Hi guys,
Just curious to know why a lender wants the borrower to have equity left in the deal at the point of refinancing. I understand this is to have skin in the game but what are the implications of having no equity left in the deal? Why is this a potential risk for investors?
Thanks!
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Its purely optics, lenders want borrowers to have, like you said, some skin in the game. If I have equity in a deal and they have a mortgage it makes the lender feel like they are in a partnership.
Practically, depending on your structure it is more or less difficult to walk away from equity. Its much harder to tell a bunch of investors you're walking away from a building that has their equity in it than it would be if its a family office. If there's no equity left in the deal and you tell your investors you're giving the building back they at least have their principal and are walking away from potential or expected loss.
Basically the classic example of "skin in the game."
Really the actual decision to be made is the same either way, is it building worth the mortgage or will it be worth it in the future to pay off the mortgage. Regardless of whether there's equity at stake there is either Expected Loss or Expected Return.
This is basically the lender relying on the sunk cost fallacy
Can you explain what you mean with " than it would be if its a family office"? I agree with your explanation, although does this also not have to do with moral hazard? From the borrower's point of view he is less willing to invest his time, money and effort into the building because he already got his equity out?
Absolutely there is the potential. That distinction was perhaps not the most helpful thing to put in the explanation. My point was, with a family office the equity is experienced real estate owners, with a fund you could have plenty of HNW individuals but not "real estate people" just cash with faces. Its harder to "sell" your equity on something like giving a building back to those who are not in the day to day with the asset.
If you have no equity in a deal you have transferred all financial risk to the lender(s). A smart lender will want a cushion between loan value and asset value so that any marginal decline in asset value will not put the lender underwater. That cushion is equity.
I always have a little qualm with the line of thinking that cashing someone out above their original equity, means that they have no skin in the game. The value of the asset went up to the point where a debt piece today is worth more than the original value. That isn't too tough to achieve with a solid value add deal since we are talking about a 25-40% pop in value. This also means that the value of the equity also went up and there is actually more equity in the deal. If anything, cash out is an indicator of performance and the experience of the Sponsor. Why punish a successful execution?
The idea that giving back a property is downside protection is also false, giving back property really hurts your cost of capital on debt in the future. I think that East Coast sponsors too often overlook this concept. Working out your assets at the bottom of the recession when you have no need to and capitalizing on the valuation in the following cycle is not a prudent tactic and will often times prove to be myopic (not to mention ethically challenged).
I understand the line of thinking that a quick pop in value does not indicate long term performance as well as a property that has been appreciating gradually over time but that is completely different than saying "sponsor has no skin in the game if we cash them out to the original cost/value of the property".
This part really depends, if you're a large enough sponsor or have been around long enough you are bound to have buildings that are given back, its just a numbers game. There are plenty of sponsors out there who gave back assets in 2010 or '91 or '80 who have no issue finding debt.
As long as there's a good explanation for it there are plenty of other lenders out there willing to chalk it up to bad timing or bad underwriting by the other lender. Its not like you can blacklist every sponsor that gave back suburban office in 2010.
I would say that it depends on the lender and type of deal. If a sponsor had given back property during the recession, the more conservative life cos will not consider them. That being said, CMBS, banks, debt funds and the slightly higher priced life cos will probably consider them.
The giving buildings back discussion is why many lenders don't like to cash out equity. Cashing out puts more risk in the deal for the lender.
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