Subordinate debt is a general term that refers to any additional financing lower in priority to the first mortgage and is a mechanism that can provide additional dollars and higher leverage to help bridge an equity gap like the scenario above. In the current market, subordinate-debt lenders will take a capital position between the first mortgage cut off and reach up to 85 percent or more LTV.
By reaching higher in the capital stack, subordinate lenders are inherently assuming more risk, and they get paid a higher rate of interest for doing so.
Interest rates on subordinate debt can range anywhere from 8 percent to 18 percent, depending on the transaction. Subordinate-debt lenders are often flexible and willing to structure the payments to match the cash-flow projections of the specific transaction. For example, the payments might be structured as an interest-only payment with a balloon, or amortized over time via routine interest and principal payments to reduce the debt.
The two most common types of subordinate debt are mezzanine financing and junior mortgages, or B-Notes. Albeit similar in application, there exist critical differentiating factors that will dictate which is proper for the specific transaction at hand.
Mezzanine-debt lenders provide subordinate debt that’s secured against an ownership position in the borrowing entity, rather than the mortgaged property itself, as the collateral for the loan. It’s essentially a pledge of the ownership interests in the property, rather than a pledge of property itself. As such, mezzanine debt is particularly useful in situations where the mortgage lender will not allow for secondary debt against the property collateral itself.
Alternatively, a junior mortgage is a secondary debt position that’s secured by the mortgaged property as collateral for the loan. This mortgage is junior in priority to the first mortgage, or senior note (A-Note), hence the nomenclature. The two mortgage notes will likely differ in their terms, however the payment priority is clear, with the A-Note having clear priority over the B-Note. Since both notes are secured by the same mortgaged property as collateral, however, the subordinate nature of the debt is established through an agreement between the A- and B-Notes holders, referred to as the lender intercreditor agreement.
Equity Joint Ventures
In cases where equity erosion is severe and there’s no longer adequate cash flow to service the existing debt, a complete restructure of the debt and equity may be a more viable option for the borrower. This effectively forces the sponsor to give up equity ownership and, in some cases, even the controlling interest in the ownership structure to entice new equity in to the transaction.
By definition, a joint venture is a business agreement whereby two or more parties agree to invest in a new entity and asset through the contribution of equity for a finite period of time. Together this new entity will exercise control over the enterprise and consequently share in the revenue, expenses and assets of the venture, the extent to which is determined during its negotiated formation. Joint-venture equity is typically available to commercial property owners in transactions where there’s a significant upside in the transaction, often stemming from a development or recapitalization scenario and resulting in enhanced cash flow and, consequently, value.
Joint ventures are heavily negotiated and can be structured in a multitude of ways, depending on the specifics of the transaction. For example, in its most simplistic form, two parties could agree to contribute an equal amount of equity and subsequently split cash flow and profit equally going forward, until such time as the venture concludes.
Recapitalization transactions tend to be messy, therefore the terms of the venture are more heavily dependent on considerations such as the balance of sponsor’s equity remaining in the deal in proportion to the equity needed to recapitalize, as well as the perceived risk and reward associated with the transaction. There are key concepts that must be addressed when structuring a joint venture related to control, distribution of cash flow and exit.
It’s imperative to understand who will control the venture, including the votes needed to make critical decisions, as well as matters of day-to-day operational control. In addition, it’s important to understand how the cash flow from the venture will be distributed, with consideration given to profitable items such as salaries and management to the extent that one party or another is more involved in these aspects. Finally, both parties must premeditate and understand the likely exit options as they relate to each party’s investment time horizon and motivating factors.
While refinancing in today’s market can be a scary venture for those who are overleveraged, there are options available. With a little brainpower and ingenuity, self-storage owners can retain both ownership and control of their asset. Going forward, as new amortizing loans pay down the principal balance of the loan, it’s less likely these problems will occur again in the future.
Shawn R. Hill is a principal at Chicago-based The BSC Group, where he provides mortgage brokerage, financial consulting, and loan-workout solutions to self-storage real estate owners nationwide. To reach him, call 312.207.8237; e-mail firstname.lastname@example.org ; visit www.thebscgroup.com .