Mezzanine Debt Still Attractive

For many real estate investors, mezzanine debt has become a mainstay in the capital stack in recent years and rising interest rates haven't done much to diminish its allure. Rather, investors are responding to the changing environment by using fixed-rate mezzanine debt or by capping their floating-rate obligations.

"Demand for mezzanine debt today is stronger than it was even 12 months ago," says Jim Knutson, a senior vice president and director in Northmarq Capital's Minneapolis office. "Investors have seen the benefit of leverage." And, he notes, even in the current rate environment, mezzanine debt is still less expensive than equity, for which investors expect annual returns in excess of 20%.

Indeed, mezzanine debt is a critical factor in making the math work in many deals. "This type of debt has become so significant in increasing short-term yield and overall returns that borrowers can't do without it," explains Charles Schreiber, CEO of KBS Realty Advisors.

But what has changed—for all types of borrowing—is a flattened yield curve between LIBOR and 10-year Treasury rates, making floating rate loans as costly as long-term loans. Today, the one-month LIBOR rate is just under 5% and the 10-year Treasury at just over 5%. "The flatness of the yield curve doesn't really pay for you to use floating rate debt," says John Cannon, executive vice president at CapMark Finance Inc.

Retire floating debt with fixed

Borrowers used to flock to floating rate mezz debt because it was far less expensive than fixed-rate mezzanine debt. That's not the case today; floating rate mezzanine debt has risen along with LIBOR over the past several months. In June, the coupon on a floating-rate mezzanine loan was about 200 bps more than the coupon on a fixed-rate mezzanine loan.

Even so, there is little sign yet of a flight from floating rate loans, Cannon says. "It's still a prudent strategy for investors." In particular, investors pursuing redevelopment opportunities still prefer floating-rate mezzanine debt, as do borrowers that don't plan to hold their assets for long periods.

On the other hand, he advises: "If you have the opportunity to replace the mezz with long-term debt, you should grab it." Borrowers should try to revamp their existing capital stack by refinancing and taking out the mezz piece with a senior note or by replacing the floating rate mezz debt with fixed rate debt, says Cannon.

"With the flat yield curve, it's very cost-effective to lock in that rate for the future," says Dave Rosenberg, managing director of the capital markets group for New York-based Meridian Capital Group.

However, replacing a floating rate mezzanine loan with a fixed-rate mezzanine loan or fixed-rate senior debt can be expensive, experts warn. Borrowers who pursue this financing option go through the loan process yet again, providing new sets of loan documents and incurring new appraisal, title and legal fees.

Capping the rate

Still, many developers and investors won’t have the option of converting their mezz layers to fixed-rate financing, says Raphael Bostic, director at the University of Southern California Lusk Center for Real Estate. It all comes down to the hold period, he points out, since many investors haven’t owned their properties long enough for them to appreciate, preventing any opportunity to refinance at an increased valuation. Moreover, most owners feel that going through another loan process would be too lengthy and costly.

What those borrowers can do, says Lucas Donahue, a loan officer with Johnson Capital in Phoenix, is purchase caps or collars for their adjustable loans. Caps protect borrowers against rate increases throughout the term of the loan and can be purchased as separate trades from a variety of sources including local banks, investment banks and specialty mortgage companies. Collars lock in a range on a floating-rate loan, specifying a maximum (cap) and a minimum (floor) rate. A collar offers the protection of a cap, and helps investors minimize the cost by setting a minimum that your interest rate will not fall below.

Experts estimate that about 90% of mezzanine debt has an interest rate cap. "It's fairly cheap insurance," Cannon notes.

How cheap? The cost of capping a floating-rate loan is much less expensive today than it was 12 months ago. For example, a two-year cap for LIBOR at 100 bps with a strike (or cap) at 6.1763% costs about 20 bps. That same cap 12 months ago, at 4.2163%, cost at least 50 bps.

"If I could comfortably build in 100 bps increase into my projections and if the loan is outstanding for 12 to 36 months, it might be worth the cost to put on a cap," says Barry Branch, principal of the Branch-Shelton Company LLC, an Atlanta-based investment banking firm. "But, I would not be rushing to put on a cap as long as my project could handle two to three more rate increases."

Indeed, the downside to an interest rate cap is that borrowers must make a bet on how much higher the LIBOR rate will rise and what the average interest rate would be over the life of the mezzanine loan. "It's really a question of your pain threshold and how sensitive your income stream is," Knutson says. "If the term of the floating rate debt is six to 18 months, you can make a calculated decision of how much short-term rates will move and figure out if you can handle the increases."

What investors should not do, the advisors agree, is swap mezzanine for equity to avoid the risk of floating rates. "I wouldn't replace dollar for dollar mezz with equity, because the equity piece costs more," says Rex Paine, co-founder of Torreón Capital LP, an Austin, Texas-based firm that provides joint venture equity and mezzanine debt.

Mezz allows creativity

Even with rising interest rates, there are still reasons to use floating rate mezzanine. "Some people think floating rate mezz debt will be 13% and will burden the property," says Hank Halas, Huntington Capital Markets, a Columbus, Ohio-based fund manager that provides both fixed and floating mezz debt. "Mezzanine doesn't have to be that way." In fact, even with today's increased interest rates, most floating rate deals would have a coupon of about 9%.

Moreover, floating-rate mezz debt will continue to provide the flexibility that borrowers need, particularly in financing value-added opportunities where lenders are unwilling to provide fixed rate mezz debt. Floating-rate mezz also allows the loan to be paid with no pre-payment penalties.

"One can be very creative in the structuring of mezzanine," Halas notes, adding that Huntington Capital Markets has put together mezz deals that boast an 8% to 9% fixed rate on the front end so the borrower is exposed to limited interest rate risk. Huntington makes its money on the back end when the property is sold or refinanced. Halas explains: "Mezzanine debt can be structured so it helps the property and the borrower."

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