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Real estate development is the art of using other people’s money. From Donald Trump to small-town builders, developers typically strive to use as much borrowed cash and as little of their own funds as possible. Doing so lets them diversify holdings and minimize exposure to the risk of loss, particularly if the lender does not require personal guarantees. In recent years, this desire has lead to the development of creative financing techniques in large-scale residential development. Trends such as mezzanine financing and land banking enable developers to shift land-acquisition and development debt off their balance sheets. In the wake of the Enron debacle, as investors and regulators begin to clamp down on off-balance-sheet financing, these controversial methods are receiving more scrutiny. In traditional real estate financings,
borrowers give a mortgage on their property to lenders in exchange
for funding. Although many real estate loan transactions involve only
one mortgage – the “first mortgage” or “senior
mortgage” – borrowers frequently obtain additional financing
through a second mortgage, often referred to as the “junior
mortgage.” To prevent borrowers from becoming over-leveraged,
lenders typically use a loan-to-value ratio, under which the first
mortgage holder limits its loan to a certain percentage of the property’s
appraised value. The junior mortgage holder may then lend an additional
amount, usually at a higher interest rate. The first mortgage holder
has the more secure rights of recovery in a foreclosure or bankruptcy
action. The bank typically funds between 70 percent and 85 percent of the purchase price for the acquisition of land. To ensure that developers have a significant financial commitment to the project, many banks now require developers to fund a substantially greater portion of the acquisition from their own funds. The same bank generally also commits to funding the development – i.e. the seeking and obtaining of governmental approvals and building of infrastructure such as roads and sewers – and the construction of the homes. The lender also may require the developer’s principals to guaranty the developer’s obligations to the lender, including the repayment of the debt. In this instance, the lender is a secured creditor – i.e. the borrower’s obligations are secured by a mortgage on the property. The presence of junior, or second mortgages, can be a complicating factor – especially when deals turn sour. Junior mortgage holders often have the financial ability to obstruct a first mortgage foreclosure, even when borrowers can’t. Meanwhile, the default of a second mortgage and the commencement of a foreclosure action by its holder can create problems for senior mortgage lenders. In addition, in transactions involving the securitization of a portfolio of senior mortgage loans, rating agencies have been particularly concerned about the bankruptcy risks posed by junior mortgages. As a result, since the early 1990s, the use of junior mortgages has decreased. At the same time, however, developers’ need and desire to borrow more funds than mortgage lenders are willing to lend them has continued to rise. And that has helped create a market for so-called mezzanine loans. Next Stop: The Mezzanine Mezzanine loans provide non-mortgage subordinate financing to developers, without subjecting first mortgage lenders to all the negative aspects of subordinate mortgage financing. Mezzanine loans, which can be made by investment banks, stock funds, banks, and insurance companies, typically supply financing of between 50 percent and 90 percent of the project’s required equity contributions or capital structure cost. Unlike plain vanilla mortgages, mezzanine financings take a variety of forms, including hybrid financial products with equity characteristics, such as a participating return and equity kickers. In the case of equity kickers, the lender’s stated return may be supplemented based on the performance of the borrower or the project. There’s another crucial difference: mezzanine lenders generally don’t lend to the corporate or legal entity that has taken out the mortgage on the land. Rather, they extend credit to the partners, members, or other equity owners of the borrower – as individuals or as a group – and take a pledge of their equity interests in the borrower. Less frequently, the mezzanine lender may take a preferred equity position in the borrower directly. This interest entitles the lender to distributions of excess cash flow after debt service, ahead of any distributions or other payments to the borrower’s principals. Yet another approach combines a senior mortgage with mezzanine financing at a combined loan-to-value ratio of 90 percent to 95 percent – at a rate that may be blended or kept separate. In this case, the senior lender and mezzanine lender are the same entity. This last type of structure may contain a shared appreciation or equity kicker, an exit fee paid by the borrower, or both. In any of the above structures, it is
common for the lender to require personal guarantees from the mezzanine
borrower. After all, the borrower’s obligation to repay the
debt is not secured by the real estate. Consequently, the mezzanine
lender’s interest is exposed to greater risk than a second mortgage
lender in a conventional mortgage situation. To compensate the lender
for such risk, the “blended” interest rate paid by the
senior and mezzanine borrowers is greater than the rate paid to a
secured mortgage lender. And while senior mortgage debt is generally
at a fixed rate, the interest rate on a mezzanine loan may fluctuate.
Also, the mezzanine lender may insist on a certain level of control
over the borrower’s business as a means to protect its investment.
