WWW.ALSTON.COM Real Estate Finance & Investment n SPRING 2019 Multiple Lender Construction Loans: A Focus on Construction Loan Financing with a Mortgage and Mezzanine Loan Component By Ellen M. Goodwin I. Mortgage and Mezzanine Lenders Jointly Originating a Construction Loan – Recent Developments A. The Rise of Mezzanine Finance in Construction Lending After the 2008-2009 credit crisis, funds for construction loans were generally unavailable, which spurred a need for new players in the capital stack. High yield lenders emerged in the mezzanine finance position about eight years ago in order to fill this lending gap and reap the benefits of the higher interest rates on the construction loans. These non-bank lenders have been even more present in the mezzanine construction space over the past four years, helping to meet the needs of the construction boom that has occurred in many of the major U.S. cities, because they are not subject to the bank regulatory requirements imposed by Dodd Frank, such as the High Volatility Commercial Real Estate rule within Basel III (“HVCRE”) that implements higher capital requirements for bank originated acquisition, development and construction loans. As a result of not being subject to rules like HVCRE, the cost of capital in the context of pre-development, development and construction lending is cheaper for these non-bank lenders. The emergence of the construction mezzanine loan market has helped increase the leverage on construction projects. A syndicate of traditional mortgage lenders (i.e., a bank club group) will lend 50-65% based on an “as stabilized” loan-to-value ratio, while a total capital lending stack which includes both a mortgage and mezzanine component may increase leverage on a construction project as high as an 80% “as stabilized” loan-to-value ratio. Since a mezzanine construction lender is in the first loss position in a default scenario and may also potentially run the risk of losing its collateral if the senior mortgage lender forecloses its mortgage loan, the subordinate mezzanine lender demands a higher yield for its funds to compensate it for its riskier position in the capital stack. While senior mortgage construction lenders may look for a rate of return on their loans of 5-6% (or 30 day LIBOR plus 300-400 basis points), mezzanine lenders are looking for much higher returns on their funds, such as an interest rate equal to at least 11 or 12% (or 30 day LIBOR plus 900-1000 basis points) plus an origination fee and exit fee. Demand for mezzanine construction loans remains strong today; however, due to the many non-bank players, such as debt funds, REITs and finance companies, that Originally published as part of The ACREL Papers at the mid-year meeting of The American College of Real Estate Lawyers, Spring 2019. Republished with permission. WWW.ALSTON.COM 2 have flooded the mezzanine lending space generally, there are many active mezzanine lenders who are willing to provide subordinate financing for construction projects in order to take advantage of the higher interest rates. Active players in this market include Starwood, Blackstone, and Apollo. B. When Will the Proceeds of the Mezzanine Loan Be Advanced? Typically, neither the mezzanine loan nor the mortgage loan proceeds will be advanced until the required equity contribution has been made by the borrower into the mortgaged property. The relationship of when the mezzanine loan and the senior mortgage loan are funded relative to each other is a business decision among the lenders. There is no market standard and there are many tensions driving this decision. Will the entire mezzanine loan be advanced prior to any senior mortgage loan advance or will the loans be advanced on a pari-passu basis? Sometimes the borrower’s equity and the mezzanine loan are simultaneously funded at closing. Mezzanine lenders like to advance all loan proceeds at closing so they can begin collecting interest on their full mezzanine loan commitment. Borrowers, however, will prefer that the mortgage loan and the mezzanine loan be funded on a pari-passu basis as construction progresses as opposed to the mezzanine loan being funded in full upfront at closing, because the mezzanine loan bears the higher interest rate and the increased interest carry would be less economically favorable to the borrower. An issue for mezzanine lenders to also consider with respect to pari-passu funding is that since many of them are non-bank lenders, such as investment funds, they may not be institutionally set up to administer monthly construction draw requests. This could be an administrative burden to some of the smaller investment funds, and many senior mortgage bank lenders also believe that some investment funds may not have the expertise in-house in construction servicing and may not be best equipped to determine if conditions precedent to a draw request are met. So in a pari-passu lending structure who should control the construction draw process if both lenders