Down Economy Business Advice

Subordination

Written by Brent Pace for Gaebler Ventures

In tough economic times it can be difficult to finance a project. One loan may not be enough; you may require several loans and equity partners. If you are looking at multiple loans for your property you should familiarize yourself with the concept of subordination.

When financing real estate, lenders have typically relied on certain standards to size how much debt you will be offered.

One of the most important of these is debt service coverage. Based on the cash flows the building generates, the lender wants to see that you will generate more than enough cash flow to pay the debt.

For instance, let's say a bank requires a debt service coverage ratio of 1.2. This means that for every $10 of debt payments, the bank requires you to make $12 in income. This is to provide insurance to your lender in the event that your income stream is impaired and you are no longer able to generate as much cash flow.

Lending standards tightening

In a recessionary market, or a financial crisis where liquidity is drying up, lending standards can get pretty tight. A bank might be very conservative and only want to give you a loan with debt service coverage of 2. Or, perhaps the lender simply doesn't think your current cash flows are realistic. If they think current leases are above market rates and likely to decline in the future, they may not wish to lend you much money.

The capital stack

Typically, the first time you get financing on a project it is called a first mortgage or first lien for obvious reasons: it's the first debt on the building. But there are a few less obvious reasons for it. You are free to go out and get additional financing on your project if possible, but you can't change the order in the capital stack. The first mortgage will always have first priority.

Let's give a simple example. Suppose you purchase an office building with cash and later decide you would like to take out a loan on the building. You go to a bank and they give you a $2 million dollar loan. This loan is the first position mortgage. Later, you decide you need additional money for capital repairs. So you go and take out a second loan for $500,000 from another bank. This loan is in the second position.

If you go bankrupt, these two lenders will both have some rights to your building as an asset. They will want to get paid back the capital you borrowed. However, the first mortgage lender will have the first rights to the project to get his money back. This is the benefit of being in the first position. The second lender will get to recover his capital only after the first lender is repaid.

Subordination and rates

In technical terms, the concept explained in the example above is subordination. The second mortgage is subordinated to the first. There could be several more loans on the project, and they would all be subordinate to the loans above them.

In terms of rates you can see what is implied by the structure of the capital stack. The first mortgage will likely offer the best terms and rates because it is the safest loan. If the first lender will only give you 50% loan to value with a minimum debt service coverage ratio of 1.5, that could be considered a pretty safe loan. The second mortgage lender, however, has a much less safe position. This loan will probably cost you several more basis points than the first due to the increased risk.

Brent Pace is currently an MBA candidate at University of California at Berkeley. Originally from Salt Lake City, Brent's experience is in commercial real estate development and management. Brent will have tips for small business owners as they negotiate their real estate needs.

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