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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   January 2013

Play to the Mezzanine

Mezzanine financing is taking center stage with increasing demand from maturing-loan owners

Play to the Mezzanine

Over the past decade, mezzanine lending has become an established player on the commercial real estate stage. Often the capital structure for a real estate transaction may need something to fill the gap between a senior mortgage and borrower equity, and mezzanine debt can meet that need. The mezzanine-debt position is subordinate to the senior mortgage and will bear losses ahead of the senior lender — making it an attractive option for borrowers who are looking for a hybrid between senior debt and equity.

Borrowers generally are interested in mezzanine lending because of its potential to enhance equity returns and its less restrictive terms in comparison with senior debt. In addition, mezzanine debt reduces the equity requirement and has a lower cost of capital versus investing additional equity. Commercial mortgage brokers who are interested in capitalizing on this growing borrower interest should familiarize themselves with the ins and outs of mezzanine lending, and discover why it may just be the next star of their business.

Mezzanine debt is becoming increasingly popular because borrowers prefer it to the investment of additional equity from joint venture partners. This allows them to retain sole control and to be the sole beneficiary of any potential appreciation of the underlying asset. The use of mezzanine debt also allows a borrower to target larger transactions and be more competitive in terms of pricing with a lower weighted average cost of capital.

In the real estate cycle that ended in 2008, the perceived opportunity in high-yield debt created a heated competition in the mezzanine-financing industry. Existing real estate and finance companies looking to expand their investment-management business focused on the real estate debt market and began originating mezzanine loans. Conventional institutional lenders, including banks and insurance companies, expanded their traditional senior-lending lines of business to include mezzanine lending. Wall Street lenders with commercial mortgage-backed securities (CMBS) platforms also began originating higher-leverage whole loans, where the senior component would be securitized, and subordinate B-note or mezzanine positions would be held on balance sheet with the intent to sell at par or better.

Further, there was a proliferation of new companies formed solely to focus on mezzanine investing and capitalize on that perceived investment opportunity. Many of these mezzanine providers traditionally had not focused on mezzanine lending and were relatively inexperienced. As a result, as the capital markets became volatile and asset values declined significantly, many groups and companies — as well as many larger institutional lenders like banks and insurance companies — were forced to exit the market.

Today’s mezzanine market is dominated by hedge and opportunity funds, mortgage real estate investment trusts (REITs), life companies and private sources. Each group has specific parameters and criteria for originating mezzanine loans. Competition, therefore, varies by the profile of each individual investment. Although the universe of mezzanine lenders has shrunk since the last real estate cycle, the environment remains competitive.

Mezzanine loans may be sourced through senior lenders, commercial mortgage brokers, directly with borrowers and even from other mezzanine lenders that are looking for a participant on a large transaction. Unlike senior loans that typically are originated through broad marketing efforts, mezzanine loans often are marketed in a limited fashion to a handful of mezzanine-debt lenders. A mezzanine lender’s success in sourcing transactions typically is driven not only by pricing, but also by strength of relationships and certainty of execution.

How it works

When senior debt is readily available for as much as a 75 percent or 80 percent loan-to-value (LTV) ratio, as was the case in the peak years of 2006 and 2007, the mezzanine position often competes aggressively for as much as 90 percent LTV or higher.

In today’s market, with senior mortgage loans generally sizing below 70 percent LTV, the mezzanine position typically will compete at a level that is between 75 percent and 85 percent LTV. Profit participation generally has not been evident as in the past unless the mezzanine loan is at 90 percent LTV or higher, and this typically is limited to development or redevelopment transactions. Loan duration has remained consistent throughout the industry’s history, with loan terms generally ranging between three years and five years, and typically co-terminus with the senior loan in a transaction. CMBS lending has increased demand for fixed-rate, 10-year mezzanine debt.

Before the economic downturn, it was commonplace to have loan payoffs in advance of maturity. This has changed, however, as the economy and commercial real estate took a turn for the worse. Mezzanine borrowers have needed additional time to achieve their exit strategies, often exercising or negotiating extension terms.

