An esoteric portion of the commercial real estate market could likely be the canary in the coal mine for the real estate market in general. This often opaque layer of financing is known as mezzanine capital, and frequently flies under the radar of federal regulators. Mezzanine financing was a big bank problem in the recession of 2008-2009, retrospectively hinting at the issues that were to come. Our capital markets are run by entrepreneurs who will eventually, and always, find ways to advance business despite government resistance. If utilized correctly and in a favorable economic environment, this type of financing can be beneficial to promote growth and help advance GDP. But in light of the changing macroeconomic world in the last year, we’re finding mezzanine financing to be a double-edged sword.
So what exactly is mezzanine financing and how is it used, and most importantly what is it telling us about the real estate market as a whole. Mezzanine financing is a hybrid of debt and equity financing that gives the lender the right to convert the debt to an equity interest in the company in case of default, generally, after venture capital companies and other senior lenders are paid. In terms of risk, it exists between senior debt and equity. This type of financing can provide more generous returns to investors compared to typical corporate debt, often paying between 12% and 20% a year.
For the lender, the upside is good. High interest rate income and most importantly how these loans are governed under the law. The mezzanine loan is secured by a pledge of ownership interests in the entity that owns the mortgaged real estate. Because those ownership interests are not real estate, but an LLC typically, the lender’s rights are governed by the Uniform Commercial Code rather than real estate law. This is big. As such, if the loan goes into default, the lender doesn’t have to go to court to assume the property, and unlike a mortgage foreclosure, the results can transpire in as little as several weeks.
So what could go wrong? Well, as you’re acutely aware, we are no longer in a low-interest, low inflationary environment. As such, these attractive loan products have become dangerous to investors. According to the Wall Street Journal, foreclosure notices were found for 62 mezzanine loans and other high-risk loans this year through October. That’s already double the number from last year.
Big banks and other lending institutions are heavily regulated by federal and state banking laws, which have been much tighter since the financial meltdown in the Great Recession. However, as mentioned, new market participants, willing to accept the risk for mid double-digit returns stepped in. Companies such as Blackstone, KKR, Starwood Capital and others lent billions of dollars for properties across the nation, particularly in New York and Los Angeles. It’s difficult to put a dollar value on the foreclosed mezzanine deals, as this information is not made public, but you can extrapolate a couple of deals-gone-south to get the picture. Earlier this year, an affiliate of asset manager Brookfield foreclosed on a 48-story tower in Los Angeles after the building’s owner defaulted on a $64.7 million mezzanine loan. Another that comes to mind was the Margaritaville Resort in NYC. The resort, with interest rates near record lows, took out a $57 million mezzanine loan against the building, on top of a $167 million mortgage, according to court records. By now you can guess the outcome. In March of this year the resort defaulted on the loan.
But fear not future mezzanine lenders, for J.P. Morgan of the sell-side says all is well. According to J.P. Morgan, a set of positive dynamics, including higher interest rates, tighter liquidity in the market and fewer lenders, have created a more favorable outlook than we’ve seen in a long time for core mezzanine debt lending. What’s particularly interesting is that a recession may diminish transaction activity, cause rent growth to slow and/or properties’ cash flows to decline, but they expect coupon payments to remain steady or even rise. At the same time, mezzanine debt’s spread over Treasuries is much wider than mortgage loans’, which allows it to be less sensitive to short-term spread movements.
Like any other asset class, involvement in mezzanine financing is all about risk v return and timing. According to J.P. Morgan, “We know that challenges lie ahead, and we are prepared. The return opportunities we expect for investors this year may come only once in an economic cycle.” The question is whether the default shoe will continue to fall, as it appears, in the mezzanine financing world, and whether this will be a contagion to the broader real estate markets, and the markets in general. Only time will tell.
