The Op-Ed Page: The New Terms of Mezzanine Lending
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.