Emerging opportunity

The scope and diversity of the U.S. institutional real estate market is expected to provide a steady stream of attractive financing opportunities in the next five years. It is essential to understand the market developments that have created this opportunity, however. First, the volume of outstanding commercial and multifamily mortgage debt grew from about $1.6 trillion in 2000 to nearly $2.4 trillion as of second-quarter 2012, according to the Mortgage Bankers Association (MBA). Of that total, it is estimated that there is $100 billion in outstanding mezzanine debt, according to the MBA.

Before the disruption of the credit markets in 2007 and 2008, public debt accounted for more than 20 percent of U.S. real estate capital-markets activity. At its peak in 2007, CMBS financing accounted for roughly $234 billion in annual debt financing. CMBS new issuance for 2012 was projected at just $35 billion, according to the Urban Land Institute.

By some estimates, there will be more than $1.35 trillion in commercial real estate debt maturities in the period between 2013 and 2016, which is likely to boost demand for mezzanine debt as borrowers seek capital solutions for refinancing, debt restructuring and discounted payoffs. Existing commercial real estate lenders, however, may not be prepared to extend credit to refinance the volume of commercial real estate loans maturing in the next few years and also may be hesitant to provide financing at previous levels of leverage.

As a result, the mezzanine lending market is experiencing a healthy pipeline of solid, risk-adjusted opportunities with strong geographic and product diversification. This significant demand for mezzanine financing is being driven by the wave of expiring loans that have loan balances higher than the level at which a new senior loan can be financed.

Senior lenders are typically more conservative today, and have reduced the percentage of senior debt in the overall capital structure of transactions and required borrowers to commit larger equity investments than in the past. Borrowers are looking for a solution to help fill this gap, creating an unprecedented opportunity for mezzanine debt. This presents the opportunity to focus on high-quality borrowers and financing the refinancing or acquisition of well-located institutional assets with stable cash flow and strong coverage to the mezzanine position.

Origination and underwriting

Mezzanine loans are originated alongside senior debt provided by banks and insurance companies. Further, mezzanine opportunities also have resulted from recently increased CMBS transaction flow, relative to the anemic issuance levels seen in the past few years. Given the disruption in the real estate credit markets, Wall Street origination platforms have created a significant investment pipeline and valuable perspective on capital flows and pricing. Mezzanine lending is often necessary in CMBS transactions where the required whole loan proceeds exceed maximum LTV thresholds of the securitization issuance.

The mezzanine market is less efficient today, however, with fewer mezzanine lenders. Each lender has its own focus on parameters, such as region, property type, position in the capital structure and size of loan. Additionally, debt stacks requiring subordinate debt often are tailored to the specifics of each individual transaction. In contrast to the 2003 to 2008 time frame, in which opportunities were driven by acquisitions and the formation of new capital structures on each transaction, today’s mezzanine investment opportunities are more complex because of the refinancing of debt that was negotiated at the height of the market. Each transaction is different and demands that mezzanine lenders exhibit creativity and sophistication in structuring loans. Borrowers also are selecting mezzanine lenders based on certainty of execution, given these complex structures.

Underwriting and pricing for mezzanine real estate debt has changed significantly in the past five years. Given the uncertainties of today’s economy, the assumptions used in cash-flow projections are more conservative, with market-rent projections typically not exceeding inflation rates. Today’s leverage levels based on reset property values for mezzanine loans are typically topping out at 75 percent to 85 percent LTV, compared with 90 percent in 2006 and 2007. Debt yields — net income divided by total debt — for mezzanine loans generally range between 7 percent and 9 percent. 

• • • 

With the opportunities evident in today’s market combined with the lessons learned in the past few years, commercial mortgage brokers who are interested in originating mezzanine loans can capitalize on business in this niche. Brokers should target experienced borrowers who have well-conceived projects, a reputation for success based on past performance and significant invested cash equity.

Brokers also must look for a real estate mezzanine lender that has a combination of financing, operating and investment expertise. This type of lender is uniquely qualified to identify and complete a variety of mezzanine and high-yield financing opportunities in today’s marketplace at attractive risk-adjusted returns. Remember, with transactions taking longer to materialize than in the recent past, having a solid relationship with mezzanine lenders that have deep and long-standing industry relationships in the debt and equity markets is necessary to gain a competitive advantage for sourcing transactions. 


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