Advancing into the seventh year of an extended and bumpy economic recovery, amidst global uncertainty on the direction and pace of growth, questions naturally arise about the relative attractiveness of alternative real estate investment strategies.
This white paper takes a fresh look at the case for mezzanine debt in the context of today’s real estate and capital market conditions.
Mezzanine lending has received critical scrutiny from institutional investors and asset consultants. Some of their apprehension is rooted in memory of the poor performance of certain mezzanine loans and commingled debt funds that were originated at the peak of the last cycle (2005–2008) and suffered losses during the Global Financial Crisis (“GFC”). While today’s mezzanine loans are far more stable and secure than those made a decade ago, the prospect of a return to aggressive underwriting and poor structuring clouds the market.
More focused concerns, however, arise through assessments of conditions in property fundamentals, and include statements such as “the window for mezzanine lending has closed” or “it’s the wrong time in the cycle.” There are questions about increasing capital flows that are possibly undisciplined and the ability of the market to prudently absorb this capital. Some observers sense that as yields compress and returns are dampened, comparable risk-adjusted returns are more abundantly available in equity alternatives.
This report aims to help clarify these issues and to define realistic risk and return expectations for mezzanine investors. The opportunity set for mezzanine debt, meaning the demand for mezzanine from borrowers and the supply of capital to meet that need, is examined. Returns achievable today are evaluated, and the risks to successful execution of a mezzanine investment program are identified.
Recap: what is real estate mezzanine debt?
Real estate developers and owners have always used a combination of debt and equity to finance their projects and acquisitions. Mezzanine debt fills a gap in the financial structure between the senior loan and common equity. It is subordinate to a first mortgage but takes priority over the property owner’s equity. Mezzanine debt generates returns that are higher than a senior mortgage but generally lower than the total return that accrues to an equity position.
For the borrower (referred to also as “sponsor”), a mezzanine loan is a means of limiting equity dilution, maintaining control of an asset and capturing all of its upside appreciation. While more expensive than senior debt, it is generally less expensive than equity. For existing stabilized properties, a mezzanine loan may also provide a way to unlock value that has been created over a development or holding period.
Focus in this report is on mezzanine financings that take the form of debt. There is a clear creditor/debtor relationship in these transactions. A mezzanine loan, however, is different from a mortgage in that the debt is not secured by a lien on the property but rather by an assignment of the borrower’s interest in the entity that owns the property. The real estate itself is already pledged to the senior lender. In practical terms, this means that the mezzanine lender will receive its principal and interest in advance of the borrower’s receipt of cash flow or sale/refinance proceeds. Because the borrower usually pledges all of their equity as collateral, the mezzanine investor is in a structurally superior position to the equity holders.1 This structure usually accelerates the investor’s ability to enforce their rights and remedies to get control of the asset in a foreclosure situation, although it should be noted that in order to gain control, the investor will need to cure the senior loan default.
As an intermediate position, mezzanine investment is best described as “a range of risks rather than a vehicle or structure.”2 It is sometimes described as a hybrid investment, with features of both debt and equity. Mezzanine loans are typically highly negotiated and custom tailored to fit the specifics of a transaction. Factors influencing the position in the capital structure, pricing, and risk profile of mezzanine loans include the quality of the project, local market conditions, and stability of cash flow as well as the borrower’s objectives, the size of the loan, and its duration. Mezzanine debt is originated to finance property development, redevelopment, and repositioning. It is also used to refinance and restructure existing capitalizations.
The type or style of mezzanine lending described in this paper is privately originated and usually for smaller projects where the mezzanine portion of the structure is significant enough that the lender can effectively exercise rights and remedies in the case of default. These loans are generally of short duration, two to three years with extension options.
The market for mezzanine capital, therefore, is both broad and fluid. As Exhibit 1 suggests, it is broad in terms of the available range of risk/return objectives and strategies and dynamic in terms of the range of real estate activities it finances at different points in the underlying real estate cycle. Although there have been efforts to quantify the size and composition of the private mezzanine debt market, they have been highly speculative and are now outdated.3
Unlike senior lending, mezzanine transactions are not defined by a set of standardized terms, nor are data on mezzanine transactions collected and made available by a recognized body. Some of the misunderstandings and confusion about this market are a result of the lack of standardization and transparency as well as the broad definition of what comprises a mezzanine position.
