Title: Once a Mortgage, Always a Mortgage - The Use (and Misuse) of Mezzanine Loans and Preferred Equity Investments
Abstract: Since the beginnings of English common law, property owners have used the mortgage as the principal instrument to finance real estate acquisitions, provide liquidity, and raise additional capital.1 And if a first mortgage proved insufficient, the owner simply borrowed additional funds secured by a second mortgage on the same property. Although the mortgage first developed in agrarian England to finance acquisitions of farmland,2 over the centuries it has proved particularly adept at satisfying the financial needs of owners with all types of real property. To this day, the mortgage remains one of the most common and successful techniques to finance both residential and commercial real estate transactions in the United States.3 As the mortgage market continued its exponential growth over the last 25 years, however, a new (and soon to be powerful) real estate financing technique also emerged. This technique first involved the active trading of whole mortgage loans4 on the secondary mortgage market5 and later the securitization of large pools of mortgage loans.6 At first these securitizations consisted almost entirely of residential mortgage loans (Residential Mortgage Backed securitizations or RMBS).7 As the industry matured, however, mortgage securitizations also soon included pools of commercial mortgage loans (Commercial Mortgage-Backed Securitizations or CMBS).8 and other large- scale financial institutions underwrote these securitizations in an attempt to duplicate the success of mortgage lenders in the residential mortgage market. With their aggressive marketing and sales, the outstanding amount and new issuances of both residential and commercial mortgage-backed securities grew at an astounding rate.9 The ascendancy of mortgage securitizations has had a profound impact on the financial markets from Main Street to Wall Street, -changing the very basics of real estate finance for first time home buyers, major financial institutions in the United States and even the global markets. The boom in mortgage securitizations has also led to the development of a vast array of new real estate financing techniques. These financing techniques, which didn't even exist ten years ago, span a broad spectrum of intricate legal structures and theories, combine elements of both debt and equity financing, and fall at the intersection of traditional mortgage financing and the capital markets. This article focuses, in particular, on two of these new financing techniques: mezzanine loans and preferred equity investments.10 In the real estate industry a mezzanine financing refers to a loan secured principally by the borrower's equity in other entities. Unlike conventional mortgage financing where the borrower owns real estate, a mezzanine borrower doesn't directly own any real property nor does it operate any business -it acts merely as a sort of holding company. A mezzanine borrower typically only owns equity in a family of other subsidiaries, and these other subsidiaries actually own the underlying real property.11 Therefore, the value of the mezzanine borrower's collateral is derived solely from its indirect ownership of the underlying real property.12 The complicating factor, however, is that this same underlying parcel of land also typically serves as collateral for a mortgage loan between a conventional mortgage lender and the mortgage borrower-the direct owner of the property.13 Because of the unique structure of mezzanine financing, therefore, the mezzanine loan is always subordinate to the senior mortgage lender's collateral. At the same time, however, the mezzanine loan remains senior to the borrower's equity investment in the underlying real property.14 Unlike mezzanine financings, preferred equity transactions aren't even technically loans. Here, the lender typically makes a direct investment (generally in the form of a capital contribution) in an entity. Typically, this entity directly owns income producing real property and is also a mortgage borrower with a separate mortgage lender. …
Publication Year: 2005
Publication Date: 2005-10-01
Language: en
Type: article
Access and Citation
AI Researcher Chatbot
Get quick answers to your questions about the article from our AI researcher chatbot