriting, Conventional Loans, Equity Loans and
Mezzanine Loans

By David Kington         May 14, 2003

The Lenderís View

Real estate financing involves a lender underwriting a real estate loan.

The goal of underwriting is to determine what loan amount the lender will be comfortable lending and what return the lender will want to receive for the risk it underwrites.

From a lenderís perspective, underwriting a loan amount involves such things as:

  • an analysis by a lender of the current (and in the case of a construction loan Ė the projected) value of the property in question;

  • the determination by a lender of the ratio of the amount of the loan to the (actual or projected) value of the property;

  • in the case of a construction loan, the determination by a lender of the ratio of the amount of the loan to the cost to acquire and develop the real estate in question; and

  • in the case of an income producing property, an analysis of the projectís income to determine the ratio of the annual net operating income of the property to the annual payments of principal and interest to be made on account of the loan - to determine borrowerís ability to service the debt until its repaid.

While real estate developersí hunger to borrow as much as possible has remained constant over the 20+ years I have been practicing law, the appetite of banks, insurance companies and other conventional lenders to accept risk has decreased. Underwriting standards have tightened up and industry accepted conventional ratios of loan to value and loan to cost have dropped.

As a result of the move by conventional lenders to less risk, it has become common for a potential owner/developer of commercial real estate to have to obtain financing in addition to conventional first mortgage financing in order to acquire and/or construct a project.

These realities have created opportunities for investors, pension funds and others to become commercial real estate lenders.

When Conventional Real Estate Financing is Not Enough

There are a number of debt and equity options open to an owner/developer of real estate who needs additional financing.

The debt options include:

  • subordinate mortgage or equity financing; and;
  • in applicable circumstances, mezzanine financing.

In my experience people tend to confuse equity and mezzanine financing.

To my mind, the key difference between equity and mezzanine financing is that equity financing involves a subordinate mortgage of property given by the owner of that property to an equity lender, whereas mezzanine financing involves the provision of non-mortgage financing to a party related but subordinate to the owner of the property in question.

By way of example, consider a Limited Partnership formed to acquire and develop a specific parcel of real property.

To the extent the Limited Partnership is unable to raise the money it needs to acquire/develop its real estate from its limited partners, it needs to borrow that money from on or more outside sources.

In the first instance the Limited Partnership will normally look to a conventional real estate lender for a conventional real estate loan.

Given current underwriting standards, the Limited Partnership will have to get some sort of subordinate financing to bridge the gap between its total cost to acquire and develop the property in question and the total of :

  • the paid up equity of the limited partners and
  • the net proceeds of the conventional mortgage loan.

One way is to finance that gap by arranging for subordinate (second, third, etc, whatever it takes) mortgage financing.

Another way is to have the limited partners arrange for a mezzanine loan on the security of a pledge of their units in the Limited Partnership.

In the case of subordinate mortgage financing, the subordinate lenderís security is the real property itself.

In the case of mezzanine financing, the subordinate lenderís security is one step removed from the real property, i.e, it is the limited partnerís right to receive money generated by the Limited Partnership by way of interim distributions or upon the on the dissolution of the Limited Partnership after the payment by the Limited Partnership of all of its debts.

Some advantages of mezzanine financing over equity financing

Bankruptcy Remote. A mortgage borrower is bankruptcy-remote vis a vis the mezzanine borrower, the bankruptcy of one wonít necessarily give rise to the bankruptcy of the other.

More attractive to Conduit Lenders. Conduit lenders (lenders who end up securitizing their loans and selling them in public markets - as Commercial Mortgage Backed Securities -- as opposed to portfolio lenders who retain loans for their own portfolio) tend to prefer mezzanine financing over equity financing. The reason is that they get a better rating of their debt from rating agencies on conventional loans they want to securitize and sell in secondary debt markets if there is no subordinate financing. In fact a number of conduit lenders will not allow secondary financing secured by a charge against the property charged by them.

Flexibility. A mezzanine loan can be made before, at the time of, or after acquisition/ development.

More Money. Arguably more money is available to a borrower under a mezzanine loan.

Some disadvantages of mezzanine financing over equity financing

Higher Rate. A mezzanine loan is not secured by any real property, so a borrower should expect to pay a higher rate than for the same amount of equity financing.

Administrative Pain. Because they donít have a direct charge over real property, to protect themselves mezzanine lenders will require certain remedial rights which involve a fair measure of control over the borrowerís affairs.

Mezzanine and Equity Intercreditor Agreements

Mezzanine Loan

A mezzanine lender will need an intercreditor agreement with the conventional lender to ensure it has the comfort of knowing its loan will be repaid out of excess cash flow remaining after payment of the conventional mortgage loan. (It will want assurances of net cash flow).

The terms of a mezzanine intercreditor agreement will depend on a number of factors including the knowledge and level of comfort that lenders have and their relative bargaining positions vis a vis each other. The terms will also involve restrictions on the mezzanine lenders ability to foreclose on its security (this is a change in control issue from conventional lenders perspective) and will involve the rights of a mezzanine lender to approve actions to be taken by mortgage borrower re: operation of mortgaged property (mezzanine lender wonít be passive but the conventional lender wonít want the to give a mezzanine lender too much slack).

Equity Loan

Because the security taken by a conventional lender and equity lender charges the same property the Intercreditor Agreement between an equity lender and a conventional lender will contain clauses establishing the relative priorities of the conventional lenderís and equity lenderís security, possibly the terms and conditions under which the equity lender will postpone its right to receive payments from the borrower to the right of the conventional lender to receive monies from the borrower and possibly standstill provisions.

Standstill provisions are probably the most contentious provisions of any such agreement. The conventional lender will want to tie the equity lender up in knots, whereas the equity lender will want the flexibility to be able to exercise its remedies in default situations.

It is my view that:

  • a conventional lender should only have complete standstill provisions where the equity lender is not at arms length to the borrower; and

  • if the equity lender is at arms length to the borrower, a conventional lender should only have complete standstill provisions where the loan is a construction loan and them only during the construction period.

Otherwise the equity lender should be free to exercise its enforcement remedies after a certain amount of written notice to the conventional lender.


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