Consequently, and significantly for institutional investors, there is no benchmark for mezzanine debt performance. While efforts are underway to create one,4 the results will not be available in the near term. The absence of a standard for gauging investment performance makes it difficult to objectively compare the relative risk/reward profile of mezzanine debt with investment alternatives and even with different strategies within the mezzanine space itself.
Exhibit 1: Mezzanine Investment
The next section of the report outlines the conditions in today’s real estate and capital markets that provide opportunities for mezzanine debt investors.
Today’s mezzanine debt opportunities
There are clear indicators of expanding new opportunities to execute mezzanine debt strategies at this point in the US business and economic cycles: disciplined lending, strong demand from borrowers and an adequate supply of commercial real estate debt.
While the recovery in US economic activity following the GFC has been uneven, and frustratingly slow, the pace of expansion appears to be accelerating and is on firm footing. Real estate fundamentals have improved at a rate even slightly faster than the overall economy. Part of the improvement derives from a healthy balance of moderate increases in demand matched by disciplined supply, and part of the improvement has been driven by supportive capital markets, including low interest rates, investor search for yield, and robust global capital flows into the country. These trends provide a positive environment for mezzanine lending.
Disciplined lending environment
The US financial markets are broadly supportive of real estate lending. Unlike the period leading up to the GFC, when key underwriting standards were abandoned by many lenders, the real estate debt markets today remain disciplined. The senior debt providers — primarily life insurance companies and banks — have increased their activity and the CMBS market, a source of securitized debt, has also begun to ramp up.
￼￼￼Exhibit 2: Disciplined Lending Environment
Significantly, today’s senior loan underwriting provides a firm foundation for the mezzanine lender. As shown in Exhibit 2, the most important indicators of risk management, the loan to value ratio (LTV) and the debt service coverage ratio (“DSCR”), are both well within historic ranges and are trending in a positive direction.
Prudent mezzanine lending depends in part on the risk profile of the senior loan. As the first mortgage reaches higher and higher levels of loan to value, the mezzanine space between the senior position and the borrower’s equity may be squeezed and pushed up the risk curve. With average senior debt in the low 60% LTV range, as shown in Exhibit 2, today’s mezzanine debt provider has the flexibility to implement an appropriate risk/reward strategy.
Demand for mezzanine debt
In this generally positive environment, the demand for mezzanine debt is expected to be strong. There are three inter-related factors embedded in US real estate and capital market conditions that should support this demand:
- A pickup in new construction;
- Expanding transaction activity; and
- Increased senior loan origination.
Significantly, these demand generators span the risk/reward continuum from providing new debt for acquisition or refinancing of existing stabilized properties, to loans for transitional redevelopment/repositioning of assets (value-added strategies), to speculative ground-up construction projects. This means that there will be expanded opportunities for a range of mezzanine investment objectives. Missing from this opportunity set are “opportunistic” lending strategies that depend on dramatic market changes or severe capital market disruption for deal generation.
￼￼￼Exhibit 3: Completions as a Percent of Stock
As displayed in Exhibit 3, commercial construction has begun to expand following the dramatic downturn after the peak in 2008/2009. New development is a primary component of the mezzanine debt market and includes speculative building as well as build-to-suit projects. The mezzanine position in a development transaction is particularly attractive to borrowers because it closes the gap between a senior loan and their equity but does not dilute their upside profit potential or impinge on their control of the asset. Financing ground-up development entails more risk, and therefore demands stringent underwriting discipline as well as a thorough grounding in real estate markets.
Transaction activity, meaning buying and selling standing property, is also an indicator of an opportunity for mezzanine lenders as purchasers refinance existing debt or add new leverage. As shown in Exhibit 4, sales totaled over $400 billion in 2014. While year-on-year increases in the velocity of the magnitude seen in recent years may not materialize going forward, it is anticipated that capital flows will continue, if at more modest rates. Transaction volumes are heavily weighted to gateway cities and large acquisition deals, transactions that may not be candidates for traditional mezzanine debt. But as investors turn increasingly to secondary and tertiary markets, and to smaller assets, there should be more room for the mezzanine lender.
