Remedies with Different Investment Types
As most investors know, different investment positions in the “capital stack” of real estate financing have different remedies available to them if there are payment defaults or other problems with an investment. We’ll explore some of the different investment types and the related underlying remedies.
With senior (first-lien) debt investments, the underlying loan is usually secured by a first-position mortgage (or deed of trust), which gives the lender advantages even in a bankruptcy situation. Oftentimes, too, a guaranty of some sort will be secured from one of the principals or a controlling affiliate of the borrower. This guaranty may be limited to “bad acts” – outright fraud or other obvious examples of willful misconduct – but it can also extend to a full payment guaranty.
With the security of a mortgage lien on the property, a lender can foreclose on the property in the event of payment or other defaults by the borrower, and either sell the property to regain the lender’s principal or take over ownership of the property. Since the property had likely been valued at more than the loan amount at the time the loan was made, there will usually be enough “cushion” – the underlying equity interest of the borrower – so that the lender can ultimately regain its invested principal. Events like the Great Recession, however, show that this initial “cushion” isn’t always enough to assure any principal return.
Foreclosures also involve potential pitfalls. The foreclosure remedy is not absolute, since tax liens and mechanics’ liens from unpaid contractors generally take priority. Additionally, many states require a lender to go through a “judicial” foreclosure process, which can mean a years-long court process, during which time the property’s value may continue to deteriorate. And if the original appraisal was mistaken, the collateral’s value may have been over-estimated in the first place.
Second Lien (“Junior,” or “Subordinate”) Debt
Second lien loans, while seen less frequently than in prior decades (many senior lenders don’t want competing claims on the primary asset), still represent a way for many borrowers to increase their leverage on a project. These loans are riskier, and should be evaluated differently from, first-lien loans. The overall loan-to-value ratio increases with second lien debt, providing less of an equity cushion for that loan; second-lien lenders are also subordinate to the first-lien lender when it comes to foreclosure or other workout situations, so that the property lien, while valuable, is no guarantee of full recovery. The interest rate on second lien loans is thus often significantly higher than for first lien loans, to compensate for this risk.
Being a secured lender (even if a junior one) does still have advantages over other creditors. Among other things, secured lenders enjoy:
- Priority vs. unsecured creditors. Secured claims are entitled to receive their full value in the collateral before any remaining proceeds are given to unsecured claims. Note, however, that this right is only of value where the collateral remains worth enough to cover the amount of the secured loan.
- Post-Petition Interest. Secured creditors are, under the bankruptcy code, entitled to post-petition interest on their claims; undersecured creditors are not. This can be significant, given that bankruptcy proceedings may run for several years.
- Protection Against Decline in Value. Secured creditors can be protected against post-filing declines in value. This right is broad, and gives the creditor a say in collateral substitutions and debtor-in-possession financings, and may also include court-ordered grants of additional (or substitute) collateral or periodic cash payments. An extremely valuable right.
- Reduced “Cram-Down” Risk. Each class of creditors generally gets voting rights in any reorganization, but a class’s objections may still be overcome (“crammed down”). It is generally much harder for a class of secured creditors to be crammed down, compared to a class of unsecured creditors.
Intercreditor Agreement Considerations. When senior lenders do allow second liens on the property, they generally seek to make the second line lender “silent” – to have it agree that it won’t exercise some of its rights so as not to harm or inconvenience the 1st-lien lender. These usually involve four key elements:
- Limitations on Enforcement Actions – at least for some period, so that the senior lender remains in the “driver’s seat”
- No-Challenge Covenants – the second lien lender must not oppose the priority of the first lien lender’s lien at least, or its enforcement efforts (at least for some period)
- Waivers of Certain Other Secured Lender Rights
Although intercreditor agreements act in some ways to limit the rights of second lien lenders, they also often clarify the right of those junior lenders to purchase the senior debt promptly after a default / bankruptcy event. This right can be valuable because it allows a second lien creditor to step into the first lien lender’s shoes and thus be able to free to exercise all of the rights of a secured creditor, which will give them more leverage in negotiating a reorganization plan. Other observers place less importance on them, since a first lien lender will often agree anyway to sell their loan if an at-par offer is made.
Mezzanine Debt and Preferred Equity
Mezzanine Debt. Mezzanine debt and preferred equity do not have a security interest in the property; rather, the legal instruments generally provide, as their primary legal remedy, for taking over the manager’s control rights in the title-holding project company. This remedy can be quicker than a foreclosure proceeding on the real property asset, but the outcome of the action is less certain, particularly as holders of these instruments do not automatically get notice from county recorders when a foreclosure proceeding has commenced.
Mezzanine debt requires a “pledge” of the sponsor’s (and sometimes all shareholders’) interest in the title-holding entity. This security interest is recorded and, if necessary, can be “foreclosed on” by an agreed process under the Uniform Commercial Code.
Many property lenders remain reluctant, however, to permit mezzanine debt to participate in a transaction; as with second-lien debt, the competing claim on control of the asset (even though less direct, with mezzanine debt) makes many of them uncomfortable. Those property lenders who do allow mezzanine debt generally demand an intercreditor agreement with the mezzanine lender, and this requirement can slow a deal’s progress.
Preferred Equity. Preferred equity relies for its remedies not on pledged equity interests but rather on contractual rights provided for in the operating agreement of the title-holding project company. Like mezzanine debt, preferred equity generally has as its remedy the take-over of the manager’s control rights in that project company. The remedy can potentially be exercised promptly; but lender approval to any change of control in the borrowing project company will generally still be required. Moreover, governmental-sponsored enterprises like Fannie Mae and, to a lesser extent, Freddie Mac are reluctant to let true preferred equity participate in transactions where they are involved; watered-down remedies for the preferred equity investor are sometimes agreed in order to appease these lenders.
One interesting twist is that preferred equity should generally not be subject to bankruptcy “cram-downs” (since it is not debt); this advantage is of only limited usefulness, however, when a project company reaches such a dire position.
A common equity position generally means that one is investing alongside the sponsor, so there isn’t much in the way of remedies with common equity. There may be manager removal rights in the event of fraud, etc., but such instances arise only rarely and even those rights are sometimes restricted where Fannie Mae or Freddie Mac is involved as the property lender.
The good news is that common equity holders are investing alongside the person/entity with the most at stake. Sponsors put real money into their projects (generally at least 10% of the total equity), and so believe in those projects and expect to make money from them. And of course there is no upside limitation with common equity investments – if a property is sold ahead of schedule for a better-than-expected price, common equity investors are the ones who would realize on those unexpected gains.
Since a common equity position involves no security or collateral, the corollary is that that investment position generally involves the highest potential returns, since there is no limit (cap) on the property’s appreciation – or “upside” – that the investor can realize. Of course, high potential returns involve high potential risks, including loss of principal – so investors need to think carefully about this trade-off.
Each investment position in the capital stack has different rights and involves different remedies. Investors are encouraged to reflect on these differences when considering investment opportunities.