The COVID-19 crisis has upended the commercial real estate market, forcing borrowers, lenders and mortgage brokers into territory they haven’t seen in years. These hard times also mean that commercial mortgage professionals must relearn the lost art of loan workouts.
Many commercial-property owners will need rescue financing from new equity investors. You can help structure and broker these deals as a way to make up for lost commissions. But you also should consider taking the idea of rescue financing one step farther — negotiating an ownership stake in the properties that you help to save.
As a result of the coronavirus outbreak shutting down the U.S. economy, many commercial mortgage lenders have stopped making new loans. They are focused on the precipitous drop in their existing borrowers’ revenues and how that will impact their own loan portfolios. Accordingly, with limited opportunities to earn commissions from brokering new loans, commercial mortgage brokers will need to adjust their business models to replace lost income.
One way for brokers to keep fees flowing is to help their clients raise funds to cover operating losses or fund an interest reserve. By raising badly needed funding or rescue financing, mortgage brokers can provide a much-needed service to their clients, many of whom may be at risk of losing their properties to foreclosure. A client’s losses could be further compounded if resulting foreclosures create personal liability under any loan covenants and if their properties need to be sold at fire-sale prices.
Despite the considerable amount of rescue funding that many clients may need to raise, standard commission rates probably will not produce the same amount of income as brokering multimillion-dollar loans does. Therefore, in order to appropriately compensate brokers for their valuable work, a more creative approach to compensation may be required.
By raising badly needed funding or rescue financing, mortgage brokers can provide a much-needed service to their clients, many of whom may be at risk of losing their properties to foreclosure.
Throwing a lifeline
As a way to help clients successfully raise rescue financing and save their properties from foreclosure, mortgage brokers may be able to negotiate a purchase of, say, a 5% ownership stake in their client’s property, in addition to or in lieu of earning loan commissions. Over time, once the property value recovers, a mortgage broker’s ownership interest may become more profitable than the cash commissions that could be earned in pre-coronavirus days.
Many commercial mortgage brokers, however, will need to relearn the nuances of the distressed-property market. With real estate experiencing a bull market for the past 10 years, understanding and having experience in loan workouts has become a lost art. Times have changed nearly overnight. A large number of tenants are expected to stop paying rent. Even investors who own institutional-quality real estate investments are unlikely to receive sufficient rent payments and other sources of ancillary revenue to cover their operating expenses and mortgage payments.
Given precipitous drops in property revenue, many investors have been reaching out to their lenders for help. Lenders may agree — or be required — to offer forbearance to their borrowers, which has occurred on government-backed multifamily loans through Fannie Mae, Freddie Mac and the U.S. Department of Housing and Urban Development. Even in these cases, however, a lender’s help will be limited.
Typically, lenders offer to add the unpaid interest onto their borrowers’ loan balances. This solves a problem in the short term. Borrowers don’t have to make mortgage payments. Over the long term, however, borrowers need to raise additional funds to increase their working capital and leasehold improvements for new tenants who will replace the ones that either downsize or go out of business, and/or to pay for the leasing commissions.
Also, some real estate owners may see this time as an opportunity and look to raise new funding to buy out existing limited partners, cover unfunded capital calls from limited partners or to pay certain tenants to give back leased spaces. By raising rescue financing, your clients may be able to use an infusion of cash to gain leverage in workout negotiations with their senior lenders. For example, the current borrower and the new investor may be able to negotiate a lower interest rate, an extended maturity date and/or a release or reduction of the borrower’s personal loan guarantee.
The Buffett precedent
Commercial mortgage brokers can draw on a precedent established by the famed investor Warren Buffett. During the financial crisis of a decade ago, Buffett negotiated a number of multibillion-dollar investments in blue-chip companies, including Bank of America, Goldman Sachs and General Electric. In each case, Buffett got the companies to issue preferred stock to his holdings company, Berkshire Hathaway. This provided for an attractive preferred return rate, plus long-dated warrants to purchase the companies’ common stocks at depressed prices.
By receiving preferred stock, Buffett’s investment was senior in priority to all of the common stock holders if the companies were to file bankruptcy and subsequently reorganize or liquidate. Buffett ultimately earned lucrative profits on his preferred stock investments when the companies recovered and the warrants increased in value as the companies’ common stock increased.
In the same fashion, investors interested in providing rescue financing in today’s commercial real estate market would likely structure their investments similar to Buffett’s. That is, with the adage of “last money in, first money out,” investors would expect to be paid back first before the owners receive any projected profits, along with receiving an equity kicker just like Buffett received with his warrants.
Instead of receiving warrants like Buffett, however, real estate investors would likely have the right to purchase an interest in a property. To do so, assuming that the ownership entity is a limited liability company (LLC), the borrower and investor would either amend or replace the existing operating agreement. This agreement would specify that the LLC issue common membership interests to the investor that specific, for example, an ownership share. Likewise, given the value of the mortgage broker who secures rescue financing, they could purchase a small ownership interest in the LLC.
Rescue-financing deals can be structured in many ways. These types of deals, however, must begin with a careful analysis. In addition to normal and customary due diligence, investors who are considering an infusion of rescue financing will want to analyze a number of factors about the property and your client’s financial situation.
First to consider is whether the property’s rent prices, occupancy rates and operating expenses are expected to revert back to pre-coronavirus levels. If not, you need to estimate what the net operating income will be once the asset is stabilized under the new arrangement, and how the new income levels will affect the property’s fair market value.
Another major consideration is the exit strategy. How long will it take before a buyer can obtain debt financing to purchase the property and how much debt will be available for the prospective buyer? In other words, what is the likely loan-to-value ratio? Also, when commercial real estate markets normalize, will buyers demand higher capitalization rates than they did prior to the outbreak? This might lower the final sales price and affect your return on investment when you cash out of the deal.
Furthermore, you will need to consider whether the financial deterioration of tenants will cause buyers to demand a higher capitalization rate. And finally, what return will equity investors demand to invest in stabilized properties given the opportunity to invest in more opportunistic, distressed assets? Based on the above analysis, investors will determine their perceived risk in providing rescue financing and, therefore, where to invest in a property’s capital stack.
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For the foreseeable future, real estate owners will need to raise rescue financing to stabilize their properties. Commercial mortgage brokers should understand how loan workouts are conducted, identifying new sources of rescue financing and how to structure such deals to everyone’s mutual benefit. You will create goodwill with your clients while earning fees and, if negotiated appropriately, acquire a profitable interest in your borrowers’ assets. •