The Op-Ed Page: The New Terms of Mezzanine Lending
Tom Acitelli Oct. 28, 2009, 3:56 p.m.
Contrary to expectations, mezzanine (or “mezz”) financing remains readily available in today’s market, albeit on dramatically different terms than would have been available 18 months ago.
In the bull market from 2003 to 2007, aggressive senior loan underwriting and mezzanine financing combined to replace the majority of the equity that had previously always been required in real estate transactions. During a sustained period of rising values, default rates on mezzanine loans were not substantially different from default rates on senior mortgage: Both were virtually zero. Mezz lenders received high yields without facing the normal proportionate losses that should be expected in high-leverage, high-risk transactions.
Over time, the perception of risk dimmed and the spread required on mezz loans dropped dramatically, while the risk level rose as a result of mezz loans reaching higher into the capital stack. As month after month and year after year of minimal defaults piled on, mezz loans began to look safer and safer, and a longer and longer track record of success could be touted. As a result, the supply of mezzanine money grew from an increasing number of sources, including some traditionally more conservative players: Insurance companies created mezz departments; pension funds invested heavily in mezz funds.
Unfortunately, it now appears that many of the mezzanine loans made at the height of the cycle will experience some significant loss. These were loans made in an environment when the hazardous combination of all-time-high valuations and all-time-high leverage levels was combined with an expectation of relative safety and security. These were loans with a very low margin of error, and many of the companies that made them have either exited the market or exited existence. The result has been a dramatic change in the players in the mezzanine market; the underwriting standards they will lend based on; and the yields they require. However, the concept of mezzanine loans as a useful investment tool for both investors and borrowers has remained intact.
Whereas mezzanine loans grew to be considered a reasonably safe investment vehicle for even relatively low-risk players, it is once again now considered the haven of high-risk money, demanding a significantly higher return than safer and lower-leverage first-mortgage loans. However, risk takers abound in the market, and so there is no shortage of investors willing to utilize mezzanine loan structures as a vehicle to enter deals at their chosen risk and return profiles.
Major investors of many types have created pockets of capital available to be structured in whatever manner is necessary to make deals work going forward. The great level of frustration felt in the market over the short supply of attractive purchase opportunities has forced potential buyers to be extraordinarily creative in seeking ways to get into those few deals where it appears they can invest at levels where they have a strong expectation of significant profits.
The potential mezzanine players in today’s market are a diverse group. Some of the major investment banks and their offshoots have high-risk money that can be structured as mezzanine debt, as do foreign investment vehicles. We have even been approached by a few supposedly stodgy insurance companies and other institutions that are in reality quite sophisticated and that will now consider making mezzanine loan investments on select assets.
These groups kept themselves out of trouble over the past few years by maintaining their traditionally conservative underwriting standards and proportionately low loan-size thresholds, and so the problems they did encounter have been manageable. Now they find themselves with significant capital to deploy, and they expect to see opportunities going forward to achieve mezzanine-type returns at leverage levels at which others were recently willing to lend in exchange for low first-mortgage returns.
It is no exaggeration to say that the future of mezzanine loans as a tool available to real estate players is very much dependent on what transpires in the coming quarters, as some increased level of defaults and foreclosures inevitably occur. The greatest risk to the survival of the mezzanine market is a comprehensive prohibition on mezz by the first-mortgage lending community. Barring that, however, mezz financing will be an active part of the landscape going forward.
Scott A. Singer is principal of the Singer & Bassuk Organization and a member of REBNY’s Commercial Division Board of Directors.