But that level of control must be limited to avoid subjecting the
lender to fiduciary responsibility and other liabilities. The first and most critical hurdle to overcome in mezzanine financing is whether the senior lender will permit it and, if so, under what terms and conditions. As in conventional financing, typically the senior lender will require the borrower to provide equity from her own funds or assets, rather than by means of further indebtedness. This hurdle pivots, in part, on whether the mezzanine financing is viewed as debt or equity. If the mezzanine financing is viewed as debt, then this is added to the debt to be advanced by the senior lender in calculating the loan-to-value ratio. But if the mezzanine financing is viewed as equity, the amount is counted towards the equity furnished by the borrower. The conclusion depends on the viewpoint of the lender as well as the form that the mezzanine financing takes. In addition, the senior and mezzanine lenders enter into an intercreditor agreement to address their respective rights. On the developer’s balance sheet, the senior loan is reflected as a liability and the land is reflected as an asset. But a mezzanine loan appears as a liability on the balance sheet of the borrower – not the developer. As a result, the mezzanine debt does not adversely affect the developer’s net worth and liquidity. The interest expense allocable to the senior loan is treated as an interest expense on the developer’s statement and the mezzanine loan interest is treated as an interest expense on the statement of the mezzanine borrower. Both types of lenders recognize the corresponding amounts as interest income. The interest of the senior lender is similar to that of the senior lender in a conventional real estate financing. But because the mezzanine lender is not a lender with respect to the entity that owns the property, it has no interest in the property. Instead, the lender’s interest varies depending upon the type of mezzanine structure. For example, the mezzanine lender may have a security interest in the shares of stock, partnership interest, or other equity interest in the entity that owns the property. A major concern of all mezzanine lenders is the potential ability of the senior borrower to declare bankruptcy. The senior lender has a high priority as a secured creditor of the bankruptcy estate, whereas the mezzanine lender has no security interest in the borrower. Furthermore, the borrowers under the mezzanine loan may have guarantees or other obligations that are triggered by the bankruptcy of the senior borrower. In an effort to deal with this risk, the senior borrower frequently appoints an “independent” director to its board. This independent director exists for one purpose only: to vote against allowing the senior borrower from filing for a reorganization in bankruptcy. An issue arises where the mezzanine lender seeks to appoint a director who is not truly independent – i.e. who may have some relationship to the mezzanine lender. In that case, the director’s vote may be challenged under the “interested director” provisions of state corporate law, with the result that the vote will not be taken into account. Other techniques to control key decisions of the senior borrower include the creation of a special class of shareholders whose vote is required on major issues, or a pledge of shares to the mezzanine lender to allow it to take over the senior borrower in certain instances. Mezzanine lenders holding “kicker” or similar interests also focus on having rights to control any action by the borrowers that may adversely affect the value of those residual or participatory interests. Within the loan documents, some lenders seek detailed veto and control rights that amount to participation in routine business matters. Debt or Equity? Whether the mezzanine financing is viewed
as “debt” or “equity” has a profound impact
on a variety of issues. Senior lenders, as well as borrowers, find
useful legal ambiguity in these elements of mezzanine loans. The equity
characteristics – such as kickers – expose the mezzanine
lender to challenges from the senior lender and the mezzanine borrower.
They may argue that the mezzanine lender is in fact equitably subordinated
to competing lenders, or is not in fact a lender. This may create
defenses to foreclosure and may also limit the mezzanine lender’s
rights if a bankruptcy petition does succeed. Challenges based on
the claim that the mezzanine debt is in fact equity, or that the mezzanine
lender is an insider of the borrower by virtue of the appointment
of the independent director and other controls discussed above, are
starting to surface. Thus, the techniques used to control bankruptcy
risk may in fact increase the risk of loss to the mezzanine lender
in an eventual enforcement action. It has become increasingly common for mezzanine lenders to require that the principals of the senior borrower form a new entity to act as the mezzanine borrower. This mezzanine borrower entity generally is structured as a so-called “bankruptcy remote entity,” that is separate from the borrowing entity that obtains the first mortgage loan. The bankruptcy of the senior borrower will thus not have any impact on the separate structure of the mezzanine borrower. Pay As You Go In recent years, developers and lenders have created a new means of funding development: land banks. In a land bank transaction, a developer locates a parcel of undeveloped real estate that it wishes ultimately to acquire in its developed state. In contrast to mortgage financing, in which large sums are borrowed up-front, land banks offer developers a sort of pay-as-you go process. The land bank, which is typically an investment bank or other financier unrelated to the developer, acquires the property. (As regulated entities, commercial banks generally are prohibited from engaging in such transactions.) At the same time, the developer enters into an agreement to acquire the building lots from the land banker, on a periodic basis, after the lots are improved. Land banks are most prevalent in areas such as the Sunbelt. The land banker funds the costs associated with the development of the project’s infrastructure. Sometimes, the land banker retains the developer to shepherd the land through the government approval process and to construct the infrastructure. Typically the developer is paid a guaranteed maximum price plus a fee. The developer then buys the improved lots from