are funding their pro-rata share of the draw request? In fact, having separate lenders with approval rights over construction draws would be undesirable for the borrower. What happens if there is a disagreement on the contemplated construction draw request between the mortgage lender and the mezzanine lender? This potential conflict could result in a nightmare with timing and the approval process for the borrower. Even though their interests are aligned as lenders, does a specifically designated construction consultant have the final say with respect to these disagreements? A senior mortgage lender may not be comfortable with giving away any control on a construction draw request and will want its ability to fund (or not to fund) draw requests to be unimpeded, as construction loans are risky investments. Finally, with respect to the sequencing of the funding of the respective loans, the mortgage lender (as the senior lender in the capital stack) likes to see the mezzanine loan fully funded at closing before it funds any portion of its loan. They view the mezzanine loan as credit support for their senior loan in that a greater portion of the project has been completed (and paid for) prior to the senior lender increasing its exposure. Under this structure, the mortgage lender takes full control of the construction draw process and the monitoring of the construction project avoiding any unwanted interjections by the mezzanine lender (although a mezzanine lender may wrangle away a non-binding consultation right in an intercreditor agreement, which is discussed below in greater detail). The mezzanine lender with a fully funded loan at closing is a more passive lender during the construction phase and the borrower interfaces only with one lender on construction draws. If the borrower is willing to move off of its desire to reduce its cost of funds, a full funding of the mezzanine loan at closing with the mortgage lender funding all construction cost advances may be the most optimal WWW.ALSTON.COM 3 and seamless structure from both the borrower’s and the lenders’ perspective. For these reasons, sequential funding in reverse order to the relative positions of the capital and equity stack is common in the mortgage/ mezzanine construction finance market. Once these business decisions have been analyzed and agreed upon between the mortgage lender and the mezzanine lender, the mortgage and mezzanine loan documents will reflect the mortgage borrower’s required equity investment in the mortgaged property and how and when the respective mortgage and mezzanine loan proceeds will be funded. The intercreditor agreement between the mortgage and mezzanine lenders, discussed more fully below, will address the relative priority of the mortgage debt to the mezzanine debt and what type of consent or consultation rights a mezzanine lender has during the loan term. Typically, the mezzanine debt and the mezzanine loan documents are subject and subordinate to the mortgage debt and the mortgage loan documents, with very few exceptions. C. Collateral/Security for the Mezzanine Loan The borrower under the mezzanine construction loan will be the direct equity owner (or parent) of the mortgage borrower or owner of the real estate who will be constructing the improvements. The mezzanine loan proceeds are typically then contributed by the mezzanine borrower to its subsidiary, the mortgage borrower, for use in the construction project. The mezzanine lender is not granted a mortgage lien on the real estate collateral but is granted a pledge and security interest in 100% of the equity interests in the mortgage borrower or property owner. When a mezzanine lender forecloses on its equity collateral, unlike a mortgage lender, it cannot foreclose out or extinguish subordinate liens on the real estate collateral. The mezzanine lender will take subject to such liens and therefore the mezzanine lender must pay very close attention to the conditions precedent for loan advances in the mortgage and mezzanine (if applicable) loan documents, such as the delivery of lien waivers from the general contractor and applicable sub-contractors, to reduce the risk of springing mechanics’ liens on the project. The waiver of these conditions to advances by a mortgage lender should require the consent of the first loss mezzanine lender in the intercreditor agreement (discussed below). Additionally, mezzanine lenders will also demand a recourse carve-out guaranty from a deep pocket guarantor which will include personal liability for losses with respect to any mechanics’ liens on the construction project, among other traditional non-recourse carve-outs. D. Identity of Mezzanine Lender Is Important to the Borrower The identity of the mezzanine lender has always been important from a senior mortgage lender’s perspective as the mezzanine lender can potentially become the sponsor of the mortgage borrower in a default scenario upon the mezzanine lender’s exercise of remedies under the pledge agreement.