All, recently spoke to someone and they mentioned they were getting an uptick of interest adding mezz debt to their deals that might look a bit more attractive than the rising rates of traditional financing alternatives.
What are you seeing in your particular markets/asset classes in regards to the 'potential' increase of mezz debt financing over traditional lending given the increasing interest rates?
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Why would mezz look more attractive? If you layer on mezz, their rate will be comparable or higher than a regular loan. To say it is more attractive will depend on the business plan i suppose, ie. if they're looking to maximize proceeds with full i/o and flip the property over in year 2.... but this will still have significant risk for the exit plan, because of rising rates, as you identified.
Any mezz lender, so i would think, would charge higher rates because they also have equity investors who require spreads above the risk free rate.
Traditional lenders are typically not fond of mezz lending/tranches behind their position (unless if it is a developer)
Good question, and unfortunately I don't know the exact answer. My assumption is the same as yours, that based on the business plan/maybe it's some sort of locked in rate as a second tranche to attract more volume. But, would a company ever purposely sacrifice the spread for the benefit pumping out deals quicker than normal?
Link_REDev these would be deals with developers where there is traditional financing, and layered mezz on top (deal independent), some equity involved.
I don't know the specifics of every deal (I do know a bit are fairly peculiar/not something most people would be okay with), just was curious if anyone else was seeing this in their deals and if it made sense "overall".
I see and yes, I see deals like that - fairly typically for a small operator in a A/B location
For developments?
The reason why you are seeing a proliferation of additional mezzanine loans is to increase leverage (total borrowed money relative to project costs), not for better pricing.
I lead acquisitions for a ground up multifamily developer and traditional lenders over the past 5-6 quarters have kept tight underwriting standards due to Dodd-Frank and their need to carry a percentage of the loans they issue on their balance sheets. As such, construction debt for new players has been very difficult to obtain as most lenders filled their development allocation buckets with deals from existing relationships. This is what has led to the rise of secondary debt - smart players have stepped in to provide this extra leverage but at a price; high interest rates and equity participation in deals if they fall apart.
Because of these higher standards, most construction loans are being underwritten at 60-65% loan to cost (LTC). Prior to the financial crisis, these same deals would have gotten 80%+ LTC construction financing. Most developers are not well capitalized so in order to do multiple deals with their limited capital most have to leverage up as much as possible.
As others have pointed out, mezzanine debt includes higher pricing since it is typically second (or third, etc. depending on capital structure) in the capital stack behind the first mortgage which makes sense given they have a higher chance of their debt not being paid. The elevated pricing is true - a mezzanine loan that gets you up to 80-85% LTC will cost around 12 to 15% interest. But imagine you're a developer and need to keep your pipeline full - the bank is only giving you 60% LTC, why not take out that 25% mezzanine loan at 12% interest if it allows you to do another deal or two?
+SB - makes sense
Also keep in mind opportunistic investments seeking mid to high teen returns are going to be less sensitive to the cost of debt as opposed to core players. So if your 60% LTC at 6% and 20% at 12% then your cost of debt has incrementally risen to 7.5% (blended). With the additional leverage your still well within your target range of returns on the equity.
Absolutely correct. As long as the ROC (high for development) is greater than your cost of debt (7.5% in this example), additional leverage is accretive to the equity returns.
Another very important thing people don't realize is that folks take out the expensive mezz for relatively short time frames on opportunistic deals that yield high returns. They're not paying 13% interest for 10 years.
Mezz debt on stabilized trophy deals can be as low as 4% if you're just bridging the gap from 50-65% LTV. Folks also need to keep in mind that slice can be further cut up into smaller pieces (i.e. senior mezz and B-piece), each of which will earn different returns as well (i.e. 6% on the a and 8% on the B). There's a lot of ways to skin the cat, especially if you are creative and know how to use leverage properly.
The most important thing that people also forget is it not even about the rate - it's really about the inter-creditor agreement and the rights the lender will have to screw you in a default scenario as well well as the cures and remedies you will have to protect yourself. You can have the best rate ever, but if the agreement is written such that the lender can literally steal your keys at the first misstep your rate doesn't matter.
Very important points here, thank you for covering these as I didn't get the chance in my previous comment. +1SB
For developments i get it, bc you're depending on your fee for the income stream. You're strategy would have to be sale, or refi asap, right? Or else you're going to be stuck with little cash flow and a ton of restrictions.
When you say acquisitions, i assume you're buying land? If you're buying and underwriting existing buildings, I imagine there wouldnt be as much mezz, because the equity wouldnt have enough CF to get interested... ?
Not quite (unless I am misunderstanding your phrasing) - the motivation for many developers is to grow their capital stack, the development fee is mainly to support operations and general/admin back and front office costs. As such, the exit is the most important variable for them and by utilizing mezzanine debt they use the additional leverage to multiply their capital by putting less money initially in and receive a greater share of proceeds out.
Yes, I am referring primarily to buying raw or entitled land. I cannot speak to how common mezzanine debt is on stabilized assets.
Not too uncommon. Mezz for existing assets is generally cheaper than development mezz and provides additional leverage for the sponsor (usually PE firms). I've seen deals where core assets are refinanced with mezz as low as high 4% fixed.
I think the real answer is mezz is being utilized on new development deals because traditional lenders just aren’t getting there at this point in this cycle on their LTC %, which in turn increases the $ amount of equity needed to move the deal forward. Sponsors/LP’s banking on say 65% LTC on a $100M deal would have $35M equity earmarked for the deal, but what if upon completing the debt raise they only found 55% LTC and now had to scramble for an extra $10M in equity? Depending on the LP’s structure this may not be as easy as one thinks. The mezz can fill this gap but at a price. On a merchant build with solid IO baked into the debt service, it could boost returns but it does quite the opposite on a long term hold unless refinanced out at stabilization.
On this topic, how is mezz debt typically structured for repayment? Does interest typically accrue or is interest typically paid monthly? And is interest--accrued or paid monthly--typically capitalized at the beginning?
I've done preferred equity, and in each case we've structured the "interest" to simply accrue, to be paid out at disposition or refinance.
YMMV - I've seen all the above in various proportions. At the end of the day, it's going to depend on the lenders return thresholds. How they get to that yield is up to them. For instance, they might take a bigger upfront fee and give you a bigger slice of accrued interest in return - if it gets them to their yield it doesn't matter (assuming all other things equal of course that they want to win the deal). It's the most creative part of lending in my opinion.
I've seen PIC versions too.
Where interest is accrued...
Interesting that this thread should come up. I was having dinner with my friend the other day; he told me that his foreign clients have bottomless pits of money to invest in U.S. real estate, but have given up because yields are so poor. He said they are now alternatively looking to place several hundred million dollars into mezzanine debt for deal-specific Class A office/multifamily/mixed-use projects in major U.S. markets (D.C., NYC, San Fran, Chicago) but don't even know where to start.
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