Exhibit 4: US Investment Activity
Mezzanine transactions are sourced from the senior debt lender, generally a life insurance company or a bank, as well as directly from the borrower, and occasionally from a mortgage broker. Therefore, the volume and velocity of commercial mortgage lending is a useful barometer of the likely demand for mezzanine structures. Debt originations have increased steadily from the GFC trough in 2009, as depicted in Exhibit 5, and were up 7% in 2014 over the prior year. CMBS lending, which tanked in the downturn, also picked up in 2014.
Exhibit 5: Debt Origination
As traditional mortgage origination has expanded, underwriting has remained disciplined. Loan-to-value ratios and debt-service-coverage ratios, standard measures of risk, are in healthy territory generally in the 60%–75% range for LTV and DSCR of 1.3 and higher. Senior debt positions in the capital stack within these ranges create a financing gap that can sensibly be filled by mezzanine debt.
Together these three growth trends: new construction volume, transaction activity, and senior debt origination all point to expanding demand for mezzanine loans and, therefore, opportunity for mezzanine investors. While this demand is not quantifiable per se, as we don’t know the share of total capitalization that could be captured by the mezzanine loan, it is likely to be larger than in the recent past.
Exhibit 6: Debt Maturities
Debt maturities also offer insight into the demand for mezzanine debt. Exhibit 6 depicts the loan maturity schedule for the period 2000 through 2022. It encompasses the outstanding loans of all the major lending groups. The data show that debt maturities peaked in 2013 for all loan sources other than CMBS. They will remain relatively stable at high levels into 2017.
Some of these loans are on fundamentally solid assets with good borrowers, but with balances that are above the LTVs likely to be provided by today’s senior lenders. Although not all maturing loans will be refinanced or include a mezzanine slice in a re-capitalization, it is anticipated that this opportunity will further add to the overall demand for mezzanine debt. Borrowers that are seeking to lock in today’s low interest rates drove refinancing in 2014, and likely in 2015.
It should be noted, however, that the regulatory environment for commercial property debt is also evolving. In particular, the role of commercial banks may change in the future depending upon the interpretation and implementation of Basel III, the global banking risk regime.
Supply of mezzanine debt
Although there are positive indicators for continued strong demand for mezzanine financing, the supply side of the equation is less clear. This is important because anecdotal evidence (which gains circulation and credence in the absence of hard data on mezzanine debt) suggest that more organizations are seeking to enter the market and competition for transactions is increasing. If accurate, the consequence could be aggressive underwriting and downward pressure on yields and returns to the mezzanine position.
Capital raising for debt investment has increased significantly over the past five years. Figures supplied by Preqin, a research firm focused on the alternative asset industry, indicate that capital raised globally by debt funds increased from $5.6B in 2012 to $10.7B in 2013 to about $20B in 2014. Nearly half ($9B) was raised by US funds last year.
The Preqin data in Exhibit 7 show that debt investment has earned a secure and significant place in the worldwide real estate investment hierarchy. In addition, the CMBS market in the US is also reviving, with J.P. Morgan estimating issuance of $105B in 2015. What is not known is what proportion of this capital will end up in a mezzanine position. Most of the funds have a wide angle view of debt and include an array of strategies ranging from whole loans to preferred equity positions (sometimes labelled “equity disguised as debt”).
Exhibit 7: Private Equity Real Estate Funds
Competition for mezzanine debt investors can also arise from an entirely different direction: joint venture equity funds. As development and redevelopment become more feasible, developers may elect to take on a venture partner rather than a mezzanine loan. In recent years many borrowers found that averaging the expense of a mezzanine loan into their weighted cost of capital was more advantageous than bringing in an equity partner who could erode their control and eat into their upside return. In the current market, some developers are opting for the equity partnership when the timing of their projects is uncertain. A mezzanine loan has a set maturity (although extension options are typically provided) that may not be flexible enough for larger, more complicated and less time-sensitive development programs.
Together these supply side issues are not to be ignored. To date, deal flow for mezzanine investors has not been impaired as the demand factors in the market far outweigh the impact of new debt supply. Although yields and returns have compressed worldwide in the face of capital flows, the relative attractiveness of the mezzanine position has not been compromised. Because private mezzanine transactions are so heavily negotiated and tailored to the specific sponsor situation, lenders with demonstrated real estate experience, strong relationships (with senior debt providers as well as borrowers), and certainty of execution will remain competitive.
Expected returns in today’s market
Today’s capital market conditions remain supportive of mezzanine lending. Returns to investors are considered to be attractive both in absolute terms (current cash yield and IRR) and on a risk adjusted basis.
