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On one hand, it has never been a better time to be a mezzanine lender. Take Pembrook Capital Management in New York City. Last year, the company fielded some 300 requests for mezz financing around the country. Managing director John Garth was able to pick and choose, settling on three of the best deals that came across his desk.
On the other hand, being a mezz lender these days has its complications. Garth is not the only provider in the market; over the past two years competition in this piece of the capital stack has increased dramatically.
In addition, it is getting harder to reap returns on traditional mezz lending, so providers are looking for less traditional structures and projects. For Pembrook, that means ground-up construction mezz finance, a new development both for this space and for Pembrook, but one that can deliver roughly a double-digit return. “This is one of the new directions in which mezz financing is headed,” Garth predicts.
Several years ago, few would have expected to see gap financing providers, a wide category that includes preferred equity, mezz financing and bridge loans, to reach very far to secure double-digit returns. Demand, it was predicted, would surge toward this capital as the expected tidal wave of overleveraged properties with debt coming due swamped the market.
That didn't happen, of course, or at least not to the extent that was predicted. Asset values rose enough to mitigate the gap exposure that existed with basic properties. Indeed, just last month the Green Street Commercial Property Price Index increased by 3%, officially marking property values' recovery to pre-recession levels.
Demand does exist for gap financing, of course—the recovery of the commercial real estate markets all but ensured that. That demand, however, is just not desperate, at least not in most cases. Hence capital providers must step up and be competitive to get the deals they want.
Nowadays, such financing structures as the one arranged for the Breakers Resort in Denver, are fairly commonplace. This spring, HFF secured $230 million in financing for the six-village, 1,523-unit community on behalf of the Bascom Group LLC. The funding consisted of a $165-million first mortgage, a $26.3-million mezzanine loan, and $38.8 million of preferred equity. The mezzanine loan and preferred equity were provided by Prudential Real Estate Investors' $805-million US Real Estate Debt Fund. Proceeds were used to refi the existing mortgage and mezzanine loans, buy-out the existing institutional equity partner and invest in future renovations.
This is not to say the crash and subsequent Great Recession have receded from memory. Their effects are still quite apparent in lending markets, with lower leverage ratios, as they say, now the new normal. Property owners are not seeking to lever up deals or balance sheets with mezz financing as they did in 2005—nor could they, at least in most cases.
Also, mezz lenders have learned to be leery of borrower and builder exuberance for projects, especially in asset classes that might be verging on oversupplied. “Construction mezz lending has a lot more risk on it and sometimes even the best developer can get into trouble,” Garth says.
A fine and prudent attitude, except that mezz and gap-finance providers are dealing with their own competitive issues. There is a lot of new entrants in this finance market, certainly more now than a year ago.
Also, senior lenders are becoming more aggressive and lending higher in the capital stack. “Three years ago they were at 60% loan-to-cost,” Garth says. “Now it is 65% to 75%. Also, I'm seeing the mezz piece getting smaller and going into more secondary and stronger tertiary markets.”
Another moving piece is the uncertainty around interest rates. Recently Federal Reserve Bank chairman Ben Bernanke indicated that there was an end in sight to the central bank's quantitative easing program. There was no specific deadline, naturally. The commercial real estate community, of course, knew this day was coming.
The question in the minds of real estate lenders and borrowers, of course, is how quickly this change will happen. That issue was among the top concerns cited by respondents in the Real Estate Roundtable's recent sentiment survey.
No one anticipates that rates will rise any time soon, Jeff DeBoer, chairman of the Roundtable, says, “but typically an investor has an exit horizon. Where interest rates will be when an asset is sold or refinanced is a big question.”
“People are definitely becoming worried about interest rates rising and cap rates expanding,” says Ronald Dickerman, president of real estate private equity firm Madison International Realty, in New York City. “It's hard to expect that cap rates will remain in the fives or low sixes and that you'll be able to exit a transaction at the same cap rate at which you entered.”
Gap finance providers are, in short, feeling pressure to be both competitive and cautious. On balance they appear to be erring on the side (in some cases, far on the side) of competitiveness.
“It's surprising how quickly the gap-financing market went from awful to fabulous,” Clayton Gantz, a partner at Manatt, Phelps & Phillips says. “Bridge financing is being provided in contexts where I am not used to seeing it provided.”
