Substitution of Collateral

Are there any Substitution on Collateral experts on this board?

I ran across a “course” that provides an overview of using common debt instruments to fund REI.

Does anyone have any experience in this area?

Thanks, john

I’m no expert, but I have heard of acquantiances doing so pretty sexy things using a substitution for collateral.

One guy I know is an avid investor, and mixes his portofolio between holders and flippers. When the choice is there, he will move a note away from a property he is going to turn over, and puts it on a property that has a healty cash flow. In doing this he maintains his cash flow (although it’s a little less) and gets more cash in hand. Not a bad way to get a low interest loan, huh?

If you get more info on this topic, do share as I’m only familiar the basics :slight_smile:

Cross collateral … seller carry back… swing loan-gap financing- bridge loan… mezzanine loan . what are you tring to do?

The “course” I mentioned in the original post explains using non-Real Estate debt instruments (Corporate/Muni Bonds) in a Substitution of collateral techinque.

I’ll put together a synopsis and post later.


Sounds like pretty cool stuff to me. Can’t wait for the post John.

Now johnny q, what exactly is a mezzanine loan?

Mezzanine loan

A Mezzanine Loan is a relatively large loan, typically unsecured (ie., not backed by a pledging of assets) or with a deeply subordinated security structure (e.g., third lien on the property but non-recourse vis-a-vis the borrower). Maturities usually exceed five years with the principal payable at the end of the loan term. In a standard offer, the loan carries a detachable warrant (finance) (the option to purchase a certain number of shares of stock or bonds at a given price for a certain period of time) or a similar mechanism to allow the lender to share in the future success of the business. Mezzanine loans can be used in financing a startup company or leveraged buy-outs, usually as part of a larger financing package.

Return and Interest
Mezzanine lenders, typically mezzanine funds, look for a certain minimum internal rate of return which can come from four sources: arrangement fee, cash interest, payment in kind and warrants. The arrangement fee, usually payable up-front, contributes the least return and is more aimed to cover administrative costs. Cash interest is the same as interest (finance), usually payable on the principal in equal periods until maturity. Payment in kind (PIK) is in addition to cash interest and accrues period after period, thus increasing the underlying principal (ie. compound interest). The PIK part is due on maturity of the principal. The achieved selling price of the shares acquired under the warrant are also part of the total return of the lender.

The idea behind the interest structure is to postpone burdening a borrower with the full interest cost of such a loan until the due date, effectively betting on substantially increasing cash flows (and equity value for the warrants) towards maturity. An extreme of such a financing instrument is the PIK loan. The other extreme would be, technically speaking, the simple loan.

Interest on mezzanine loans is substantially higher than senior debt or debt of higher priority, thus making the compound interest a substantial part of the repayable principle. In addition, mezzanine loans typically carry some refinancing risk, meaning that the cash flow of the borrower in the repayment period will usually not suffice to repay all monies owed if the company does not perform excellently. By that definition, mezzanine lenders prefer borrowers with strong growth potential.

Real estate finance
In real estate finance, mezzanine loans are often used by developers to secure supplementary financing for development projects (typically in cases where the primary mortgage or construction loan equity requirements are larger than 10%). These sorts of mezzanine loans are often collateralized by the stock of the development company rather than the developed property itself (as would be the case with a traditional mortgage). This allows the lender to engage in a more rapid seizure of underlying collateral in the event of default and foreclosure. Standard mortgage foreclosure proceedings can take more than a year, whereas stock is a personal asset of the borrower and can be seized through a legal process taking as little as a few months.

Leveraged buy-outs
In leveraged buy-outs, a mezzanine loan is used if the purchase price of the target exceeds leverage levels up to which lenders are willing to provide a senior loan or a second lien loan. It is typically provided to the acquistion vehicle, either another company or a special purpose entity (SPE), and not to the target itself. In an SPE with no intrinsic cash flows, the repayment structure of the cash interest through eg. dividends introduces additional risk (eg. minimum or accumulated net profit,tax) to the instrument.

Mezzanine loans in leveraged buy-outs typically carry a substantially higher interest and fee burden than senior loans or second lien loans of the same transaction, however, are less expensive than a PIK instrument. The acquirer has to be very diligent in assessing whether the cost of taking out a mezzanine loan does not outbalance his internal rate of return of equity investment.

Thanks Johnny Q, very informative.

So it sounds to me like you would use this type of loan when you would like to finance 100% of a large acquisition, typically a buy out or a major development project. Something like hard money for the big boys, I guess :). The fact that the loan is collateralized by the company and not the asset is scary, though!

I do have a few more questions, if you dont mind.

The achieved selling price of the shares acquired under the warrant are also part of the total return of the lender
With this statement, are you referring to the stock in the acquiring vehicle, or the stock in the targeted buy out? If it is the asset you are buying out, would that mean that the return would be less for the lender if you strike a lower purchase price, and vice verse? I guess that would make sense, seeing as there would be less risk, but please clearify if I'm chugging down the right train track of thought.

From what I gather about the PIK, it sounds like if that is incorporated into the loan it will be similar to a neg am loan- where as you own more at maturity than you did when you borrowed. Yikes! :o Sounds very risky, but I’m sure if the deal is right it would warrant such an extreme. What type of situation would warrant such a risk? It doesn’t seem like something you would use for a long term strategy…maybe to acquire then liquidate a given buy out? I know this is a vaque question, but im not familiar with how such a high risk loan plays into major acquisitions, so please help me connect the dots. Corporate flipping, I guess? ;D

Read your comments, let me get back to you later. Closing 2 commercial deals right now and a few refi…Will reply soon.