Exhibit 8: Property Valuation Trends
Mezzanine debt was heavily over-sold and over-promised in the period running up to the GFC. At that time it was commonly held that mezzanine loans could provide “equity returns with debt risk.” When capital dried up and valuations plummeted (Exhibit 8), investors paid the price. In the years immediately following the trough (2009–2012), a smaller number of more experienced (and chastened) mezzanine lenders returned to the market and successfully took advantage of the juxtaposition of capital market illiquidity and improving real estate fundamentals to achieve favorable returns.
What can realistically be achieved in the current marketplace?
As noted above, the mezzanine debt market is both broad and fluid. Therefore, it offers a range of risk/reward opportunities over the course of the real estate cycle. As an intermediate position between senior debt and equity (common and preferred) the pricing and performance of the mezzanine piece reflects the ebb and flow of pricing and performance in those two investment sectors.
The expected return for mezzanine debt in a fixed income context is illustrated in Exhibit 9. Senior loans should provide a gross IRR between 4% and 5%, exclusively from current income. Further along the risk spectrum, low and moderate risk mezzanine debt of similar term but slightly higher LTV, achieves a 9%–12% return. Higher-risk mezzanine investment, shorter-term with still higher LTV, targets an IRR of 12%–15%. Return to the mezzanine loans is a combination of current and accrued income.
Exhibit 9: Mezzanine Investment: Range of Returns
The duration of mezzanine loans is short, averaging three to five years in today’s environment. Maturity can often be extended for fixed periods in the case of adverse project or market conditions. As with the coupon, the maturity is a contractual obligation. For investors uncertain about the direction of interest rates or valuations, the short exposure provided by mezzanine debt can be an attractive alternative to longer term senior loans or less well defined preferred equity. In effect, the mezzanine investment serves as a hedge against uncertainty.
The coupon for mezzanine loans in the current environment averages 6.5%–7.5%. This is a contractual obligation. In blended terms across the risk spectrum, the current return to investors comprises about half of the total return. The predictable, stable component of return makes the risk-adjusted performance of mezzanine loans even more compelling.
There is also a risk/return dimension that derives from the real estate itself: the assets that collateralize the mezzanine debt. It is important that the return expectation for the loan is realistically aligned with the inherent cash flow capacity and appreciation potential of the property. In vocabulary that is familiar to direct real estate investors, the assets can be categorized as stable, transitional, and development. The term transitional is coincident with the value-added category in the private equity sphere.
Mezzanine debt on stable assets, standing properties with high occupancy and stable rent rolls, is currently in an IRR range of 9%–11% with a target multiple of 1.3–1.4x. Loans for these core properties have an LTV in the range of 65%–85% and have a longer duration than the higher return categories. Transitional assets command a similar multiple with a higher gross return of 12%–14%. These are properties that are undergoing a repositioning, re-leasing, or moderate capital improvement program. Development opportunities, as shown in Exhibit 10, edge closer to riskier equity returns with target IRRs of 14%–16%.5
As might be anticipated, competition amongst lenders is most concentrated for stable assets. They are the most straightforward to underwrite and their predictable cash flow allows for high ratios of debt service coverage with the lowest LTVs. There are fewer mezzanine lenders focused on transitional investments and fewer still on development property. In part this is because strong real estate skills are required to prudently assess the risks of these transactions and the borrower’s ability to successfully bring them to fruition in a timely manner.
Exhibit 10: Mezzanine Debt Returns
Mezzanine investment in development assets requires an “active” lender, one that has the real estate operational experience and the financial strength to step into an ownership role in the case of borrower default. Many fixed income investors and capital allocators do not have this professional capability and capital capacity. Simply put, in order to protect an investment in the case of foreclosure, the mezzanine lender will need to cure the senior position, and possibly pay off the senior note, which requires capital.
In today’s environment, expected returns (gross IRR) for direct property investment are in the 6%–8% range for core assets. Core properties are similar to the stable assets within the debt framework. Value-added private equity (roughly analogous to the transitional category) commands expected returns in the mid-teens, 13%–16%. However, these assets may be levered as much as 60% to achieve those results. Mezzanine debt absolute return expectations compare favorably with those available in the direct property investment market.
Risks and risk mitigation
Returns to the mezzanine investor are competitive and remain attractive in today’s capital market environment. What about risk?
