Tranche Warfare

100church 2 Tranche WarfareIt was a foreclosure auction that lasted a lightening-quick 10 minutes, but to many real estate experts who watched the proceedings, the acquisition of Boston’s John Hancock Tower represented everyone’s worst fear.

As it turned out, New Jersey–based Normandy Real Estate Partners had been quietly buying up debt on New England’s tallest building since last June, shortly after its owner Broadway Partners—only two years ago one of New York and the nation’s busiest tower buyers—defaulted on loan payments.

What real estate developers and senior lenders noted, however, was that for the first time in recent memory, a mezzanine debt holder had successfully pulled the rug from under a delinquent owner, on a grand scale.

“Without question,” said FirstService Williams executive chairman Robert Freedman, who was not involved in the deal but observed the repercussions of the auction, held in Manhattan in March. “Depending on how much the asset value eroded, and which tranche was impaired, what this deal really did was usher in the era of tranche warfare. It’s a harbinger of things to come.”

Now, with mezzanine lending ground to a halt entirely in New York, debt holders, senior and junior, are gearing up for tranche warfare and, perhaps, bitter court battles in a bid to untangle the complicated financial web that has resulted due to the wave of troubled loans that are about to hit maturities.

An estimated $100 billion in mezzanine loans are currently outstanding across the country, according to Jones Lang LaSalle. It’s a relatively small percentage of the $3.5 trillion in outstanding commercial mortgages nationwide, but industry experts say that could all change in the next few years or even next quarter.

“The default rate has been relatively modest,” Mr. Freedman said. “It’s only in the next cycle that we’re going to be able to determine how the mezz debt players have actually fared in the market.”


TO BE SURE, SOME of the biggest pre-recession developers, who scooped up property at the height of the market back in 2006 and 2007, are still entangled in loan repayments and other difficult default challenges. Chief among those battered developers was Harry Macklowe, who took out a $275 million mezzanine loan from Vornado Realty Trust in 2003 to buy the iconic GM Building on Fifth Avenue from Conseco, which he did for a record-shattering $1.4 billion, the highest price ever paid at the time for an office building in the United States.

Although Mr. Macklowe successfully paid off the loan in 2005, another property buying spree two years later—just months before the market began to tank—required a pricey $1.2 billion mezzanine loan from Fortress. The need to repay the hefty loan is what ultimately forced Mr. Macklowe to put the GM Building and several other high-end properties up for sale.

Mr. Macklowe—who still earns a profit on management fees at many of the buildings—paid down the Fortress deal late last year, analysts said.

More recently, New York’s biggest office landlord, SL Green Realty, successfully took over leasing and management responsibilities at 100 Church Street in August after the Sapir Organization failed to cough up $85 million in loans to the REIT and to Gramercy Capital. In a suit that has been closed, Sapir had alleged that SL Green had knowingly hindered its ability to finalize leasing deals.

“The mezzanine lenders are looking more like equity investors, and they’re finding themselves in the position of having to defend their security interests,” said Douglas Hercher, executive vice president and principal of Cushman & Wakefield. “They’re not wondering whether they’re going to get fully paid back; they’re wondering if they’re going to get paid back at all.”

Many of the investment funds and real estate investment trusts that have acted as junior lenders in the past did not return calls for this article, an indication, said industry experts, that they either did not want to reveal their “loan to own” strategies or were simply weary of being cast as a villain.

Unsurprisingly, New York developers hit hardest by recent defaults, like Mr. Macklowe, did not return calls either.

“The anecdotes that go with these are painful for a lot of people, so you’re going to have a hard time finding participants in the market that want to talk,” said William Shanahan, a vice chairman at CB Richard Ellis. “It’s sort of like watching someone die.”

LePatner & Associates founding partner Barry LePatner, meanwhile, said mezzanine lending had all but dried up in the city, primarily because developers are now being required to put up as much as 50 percent equity in order to qualify for construction loans—a costly sum that becomes even more expensive when construction cost overruns are accounted for.

Mr. LePatner and other real estate executives added, however, that mezzanine lending would return, especially in growth sectors like education and the real estate–intensive health care industry, which is expected to satiate a need for more real estate as baby boomers age.

Real estate experts predicted that office investment funds like Beacon Partners, Shorenstein Properties and Tishman Speyer would all surface as mezzanine debt holders, while others, like the Blackstone Group, AREA Property Partners, Starwood Capital and Colony Capital, would continue to provide similar junior loans.

“If I’m a mezzanine lender, I’m thinking about what I’m going to do when I want to lend, or what’s the best way to maximize my investment but minimize my risk,” said Mr. LePatner. “You exist to lend money, so you go to the sectors of the economy where you can get the best returns on investment. You exist to lend.”

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