“Structures, deals and offerings are constantly morphing,” says Jerry Swartz of HKS Capital Partners LLC in New York City. “Every day, it seems, there is something a little different available on the market.”
It is the same old, but still evergreen, story, he continues: “There's a lot of capital out there looking for a home, and gap financing is a very viable investment.”
Examples are certainly plentiful. Earlier this year, to name just one, Denver-based JCR Capital held a final closing for its second commercial real estate finance fund, reaping $106 million in commitments. According to local news accounts, it exceeded its initial target of $100 million. The fund's strategy is to provide debt, preferred equity and joint-venture equity to real estate projects with returns targeted in the high teens to low-20% range.
Dickerman of Madison International believes that this new generation of preferred equity providers could fill, in some cases, a similar role to the one his firm plays—that is, as a substitute for partial interest investment or finance. “But I do think it would be hard for many sponsors to find an equity investor with the right temperament for these kinds of transactions,” he says. Still, there likely are at least some out there.
Dickerman makes a valid point; the company has carved out a specific niche in the gap financing community by investing or financing partial stake or interests in assets. The company plans to deploy about $1 billion in such transactions between 2012 and 2013, he says.
“What we are finding is that the temperament of capital is still somewhat cautious, still unlikely to lever up significantly,” he says—giving companies like Madison plenty of run room.
There are all sorts of scenarios in which Madison's particular flavor of gap financing is useful. To give one example, Dickerman tells of an investment the company made in 2012 in a property in Miami owned by Tishman Speyer.
“Tishman had a gap exposure as they were looking to buy back a mezz loan,” he says. “We bought a partial interest in the building and Tishman used the proceeds to extinguish their mezz loan.”
Reports of competitive opportunities, in fact, can be found across many markets and assets. “It is interesting that there are a lot of markets—New York, Miami and San Francisco, for example—that have strong condo markets but there is a real dearth of construction lenders,” says private equity firm GTIS Partners' president and founder, Tom Shapiro.
That, in fact, is the company's sweet spot for the moment. “We like those markets that are very strong from a sale perspective but are still not serviced well from the capital markets perspective, because they are still somewhat in distress,” he says.
For his part, Swartz points to mezzanine for construction loans. “We have done a few of those,” he says.
“We recently did a construction loan for a residential conversion in New York—it's a former school building on the Upper East Side that is being converted to an apartment. The construction loan is 65% LTC and the mezz piece came in at about 85% or so.”
To stay competitive, Swartz offers “good guy walkaway” guarantees, so the borrower doesn't have to provide a personal one. These are guarantees in which the borrower, if it can't complete the project, promises to hand over the keys and walk away.
“We are also able to do pari passu lending,” he adds. “In most cases a construction lender requires the equity of the borrower, or the 35%, to go in first, on day one, before the lender will provide any funding. We have some lenders that will do pari passu, meaning the equity goes in with the lender's money, making it easier on the borrower.”
The fact that mezz debt is being provided at all for construction—never mind the bells and whistles—is an eyebrow raiser, Gantz of Manatt, Phelps & Phillips says.
“Prior to this recent cycle I have never seen mezz debt in construction, and the fact that I am seeing it provided now leads me to believe that the pressure on these capital providers is greater than it ever has been.”
The concern, he continues, is that competitive pressures will overtake caution and underwriting standards will start to erode.
“That, of course, is the subtext to all these transactions. It certainly was a major theme leading up to the crash—lenders get too aggressive, overleverage the properties and then everyone pays a price if the economy turns or fundamentals change.”
Garth, for one, is aware of the risks and takes the proper risk mitigation measures. For example, the company passed on a number of new projects in Houston and Dallas that didn't offer a particular reason to jump in. “There are so many projects going up in those markets now, we are beginning to fear overbuilding,” Garth says.
The risk mitigation processes were in overdrive when the company embarked on the ground-up mezz construction loan, a deal structure that was relatively new when it closed in the second half of 2012.
It was for a multifamily project in Silicon Valley, Garth reports. “Our piece in this project is about $15 million and the senior debt is about $30 million.”
“There was a lot of things about the project we liked—the land basis was favorable, the developer is very strong and we felt that overall it was a well conceived project in a very strong location.”
Garth says the company considers a wide range of factors before moving forward on any one project. “Construction is always a risky undertaking; that is going to be true no matter what the structure of a deal is.”
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