Mezzanine lenders may be reveling in robust demand for higher leverage from borrowers. But at the same time, they are fighting for deals amid an increasingly crowded field of competitors.
Lenders and investors across the board, from life insurance companies to private equity funds, are drawn to mezzanine lending for the higher yields that the sector typically delivers. In addition to traditional competitors, there has been a significant increase in new competition from private equity funds that have a cyclical high amount of capital to put to work, says Steven Schwartz, a partner heading the acquisitions group at Torchlight Investors, an investment management firm based in New York City.
In fact, private equity real estate debt funds are coming off a huge year of fundraising success in 2014. According to London-based research firm Preqin, nine U.S.-focused closed-end private real estate debt funds with a mezzanine financing component closed last year with an aggregate capital raise of $7.6 billion—nearly four times the $1.6 billion raised in 2013.
Mezzanine financing has been a successful investment program for Pearlmark Real Estate Partners, a private equity firm based in Chicago. The company started investing in mezzanine debt in 2000 and is currently raising capital for its fourth high-yield investment fund. Pearlmark Mezzanine Realty Partners IV has a target fund size of between $300 million and $500 million and expects to generate a net IRR of 10 to 12 percent for investors over a three- to five-year investment holding period.
“We always have competition, but it is very fragmented, and it can really vary on a deal by deal basis,” says Mark Witt, a managing director at Pearlmark in Chicago. Lenders tend to focus on different niches within the mezzanine financing sector. For example, the life insurance companies are generally looking at maximum loan-to-leverage ratios (LTVs) of 70 to 75 percent, while private equity firms such as Starwood and Blackstone focus largely on deals sized above $15 million, says Witt.
That being said, the increased appetite to participate in mezzanine lending is creating a fiercely competitive environment, especially in primary markets and top secondary markets where some lenders are stretching to make deals, notes Schwartz. The area where that competition tends to show up first is in lower pricing, diminished covenants and leverage that is creeping up to the point where it becomes unattractive to lend, he says.
Torchlight Investors, which expects to place about $500 million in mezzanine and bridge loans this year, typically avoids primary markets in favor of secondary and tertiary markets. “In those markets, it tends to be a little less crowded. You have a little more purchasing power to negotiate terms,” says Schwartz. The trade-off is that they are smaller markets, which makes it even more important to do the homework to make sure the demand drivers are there, he adds.
Competition is also putting pressure on pricing, albeit not to the same level that is occurring on the senior debt side. There has been a tightening of spreads, especially in gateway markets such as San Francisco, New York and Washington, D.C. where deals are ultra-competitive, says Witt. Even though pricing is a factor, mezzanine borrowers tend to be more focused on selecting a mezz lender that has a strong track record, including good experience working with a variety of senior lenders. What happens in the mezz space, even more so than on the senior debt side, is that borrowers really look at a lender’s ability to execute, he notes.
Despite concerns about competition and aggressive underwriting, there is healthy borrower demand for mezzanine loans. “Borrowers have been very active across property types, and transaction activity has been very strong overall,” says Schwartz.
“It has been very active, especially in the last two to three months as activity has picked up dramatically,” says Witt. “Just in the last two weeks we have closed three deals.”
Pearlmark expects to place about $150 million in capital in mezzanine loans this year and typically looks at deals between $4 million and $20 million across all property types, except for for-sale housing and condominiums.
Mezzanine activity has been bolstered by the high volume of CMBS loan maturities. Both 2006 and 2007 were record high years for CMBS issuance at $198.3 billion and $228.5 billion respectively, according to Commercial Mortgage Alert, an industry newsletter.
“A lot of those loans were done at LTVs that were higher than what you currently see in the market for senior loans. Therefore, borrowers that are trying to refinance might be coming up short as far as proceeds,” says Witt. Today’s LTVs for senior loans typically average around 60 to 65 percent compared to upwards of 85 percent during the peak of the last cycle. Some borrowers need to layer the mezzanine debt on top of the senior loan to achieve the higher leverage necessary for them to refinance. “So we are very optimistic over the next two to three years in terms of where production volumes are going to be,” he says.
Another good source of business for mezzanine lenders are value-add opportunities where a borrower is looking to execute on a business plan and needs additional capital. Mezzanine financing can be a cheaper source of capital compared to bringing in an equity partner and having to share in the upside of a deal.
There is a lot of demand coming from borrowers with value-add or transitional assets, says Schwartz. CMBS has also provided a nice boost both on new issuance and the refinancing opportunities that are beginning to hit the market. Although those loan maturities have not yet had a significant impact, Schwartz expects that demand to rise in 2016. “I think we will see more of it next year. I don’t think it is going to be quite the opportunity that everyone thinks in terms of magnitude, but it will be there,” he says.