In the boom years, mezzanine financing—debt that fills a gap between senior financing and equity—was a hot spot for some capital providers. The sector cooled considerably after the financial crisis set in. But 2012 may go down as the year mezzanine lenders came back in a big way due to a constellation of factors coming into line.
Most significantly, 2012 will be marked by an uptick in maturities of existing debt, creating a big demand for refinancing. And with senior lenders more conservative than they were before, mezzanine lenders will have an ability to fill the capital stack for qualified borrowers. Moreover, the continued increases in investment sales and, in some cases, development, are also places mezzanine debt can play a role. “Mezz lenders feel there will be good opportunities in 2012,” says Mitchell W. Kiffe, co-head of national production for the debt & equity finance group within CBRE Capital Markets. “There’s an avalanche of maturities coming due, and that’s why a lot of people in the space think the market is going to come to them.”
“Mezz lenders feel there will be good opportunities in 2012,” says Mitchell W. Kiffe, co-head of national production for the debt & equity finance group within CBRE Capital Markets. “There’s an avalanche of maturities coming due, and that’s why a lot of people in the space think the market is going to come to them.”
Development drives demand
Many lenders were similarly optimistic about 2011, which didn’t play out to be as bullish a year as they had hoped.
“It was our expectation that there would be more pressure on all parties because there were a lot of unhappy marriages between lenders and borrowers,” says Bruce Lowrey, managing director of RockBridge Capital LLC, an investment firm that focuses exclusively on hospitality properties. “They were able to stay together, but I think there will be more mezzanine volume as these marriages split.”
Mezzanine lenders that managed to deploy capital during 2011 focused primarily on development projects. Since the pool of construction lenders continues to be shallow and lenders are imposing low loan-to-cost ratios on qualified borrowers, developers are looking for mezzanine capital.
GTIS Partners, for example, placed about $200 million in mezzanine loans in 2011 by focusing on development deals in the homebuilding sector, according to Tom Shapiro, president and founder. Previously, the private equity firm focused on the four main commercial property food groups and hadn’t placed a mezz loan since 2007.
“Compared to what we have been doing on the mezz side, 2011 was very active for us, but I think that’s because we sought out development opportunities in sectors that other lenders ignore,” Shapiro says, adding that GTIS currently is working on closing a mezz loan for a vertical condo construction project. “We’d like to do $250 million worth of mezzanine loans in 2012.”
For development deals, mezzanine capital is used in lieu of a third-party equity partner, explains James Tramuto, an executive vice president in Jones Lang LaSalle’s capital markets group. “Development has always been a tough sell for equity, and there are only so many equity partners who have capital that is cheaper than mezz money,” he says.
In 2011, Tramuto placed mezzanine money with a variety of development deals including: a student housing project in Georgia; industrial build-to-suits in California and New York; and a suburban multifamily community in Texas. The mezz money filled the capital stack from 60 percent to more than 90 percent at rates ranging from 10 percent to the mid-teens—much lower than the yields required by equity partners.
Pricing disconnect continues
Pricing was one of the key reasons why mezzanine lending volume wasn’t as strong as many expected. Many borrowers who considered mezzanine money balked at the expense.
Even in cases where borrowers were refinancing, many opted to obtain additional financing from their primary lenders rather than work with mezzanine specialists. In fact the high price of mezzanine money was one of the biggest impediments to a robust mezzanine lending market in 2011.
“Borrowers didn’t want mezz money as much as lenders thought they would,” recalls Dan Gorczycki, managing director of Savills. “For acquisitions, there weren’t too many people who wanted a 15 percent mezz piece on them.”
“A lot of the mezz capital in the market was inappropriately priced,” adds Riaz Cassum, a senior managing director in HFF’s Boston office. “There was a big disconnect for most of the year, and there’s still somewhat of a disconnect.”
For most of 2011, mezzanine money was priced in the mid-teens to low 20 percent range. At the mid-year mark, pricing decreased slightly, but flattened at the end of summer as concerns about European debt and the U.S. economy caused a chill in the capital markets. At the end of 2011, the cheapest mezzanine money was priced at about 10 percent, while some mezz lenders were still pricing their money above 20 percent.
Many industry players contend that borrowers who pushed back on mezzanine pricing did so simply “for the principle of the thing” rather than true economics. Others simply prefer equity over subordinate debt.
Mezzanine capital, by its very nature, is considered expensive. But given the current interest rate on senior debt—in the 3 percent range—the overall cost of capital for a borrower using both senior debt and mezzanine money could still be relatively low, Cassum points out.
