In case you missed it: Read “What Is a Commercial Real Estate Equity Loan?”
What are the different methods of collateralizing Equity Loans?
A common issue for established real estate entrepreneurs is that, while they have substantial net worth, it is illiquid and cannot be used to fund new deals. The net worth is often comprised of partnership interests, or wholly owned properties. Their portfolio, already leveraged by senior loans, may have prepayment penalties which prevent the borrower from obtaining a conventional refinance loan to “cash out”. Additionally, if they have partners, it may not be possible to sell or refinance without obtaining permission from the other stakeholders.
Equity Loans address all of these issues, while being mindful to creatively structure around any partnership or lender covenants which may restrict pledging of the borrower’s equity positions. These restrictions can often be overcome by employing alternative methods of collateralization.
1. Second Mortgage
This is the most common method of collateral security for a lender providing subordinate debt also known as a mezzanine loan. The mortgage is recorded on the title to the property in second position behind a first position mortgage lender. This form of collateral is not always viable for a property, as it requires the first mortgage lender to provide acknowledgement, referred to as “recognition,” to the second lien holder as well as an intercreditor agreement.
While ideal for a mezzanine lender, the first mortgage lender is often reluctant to allow for a second mortgage. Mezzanine loans are often also secured by a UCC-1 perfected pledge of the borrower’s equity.
2. Preferred Equity Units in the LLC
Equity Loan providers may take ownership of preferred equity units in the entity that holds ownership to a property. This “debt-like” preferred equity is often structured like a loan in second position on the capital stack.
The capital provider is provided with a preferred class of units in the LLC (or shares in the corporate entity) which receive distribution of capital from the underlying property with priority ahead of common equity holders. Where common equity takes the “first-loss” risk, preferred equity is less risky as the investors receive their capital back first.
3. Perfected Pledge of Equity
A pledge of a borrower’s equity, whether wholly owned or as part of a partnership, it is often pledged as collateral for an Equity Loan. To “perfect” or record this pledge, a UCC-1 statement must be filed by the lender. The UCC-1 is a legal notice filed by creditors for any business loans under the Uniform Commercial Code (“UCC”). This filing establishes a priority over which the collateral may be seized relative to any other creditors.
As a mortgage is recorded at a county’s registry of deeds, this pledging is done with a UCC-1 filing. This UCC-1 is filed with the agencies in the state where the property or entity is located in order to announce the lender’s rights to the collateral. Sometimes the perfected pledge will be a viable substitute to a second mortgage for a mezzanine lender. Loans on partnership interests may also use the perfected pledge method for their security on borrowers’ equity positions.
A common challenge with a perfected pledge of equity is that it typically requires recognition from the senior loan creditor and any partners related to the entity. In cases where this recognition is not possible, there may be alternative methods to get a lender comfortable.
4. Pledge of Proceeds
A pledge of proceeds is an unsecured and unrecorded method of collateral that is much softer than the alternative methods. A pledge of proceeds provides the lender with claim to any proceeds deriving from distributions to the underlying equity position. This method may be most advantageous for the borrower, as the lender cannot seize the underlying asset upon default.
Some lenders are comfortable using a pledge of proceeds to free up liquidity on partnership interests – or wholly-owned interests – when a lien cannot be recorded against them. Pledges of proceeds are most common as a method of cross-collateral; where a lender’s primary collateral is on a separate asset, and they are looking for some additional collateral protection. Depending on negotiations with the Equity Loan lender, the pledge may be triggered upon a default, or these pledged proceeds may be paid on a current basis.
5. Option to Purchase
Providing the lender with an option to purchase the underlying collateral, which is triggered in the event of a default, is another unsecured and unrecorded method of collateral. This method can only be employed if the borrower has the rights to unilaterally sell the property.
The purchase price is typically determined by a formula which pays market value for the property, less the value of the borrower’s net equity in the property. This provides that the balance of any third-party obligations or partnerships outstanding, at the time of purchase, are paid off by the sale proceeds. The property is then re-sold by the creditor, and remaining proceeds are used to first pay off the balance of the Equity Loan, and any proceeds thereafter are returned to the borrower.
Many real estate entrepreneurs believe that they cannot use the equity positions in their portfolio as collateral. However, by working with a creative financing partner familiar with the methods above, and other more technical methods, there is often a solution. The result is a thoughtful structure that maximizes the real estate entrepreneur’s availability of non-dilutive capital.
Disclaimer: If you are structuring or negotiating an Equity Loan with a capital source or looking to invest in one, it is important to always seek appropriate legal and financial counsel. Valencia Realty Capital, LLC does not provide any legal or financial advice. This information is for educational purposes only.