Mezzanine debt investors face many of the same risks as direct real estate investors and some that pertain to the structure and positioning of the mezzanine piece of the capital structure. They include such fundamentals as local market supply/demand, project costs, borrower strength, value changes, magnitude and timing of cash flows, and exit timing.
There are, however, a number of issues in the marketplace today that warrant special attention:
Rising interest rates
Many mezzanine loans are written on a floating rate basis, which offers protection to the lender. For the borrower, higher rates impact current cash flow (the senior lender is paid first) and yields (equity yield equals cash flow less debt service). More broadly, rising rates may reduce liquidity in the market, negatively influence exit timing and loan payoff, and diminish valuations via higher cap rates. Rising rates may be less harmful if they accompany stronger economic activity that in turn leads to improved leasing velocity and rental rates.
Exhibit 11: Operational Volatility
The mezzanine loan offers some protection against declines in operating cash flow. The example shown in Exhibit 11 illustrates the hypothetical impact of changes in a project’s cash flow (“NOI”) on the sponsor and on the mezzanine lender holding a 7% coupon loan. As property NOI declines the lender still gets paid. In this particular case, the 7% current cash payment will remain intact until the property cash flow has declined 25%.
Decline in valuation
Asset re-pricing can occur when interest rates rise, when there is volatility in cap rates, or when liquidity dries up. The mezzanine position offers some protection against financial and capital market volatility. The mezzanine lender trades uncapped equity upside for a contractual return on cash flow. Therefore, in the event of substantial real estate devaluation, the mezzanine structure continues to provide attractive risk adjusted returns.
In the example, as values turn negative the mezzanine IRR continues to exceed that of an equity ownership position, in this example an equity joint venture. As a rule of thumb, the mezzanine position is typically not completely impaired until the valuation decline approaches the sponsor’s proportional equity position.
￼Exhibit 12: IRR vs Valuation Change
Default and foreclosure
No amount of risk mitigation offers complete insulation from market shocks and poor project performance. Mezzanine investment is structured through an assignment of interest in the borrowing entity rather than in the property itself via a deed of trust. Therefore, in a default situation, the lender typically can gain control of a property much more quickly than in a bankruptcy situation. The relationships governing these rights and remedies are defined in carefully negotiated inter-creditor agreements.
However, in most situations, taking control of the project requires that the senior loan first be paid off. This means that the mezzanine investor needs access to the money to take out the mortgage holder. In well-capitalized mezzanine structures today, the mezzanine lender will be careful to take a position that accounts for 10%–30% of the total cost of the property. A smaller share in the capital stack, called a “sliver,” will not provide the investor with the capability needed to take out the senior lender.
Commingled mezzanine debt funds that have completed their investment period commitments, and do not have additional capital call arrangements, may face similar difficulties should they want to cure and protect their positions.
Mezzanine debt investment is not a perfect solution to every real estate capitalization. In today’s real estate and capital market environment, however, there is significant demand for this type of structure for refinancing maturing loans and providing new ones for acquisition, repositioning, and development. Senior debt, which provides the foundation for the mezzanine risk/reward profile, is disciplined and underwriting is cautious. The supply of capital for these opportunities is increasing as investors seek yield, but it remains limited and controlled. Returns, especially as adjusted for downside protection, are competitive with mainstream private equity and debt alternatives. Risks to the mezzanine position appear manageable at this phase of the real estate cycle. Does mezzanine debt make sense today? Yes, it does.
1. Andrew Berman, “Mezzanine Debt and Preferred Equity in Real Estate,” Chapter 9, Kent Baker (ed) Alternative Investments: Instruments, Performance, Benchmarks, and Strategies, John Wiley, 2013.
2. Jennifer Petch, “Somewhere Between Debt and Equity,” The Institutional Real Estate Letter, March 1997.
3. Yougo Liang, “Mezzanine Finance: Completing the Market,” Prudential Real Estate Investors, PREI Report, May 2001; and David Watkins, et al., “Real Estate Mezzanine Finance: Market Opportunities,” Real Estate Issues, Summer 2003.
4. The Gilliberto/Levy Index of senior debt is being extended to cover mezzanine debt.
5. The target gross IRR range of 9%–16% represents a net IRR range of 7.75%–13.71% and a fee load range of 1.25%–2.29%.
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