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CRE-Finance LLC Offers Insight into the Cost of Equity

The first step to becoming a true financier is to understand the concept of equity.

This is an immensely important article for you, suggests Todd Tretsky of Commercial Real Estate Finance LLC. If you can make the leap from just arranging commercial real estate loans (debt) to arranging both commercial real estate debt and real estate equity, you will have truly become a commercial real estate financier.

The first step to becoming a true financier is to understand the concept of equity. Equity has about a dozen different definitions, depending on the situation. It is also important to not only understand the concept of equity, but also about the cost of equity too.

Equity is the first-loss piece. It's kind of like that old joke: What do a divorce and a tornado have in common? Answer: Somebody is going to lose a trailer. If anyone is going to take a loss in a real estate deal, it's going to be the holder or the contributor of the equity.

For example, let's suppose four yuppies pool their savings to buy a rental duplex in Council Bluffs, Iowa. Between the four yuppies, they put 30% down on a $200,000 purchase price. Crop prices suddenly fall, over-leveraged farmers across the country start losing their farms in foreclosure, and John Deere closes the nearby manufacturing plant. Ten thousand workers are laid off in Council Bluffs, and rents plummet.

The yuppies can no longer find tenants for their rental duplex, they fall behind in their mortgage payments, and eventually the house sells at the foreclosure sale for $150,000. After the $10,000 selling costs (foreclosure trustee, title policy, closing costs, etc.), the bank nets $140,000 - enough money to be repaid in full.

All is well, right? Not if you contributed the equity! The first people - and in this case, the only people - to lose money in this failed investment were the contributors of the equity, says Tretsky. They lost their entire $60,000 down payment. Equity is always the first-loss piece.

Remember, we're talking about the cost of equity. Investing in equity is very, very risky, and in order to attract investors, the potential return has to be higher than what they can receive in competing real estate investments.

Well, banks are making commercial first mortgages at around 5.5%. Their loans are pretty safe, typically just 65% LTV to good credit borrowers. Hard money lenders are offering investments in commercial first and second mortgages at rates of between 10% and 14% (and they charge their borrowers 3 to 5 points as well). Even hard money second mortgage investments are far safer than equity investments.

Therefore, you should not be surprised to learn that equity investors want to earn at least 16% to 20%. In addition, the broker syndicating the investors is going to charge at least 6 to 10 points. This is the market. Equity is expensive.

Here are some sample scenarios to think about:

1. The owner of a company has a balloon payment coming due on his industrial building. He owes $2 million. The property was once worth $3 million, but after the Great Recession it has fallen to just $1.9 million. The bank has offered to accept a discounted pay-off (DPO) of just $1.35 million, but the largest new mortgage he can find is $1.1 million. He is $250,000 short, and he doesn't have the dough to make up the difference. CRE-Finance may be able to raise the $250,000 short-fall needed.

2. An experienced commercial real estate investor spots the deal of a lifetime - a partially leased office building in an affluent part of town that would cost $3 million to rebuild. The seller has accepted a $2 million purchase offer, and the buyer has 25% ($500,000) to put down. The buyer approaches every bank in town, but none of them (the big sissies) will lend more than $1.1 million because of the vacancies. CRE-Finance may be able to raise the $400,000 short-fall for him.

To discuss your commercial real estate questions and equity or are seeking financing, please reach out to Richard Tretsky at 212-257-7307 or Todd Tretsky at 212-257-7305 or visit our website at www.cre-finance.com.