What is the objective?
It seems clear that MakerDAO needs to onboard large amounts of real world assets in order to meet continual DAI demand. Leaning on my background and existing businesses, I’d like to propose specific assets, structures and counterparties so that we can achieve this in the near-term to help build real-world DAI utility.
How do we do that?
Since I got engaged with MKR coming on two years ago, I have been fascinated by the scope and possibilities that MKR and DAI could bring. That said, governance is a process, and expanding the DAI ecosystem in a "peg-mindful way" just takes time. Further, the launching of MCD and then collateral onboarding process had to be defined.
The above being said, now is the time to really engage to bring to the forefront the discussions of off-chain collateral (e.g. the benefits, the risks, the structure, etc. ). I believe it to be a calling for MakerDAO as a whole.
After researching the matter at length and inspiration from Occam's razor (the simplest solution tends to the right one), rather than try to completely ignore the existing banking system, we should use it as a guide and then enhance it.
So, let's do that.
First let me take a step back and introduce what I am trying to do.. what I have been doing.. and how I am currently engaging with the existing banking system and how Maker can play a role (either as a complement or a replacement).
Without putting my CV here, I am an engineer that ultimately went to grad school to get a business degree and followed down the finance path. Having had exposure to PE (buy and sell side) / Hedge Funds / RIAs / BDs, I am now in the middle of a commercial real-estate development firm and am now responsible for building the capital side of that business.
The type of financing that my business engages in is called a Credit Tenant Lease. To offer a brief definition:
“Credit Tenant Lease (“CTL”) Financing is a method of financing real estate in which the landlord / owner borrows money to finance the development or purchase of a property and pledges as security rent to be received from the tenant and a mortgage on the property.”
The type of CTL we engage in specifically are single-tenant net lease space. This means that a credit-rated tenant (rated by one or multiple of the big three rating agencies) leases the property on a long-term basis with certain responsibilities for insurance, maintenance, and taxes etc... Here is a quick primer on this sector of commercial real estate: https://www.cbre.us/research-and-reports/US-Net-Lease-Investment-Report-Q1-2020
Without dragging on about the net lease space, basically it has all the economics of a bond but, it is not a bond in the securities sense. Depending on what is being built, these individual projects are typically in bite size amounts ranging from $1MM-5MM. In addition, there are other tax friendly aspects such as 1031 exchanges that make this structure appealing. In summary, the net lease space has a robust secondary market for investors that are looking for a return while the underlying asset is risk-mitigated; the lion’s share of risk exposure is in the credit quality of the tenant. Developers engage with tenants to build locations and be a part of their expansion plans. That build-out is a developer's transactional pipeline. Having a pipeline of deals, especially ones that are resilient during a recession, takes a significant amount of networking and track record.
What is interesting is that once a project has been completed, there are buyers waiting to buy the stabilized product. Developers take the risk of purchasing land (in-use or vacant) then engaging with a tenant and getting the project to a store opening (permitting, construction, etc.). Many ask why wouldn't the tenant just do it themselves?" The answer is that some do, but most (tenants) logically use the developers (and their financiers) as a quasi-outsourced investment bank that allows them to optimize their operational expenses and enhance their Return on Assets and Return on Equity. The key component, however, remains that a credit worthy party is "on the hook" for the term of the lease for rental payments.
The above is a general introduction to CTLs. I am happy to go deeper (below or public / private sessions).
Moving on, how do developers in this space currently get projects financed?
There are fundamentally two ways:
A.) Engage directly with a bank (or financial institution) and get a project/construction loan *once* the project is “shovel ready.” The borrower would then negotiate terms (price / recourse / term / equity requirement) with the lender. Once the equity is secured, the loan closes and each payment thereafter needs to then go through a draw schedule process to authorize the release of loan proceeds in an incremental way.
B.) Engage with a 100% loan-to-cost financier (like me). They would provide a loan (usually also with draw schedules), typically with conditions that are more friendly to the lender, but the borrower does not need to have any equity in the deal. Costs are significantly higher than going directly to a bank, but they secure the equity.
Here is where initially I saw the gap for MakerDAO, to lend money directly into these projects, and below is why it won’t work as originally conceived.