the land banker, and often obtains financing for the purchase of the improved lots from a conventional lender. The purchase price is a fixed amount per lot, frequently based on a predetermined formula designed to result in the land banker achieving a certain internal rate of return on its total investment. Under this structure, the developer’s acquisition of the property is deferred until after the property is developed and improved. And since the developer typically has the option (rather than the obligation) to purchase the lots, the developer is subject to less risk than in a conventional mortgage or mezzanine financing. The developer does not make any payments until and unless she purchases the lots. And if the developer decides not to purchase, typically she merely forfeits the deposit or down payment. One of the reasons that land bank contracts typically do not provide for their specific performance in the event of a developer’s default is that the developer would face a greater risk that the transaction will not be viewed as a sale, and thus would be required to reflect the obligation to purchase the lots on its balance sheet. Developers pay a price for such flexibility, however. Land bank transactions typically result in higher costs to the developer than does mezzanine financing. And due to the risks involved and the limited number of land bankers in the market, the use of land banks is typically reserved for those instances where the developer is able to locate for purchase property which is priced under the market. Often times the property involved is distressed property sold at a dramatic discount. Costs and Benefits Compared with mortgages and mezzanine
loans, the land bank structure results in the greatest leveraging
of the land purchase price by the developer. The only cash payment
by the developer at the outset of the transaction is the down payment
or deposit. Periodic interest payments are not due during the development
process. As the developer purchases and closes on lots, the purchase
price includes a portion allocable to the land purchase price and
the balance allocable to the built-in “interest.” Although
the built-in “interest” in a land bank results in a higher
price for the lots, the developer has less risk because she defers
the payment until she is more likely to need the land for construction
of a home for resale. The built-in “interest” rate tends
to be significantly higher than in the conventional mortgage situation,
but is in a similar range to the rate charged by mezzanine lenders.
When it comes to balance sheets, the developer does not reflect the land as an asset because it merely has the contractual right to purchase it. Once the developer takes down a lot, the land is reflected as an asset. And the mortgage financing that the developer obtained for acquisition and construction of the individual lots becomes a liability. The developer’s income statement does not reflect as an interest expense the portion of the land purchase price that is the profit element portion of the purchase price payable to the land banker. Keeping the land and a corresponding liability off its books during the acquisition and development process is a tremendous benefit to the developer. It enhances the developer’s ability to obtain financing for its operations, and loan-to-value ratio remains stronger than it would be even compared to the mezzanine loan structure. This arrangement is particularly useful for public developers, as their earnings per share are not diluted when the land is not producing income. At least one publicly traded builder, Lennar Corp., has established an affiliate that acquires the land and owns it through the development process until the public builder is ready to use the land for construction and resale to its customers. There are pitfalls to this approach. The land bank must be carefully structured to ensure that the deal is treated as a sale between the land banker and developer, and not re-characterized as a loan. If that happens, the developer loses the benefits of “off balance sheet” financing because it would have to reflect a large liability on the balance sheet. If properly structured, the land banker should be respected as the owner of the property for income tax purposes, until the closing on the sale of the relevant portions of the property to the developer. As such, the land banker recognizes ordinary income from the sale of the lots as the closings on the lots occur. No portion of the purchase price is allocable to interest, with respect to either the land banker or the developer. However, there may be a risk that the Internal Revenue Service will attack the land bank as merely a financing device rather than a true “sale.” Although there are no cases, regulations or other interpretations on point, in other contexts, the courts have upheld the IRS’s position that a transaction structured as a sale should be re-characterized to reflect the underlying nature of the transaction. If the developer defaults on its obligation to purchase all or a portion of the property from the land banker, the developer might seek to file for bankruptcy protection. When doing so, it might assert that the transaction was merely a financing device and request that the court treat the property as an asset of the bankruptcy estate of the developer. If the court were to grant relief to the developer, an interesting issue would be whether the court would treat the land banker as a secured creditor – even though no mortgage or security agreement exists. Perhaps, the court would recharacterize the deed as a de facto mortgage. This is all speculative, since there have been no reported decisions supporting this approach. Quite apart from legal challenges, there is a larger existential question surrounding the growth of mezzanine loans, land banks, and other off-balance-sheet financing techniques. Investors have suffered as a result of a series of episodes in which it became apparent that publicly held companies were substantially under-reporting their debt obligations. As a result, the entire financial community is now shining a spotlight on innovative financing techniques. And as investors and lenders demand simplicity and clarity in balance sheets, borrowers may find that the benefits of off-balance sheet financing may no longer outweigh its costs.
Jeanne A. Calderon is clinical associate professor of business law at NYU Stern.
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