Consider this example: a private buyer is looking to acquire a suburban office building in a major market. The well-leased property will trade for a 6.5 percent cap rate. The buyer is able to obtain a senior loan for 50 percent LTV at 3.6 percent and mezzanine loan for 10.5 percent that will bring the deal to 60 percent leverage. The blended cost of capital ends up at about 4.8 percent—providing positive leverage for the borrower.
“The message that we’re sending to borrowers is that subordinate financing allows them to have positive leverage and avoid diluted ownership,” says George Perry, senior vice president and director of investments with Malkin Strategic Capital, a mezzanine lender and preferred equity investor.
But borrowers have very different views on subordinate financing versus equity financing. “Sometimes they feel more comfortable with equity partners because they don’t have a gun to their head with repayment, and they’re willing to give away some of the upside,” Perry says. “On the other hand, some sponsors are very comfortable with subordinate capital and are willing to pay for it.”
As long as the rate for 10-year Treasuries remains low and the supply of mezz money remains robust, borrowers should still be able to create an inexpensive capital stack, Perry says.
Avalanche of maturities
Most commercial property experts predict investment sales activity will increase in 2012, offering more opportunities for mezzanine lenders, but debt maturities are expected to offer the biggest opportunity for mezzanine lenders.
Although the capital markets have thawed, borrowers must deal with more stringent loan-to-value parameters. With most senior mortgage lenders unwilling to go above 70 percent, borrowers must either find additional equity or slot in mezzanine money.
Both 2005 and 2006 were big years for conduit lending, and most of those loans had seven to 10-year terms. In addition, five-year loans originated in 2007 will also be coming due. That means a large swath of CMBS loans will come mature in 2012.
Plus, while lenders were willing to “kick the can” and extend performing loans for two to three years, that won’t be the case in 2012. Mezz lenders are eagerly awaiting those borrowers coming to them to fill gaps in their capital stacks.
No shortage of mezz money
Borrowers seeking mezz money will have ample opportunities to find it, experts note. In fact, there’s more available now than in several years, but it’s impossible to quantify the exact volume.
However, today’s mezzanine lenders are somewhat different from those in the mid-2000s. Many mezzanine lenders that were active five years ago have been forced to focus on asset management and are trying to deal with their current portfolio of loans—many of which are in trouble.
As those lenders struggle with legacy issues, new mezzanine lenders have entered the market. Debt funds and mortgage REITs are among the new class of mezzanine lenders.
“Mortgage REITs were not that active five years ago, and there weren’t as many big debt funds out there doing bridge or mezz lending,” Cassum says.
Many private equity players—including The Blackstone Group and Fortress Investment Group—raised debt funds during the most recent credit crisis to take advantage of distressed borrowers and properties, says Cassum. But they’ve had challenges placing the money. “The debt funds that raised mezz money have strict return requirements and caps on how high they can go up in the capital stack,” says Tramuto.
At the same time, private equity players have been unable to find enough deals to deploy capital, and are seeking other opportunities. Tramuto says private equity funds started going head-to-head with debt funds and mortgage REITs during the last few months of 2011.
“Equity funds have a lot more flexibility and can be more creative,” Tramuto says, explaining that there are very few deals today that meet the risk parameters for equity investments. With pressure to deploy capital, equity funds have decided to do riskier deals but in a debt position rather than equity. And by taking a mezzanine position, they’re still getting the yields their funds require.
“It’s not the old days of having just a bucket of mezz lenders,” Gorczycki of Savills points out. “Capital providers are playing across the capital stack. They’re saying: ‘I want mid to high teen returns, and I’ll get them any way I can’.”
Sidebar: The Next Wave of Synthetic Loans
In an effort to attract borrowers and differentiate themselves, a handful of mezzanine lenders are acting as “one-stop shops” for borrowers by providing packaged loans, selling off the senior mortgage piece and creating so-called synthetic mezzanine tranches that allow them to meet their yield requirements.
Dubbed A/B transactions, these loans are gaining popularity because the structure circumvents any issues regarding intercreditor agreements and simplifies the process for borrowers.
“One of the big challenges with mezzanine lending is that senior lenders don’t really like subordinate debt, and deals become more complicated because of intercreditor agreements,” says Riaz Cassum, a senior managing director in HFF’s Boston office. “When a lender provides a single loan and then creates a synthetic mezz loan later on, the lender takes the execution risk and there’s no need for an intercreditor agreement.”
Cornerstone Real Estate Advisors is one mezzanine lender that has embraced A/B transactions. “We think it’s a fairly viable strategy,” says Rob Little, who heads up the firm’s debt business. “Overall, they’re cleaner transactions, and borrowers tend to like them. And they make us more competitive.”
— Jennifer Popovec