Each of these projects require diligence, document review, oversight, occasional waiver requests and a high degree of certainty to outcome (e.g. no borrower / developer will want to risk his / her pipeline and take the chance of pissing off the tenant if for whatever reason the MKR community didn't approve an individual deal. Further, the MKR community is not set up for nor should be lending off-chain directly into projects, regardless of size. We haven't even started to talk about how to handle trust with this yet? The confirmation of equity, historical expense verification, and property capital allocations and releases just make the entire process untenable for MKR approval. Summary: banks and the current finance space have been optimizing this space for decades, trying to insert MKR here "could" work.. but would be constant brain-damage for the borrower and the MKR community cognitive overhead would frankly interfere with the governance process and over time be discarded as a novelty.
So how do we make this work within MakerDAO?
Rather than MKR providing a loan to a specific project, which would require significant MKR oversight and cognitive load, MKR should be engaging with parties as a complement or a substitute to a bank credit facility. We should use market forces and alignment of economic incentives to ensure desired positive outcomes.
At its core, MakerDAO is like a Repo facility, or a credit facility, that can be drawn on or collapsed at will. In the banking world, this is known as a revolving credit facility and can be approved in favor of a given borrower. These revolver agreements are exceptionally well drafted and utilize battle tested legal documents. They represent an allocation of the bank’s reserves, and they are difficult to get if you are a small player.
So how and where can MKR play in the net lease space?
As I outlined above, I am currently building a sister company to the real-estate developer for this net lease space. This sister company will be a finance company that provides 100% loan-to-cost to real-estate developers across the United States with international expansion planned. Loans could be used for refinancing or new construction. That is to say that the business of this company will be to provide loans. This is not an investment company, it is an operating company, a critically important distinction.
In doing so, this lender ("LendCo") will engage with willing borrowers (“BorrowCo”) to provide their capital needs, but in a massively risk mitigated way.
We plan to mitigate the risk by being the hybrid between a bank, a hard-money lender, and a massively de-risked development firm (if things go sideways). This means that absolutely every payment that goes out has to go through our internal controls for an approval cycle. All projects must have a lender approved general contractor manager (or mgmt firm) sign off on the GC invoice and have associated lien waivers. All GC / engineering / arch. / lease contracts must be in a place that would allow the lender to step in to displace the borrower and step in to his / her shoes should there be issues.
Fundamentally as a lender, you have to work in reverse when designing the structure. We have to assume that everything goes wrong and build the protections in backward such that the borrower is taking the risks. When this LendCo lends money to the SPV for a new developer (BorrowCO), what happens if something happens to the principals of the borrower (e.g. someone gets hit by a bus or has GC issues) that the project can be rescued and then divested). Notice the rescued part. More on that part later (or in another post).
The Lender should take credit quality risk and construction execution risk. This is why economic incentives are critical and picking the right internal controls make all the difference in the world. Further, the developer makes nothing in the project until the project is sold (and the lines are repaid down thereafter).
We solve many issues at the same time by doing the following:
- Requiring that BorrowCo use a cookie cutter identical operating agreement with each project in its own newly formed legal entity (Delaware LLCs)
- Require that BorrowerCo give first position senior lien in favor of LendCo and not take any speculative risk.
- Require that BorrowCo provide certain reporting
- Require that BorrowCo maintain certain financial requirements
- Require that BorrowCo and the developer maintain certain assurances in favor of LendCo
- Requiring that LendCo have an Equity contribution requirement
- Requiring that LendCo have reporting requirements (quarterly financials / annual audits)
- Requiring that all loans meet an underwriting criteria (and that appraisals are never older than 6 months)
- Requiring that certain LTV / LTC / DSCR / developer exit spread / current loan constraints limit the amount of loan proceeds with the remaining being filled with equity
- Requiring that LendCo use equity first (critical)
- Requiring that LendCo get approved legal opinions from the borrower on loan enforceability in that jurisdiction (w/ State specific requirements)
- (just to name some)
Why does this matter?
If we look at MKR as a decentralized governance token, we could step back and look at this in reverse. What happens if LendCo fails? What happens if LendCo had a traditional revolver that collapsed the bank? If we take that bank that failed because it had a credit facility that failed, how would that money be recovered? Answer: An appointed receiver would foreclose on the assets and the bank's receiver would get the proceeds. For a MKR revolver structure, the trust agreement and trustee would encapsulate the value pursuant to an executed revolving credit facility agreement and return the DAI. That is to say, the revolving credit facility agreement embodies a lien over the entire LendCo. So as a fiduciary over the equity, I must do what is in their best interest (and the revolver is senior to their position)- leaving MKR protected. The Senior money gets paid back first.
Wait... are we not reverse engineering how a CMBS works?!
