Mezzanine lending in commercial real estate, which has been an established form of financing for more than two decades, is a hybrid of senior debt and equity. It fills the gap between a first-position mortgage and investor equity, typically occupying one or more intermediate positions in the capital structure between debt and equity.
Commercial mortgage brokers should understand how the insertion of mezzanine debt may save a client’s deal by creating a greater cushion against risk for a lender while also having financial appeal for an investor who shuns the risks of an equity investment but is seeking a return beyond senior debt.
Because mezzanine debt is in a subordinate position, it will bear losses ahead of the senior mortgage lender. Mezzanine products are proliferating for a variety of reasons, however. This includes a limited availability of traditional credit at higher loan-to-value (LTV) ratios; stringent credit standards and conservative valuations ascribed by traditional, senior balance-sheet lenders; and institutional-lender limitations, including liquidity concerns and risk-based capital restrictions.
Many mezzanine loan products are considered unsecured because there is no lien on the borrower’s assets, although these loans are typically secured by an equity partner’s ownership in an asset. They are often short-term loans and are generally co-terminus with the senior mortgage, meaning they mature at the same time.
Again, mezzanine debt creates a financial position that appeals to certain investors. Those who do not have a strong opinion regarding the timing of economic cycles may receive a higher risk-adjusted return that compares favorably to senior debt and equity returns. The lender has a valuable “equity” cushion by not being in a first-loss position. Mezzanine investors seek equity-like exposure to returns, but desire some risk protection. This is achieved by having a priority claim over equity, and through higher yields than senior debt and equity.
Borrowers generally find mezzanine debt attractive because it has the potential to enhance equity returns and is less restrictive than senior debt. In addition, mezzanine debt reduces the equity requirements for a deal, and it has a lower cost of capital than an equity investment.
Borrowers often prefer mezzanine debt to investments from joint-venture equity partners, because the former allows them to retain full control — and the full potential appreciation — of the underlying property. The use of mezzanine debt also allows a borrower to target larger transactions and be more competitive in terms of pricing, because the average weighted cost of capital is lower.
During the mid-2000s, competition in the mezzanine-financing industry increased significantly. Real estate and finance companies looking to expand their investment-management business focused on the real estate debt market and began originating mezzanine loans. Traditional institutional lenders, including banks and insurance companies, expanded their business-lending lines to include mezzanine loans.
A mezzanine lender’s success in sourcing transactions is often driven not only by pricing, but also by strength of relationships.
Lenders with commercial mortgage-backed securities platforms also began originating higher-leverage whole loans in which the senior component was securitized, and subordinate B note (or mezzanine) positions were held on balance sheets, with the intent to sell at par or higher. There also was a proliferation of new ventures created solely to focus on mezzanine financing and to capitalize on investment opportunities. After the financial crisis hit in 2008, which caused asset values to decline significantly, many of the new mezzanine lenders ceased to exist, and many large institutional lenders exited the business.
Today’s mezzanine market is dominated by hedge and debt funds, mortgage real estate investment trusts (mREITs), life insurance companies and private sources. Each group has very specific parameters and criteria for originating mezzanine loans, so competition is more limited and varies by the profile of an individual investment.
Mezzanine loans may be sourced through senior lenders, commercial mortgage brokers, directly through borrowers and from mezzanine specialty lenders who are looking for a participant on a large transaction. Unlike senior loans, which are typically originated through broad marketing efforts, mezzanine-loan opportunities are often marketed in a limited fashion to a handful of mezzanine-debt lenders. Therefore, a mezzanine lender’s success in sourcing transactions is often driven not only by pricing, but also by strength of relationships, certainty of execution and an ability to provide creative transaction structures.
Underwriting and pricing for mezzanine debt has changed since the financial crisis. The assumptions used in cash-flow projections are more conservative, with market rent projections generally not exceeding inflation rates. Debt yields — net operating income (NOI) divided by total debt — for mezzanine loans generally have an average annual return rate between 6 percent and 8 percent.
In 2006 and 2007, prior to the financial crisis, senior debt was readily available at a level of up to 80 percent LTV and mezzanine debt filled the gap up to 90 percent LTV or higher. In today’s market, with senior mortgage loans often sizing at 70 percent LTV or lower, mezzanine debt may cover less of the capital stack. It is often available up to 75 percent to 90 percent LTV, depending on the product type. Loan durations have stayed consistent, ranging from three to five years and are typically co-terminus with the senior loan. There also is demand for fixed-rate mezzanine debt with loan terms ranging between seven to 10 years.
The U.S. institutional real estate market is expected to continue providing a steady stream of attractive financing opportunities over the next five years. The volume of outstanding commercial and multifamily mortgage debt grew from approximately $1.5 trillion in 2000 to more than $3.9 trillion as of third-quarter 2017, according to the Federal Reserve. A significant amount of this debt will mature and require refinancing.
• • •
Mezzanine finance is in a class all its own. It occupies a unique position within the capital stack between senior debt and equity. This position provides higher, equity-like investment returns while maintaining many of the risk controls inherent in debt investments. From a borrower’s perspective, mezzanine debt lowers the weighted average cost of capital and maximizes the potential equity return. It also can minimize joint-venture equity dilution and enable a sponsor to spread finite capital across a larger portfolio of assets.
As the current commercial real estate loan cycle enters a maturing phase — with slower rental-rate growth and moderate appreciation of assets — fixed-income investments, or assets with fixed-income attributes, will become increasingly attractive. Commercial mortgage brokers should be aware that mezzanine loans secured by quality commercial assets and featuring market-standard creditor rights can offer a superior risk-adjusted investment return, and that can be a big assist in closing more deals for clients.