Yes somewhat, we are. A CMBS is security that a trust company maintains that follows a previously agreed upon trust agreement and should any of the collateral inside that trust fail, the trustee is authorized to divest those assets, recover what they can, and pay the owners of the securities in accordance with the agreements (e.g. tranche). It is actually closer to reverse engineering a bank without a depository aspect.
Point being, when one looks at the cognitive load on providing these net lease loans, it does not make sense for Maker to ever provide these directly. However, it makes all the sense in the world for MKR to be setting up a revolving credit facility for a Lender that has the equity needed to be the buffer for protection for MKR holders. Further, a revolving credit facility agreement provides all of the required disclosures and reporting requirements that the MKR community would need to assess the continual risk which must be delivered periodically per the revolving credit facility agreement. Having an authorized party execute both the revolving credit facility agreement and the trust agreement (when agreed upon), would allow MKR holders to keep control at the MKR level, have the desired reporting requirements on the borrower, and always retain the ability to hit the "red button" (i.e. liquidate the Vault) should any fraud, misconduct, or any other reasons to trigger the provisions in the legal agreements to action accordingly.
It is important to note that the current plan would have LendCo be capitalized w/ 30% equity to be married with 70% debt from a MKR revolver, and THEN lend that out at 100% loan-to-cost to a borrower (for new construction, modified for refinance as the risk is lower). Even during the worst part of the 2008 financial crisis, stabilized credit tenant leases with solid tenants never dropped more than 15-20% of their value before rallying to a 10% premium 6 months later. So if for some reason we had to do a firesale, the equity in LendCo would get hit before MKR. The rates should reflect this risk.
Having been personally on the borrowing side now for multiple deals and growing, the time is right for me to launch a LendCo and secure a revolver. We have a "captive" developer and pipeline of transactions (both as refinance candidates and new construction) as well as another developer (and its pipeline) in the works.
So would you just be doing what a bank would do with a revolver and replacing it w/ a DAI loan?
To an extent, yes. BUT with abstracted community rights enforced (if needed via external trustee) triggered by smart contract (via MKR governance).
Critical components that are essential for this to work
- Keep it efficient w/ control at the top (with governance & an executive vote)
- Rate sensitivity (more on that in another post)
- Incremental growth (start with a low debt ceiling)
It will be a learning curve for both Maker and LendCo initially and the projects we do are risk distributed, small capital bites in nature (no skyscraper finance here!). Each project is decently small with the aggregate of the number of projects being a reputable amount.
Interestingly enough, for the above structure, the majority of the risk is in getting started. From a practical standpoint, LendCo with one project and one senior lien (as an asset) has more concentration risk than if we have 20 projects in parallel. The concentration risk dissipates the larger the structure gets.
In addition, as the lender, we will require from the borrower a certification that all attempts will be / were made (within reasonable economic constraints) to fulfill sustainable environmental objectives. Initially, this won’t have a huge impact, but over time, it will. Further, our objective will be to take the above construct and expand to lending in the renewables space (save that one for another post!)
Today, it is easy to get distracted by the question about what impact does COVID have on your business. While the answer thus far has been basically zero (as that question is really focused on the tenants, to which all of them thus far have been recession-resistant and covid-resistant), the real focus for the discussion in this post should be about the structure, legal, and risk mitigation.
Once this nut is cracked, the scale and volume of deals will come in from other participants. I aim to be first, but I will most certainly not be the last party to ask for the above structure. Make no mistake! We can deploy decentralized originated capital off-chain and compete toe-to-toe with existing financial institutions. In doing so, we cause a constant flow of capital buying and selling DAI to further strengthen the peg!
The above structure is being done today with banks (but without the trustee component). I recommend setting up a new collateral category called “Revolvers” with a sub-category called “Commercial Real-Estate”. The emergence of off-chain revolvers is about to start for MakerDAO.
I encourage any of you (individual / group) in a public or private manner to reach out to me to discuss the above. When viewed individually, not one item in this is "hard", rather there are many small parts that look way more complex than they really are until you break them down.
My goal is simple and straightforward. Engage the MKR community directly, bluntly, openly. Answer questions, address concerns, modify documents accordingly, and ultimately get a "deal done" that would grant a decent revolving line of credit in favor of LendCo with all due reporting requirements going to MKR authorized representatives. All of the legal documents to accomplish the above are there (but need customization). Securities counsel has been engaged to draft as needed. The mental gymnastics on how to do this are complete. Now it is time to engage, discuss, debate, document, agree, and build.
Let's roll !!
(note: apologies for the length of the post. there are many things that got left off of this post including but not limited to tax implications. The above was me trying to keep it short!)