Throughout my discussions with investment and financing professionals within the real estate industry, we have reached the stage of the cycle where most seem convinced we still have “room to run”.
The most common reasons and rationale I hear about why a downturn is not imminent is because banks are being far more conservative (lending only up to 65% LTC for ground up projects in my experience) this cycle and that leverage is much less (vs previous financial crisis, which is not saying much).
This is assuredly true for the first in line loans but the factor hardly anyone mentions is mezzanine debt. Although I believe human sentiment/behavior and external factors outside the real estate industry will likely be what “swings the needle” in the other direction, there are several reasons why secondary debt could accelerate a decline:
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Mezzanine debt’s high yields brings new, inexperienced players - the behavior that the low interest rate environment we are in and the corresponding asset prices can best be characterized as “the chase for yield”. The high relative returns have likely caused new players to enter the mezzanine debt industry who do not have the capabilities to effectively operate taken over assets.
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Mezzanine debt carries high pricing - although this is often mitigated by being a small slice of the capital stack and potentially being drawn out late, projects that are mid construction and suffer from lack of labor, delays and incoming competing supply (specifically in multi family) are at risk of holding onto these loans longer than anticipated, potentially causing a cash crunch for operators.
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Mezzanine debt encourages and allows poorly capitalized operators to do more deals - yes, I recognize that mezzanine debt investors underwrite developers as any lender would but as an analyst entering the LP space several years ago one of the most eye opening experiences I had was how poorly capitalized, inefficient and even inexperienced operators could still raise capital and get deals done. Mezzanine allows these players to stretch their money further, doing more deal with less capital at risk.
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Mezzanine debt is largely private and unpublished - mezzanine debt represents private loans and the total volume of the industry largely goes unpublished. The extent and pricing to which deals have been leveraged is usually only known to finance intermediaries and the investors themselves.
In closing, mezzanine debt appears to me to a be an underrated factor which could help accelerate a decline and offer opportunities for liquid operators over the next three to five years. Due to its largely unknown total volume in the industry and its ability to encourage poorly capitalized operators to stretch themselves thin, the high pricing could leave many vulnerable to supply side risk factors. High yields have also likely encouraged new players to join the industry who will have difficulty running the assets themselves.
My questions and discussion points for you:
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What I’m missing - what factors, parts of the process or market conditions am I missing or understating in the above analysis that could offset the above dynamic?
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Data - do you have any data sources that demonstrate total volume of mezzanine debt? Even better, specific to property type or even location?
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Articles or books - what are the best articles and books one can read to better understand the takeover process? Do you know of any good articles pointing to the prolification of mezzanine debt?
Additional reading:
http://pages.stern.nyu.edu/~igiddy/articles/CRE_mezzanine.html
https://www.wallstreetoasis.com/forums/re-mezzanine-debt
https://www.wallstreetoasis.com/forums/mezzanine-financing-for-real-est…
https://www.wallstreetoasis.com/forums/mezz-debt-vs-traditional-debt-fi…
https://www.wallstreetoasis.com/forums/pref-equity#comment-1820727
Would love to hear from any mezz lenders and if they’re making a killing in today’s atmosphere.
Ok so the mezz lenders might take a loss, so what? Mezz lenders are the unsophisticated lenders who take on more risk and earn a lower yield than b-piece buyers.
what is typical b-piece rate compared to usual mezz debt rate? i would have thought mezz debt would pay more but obviously it depends on the deal.
While the banks and lenders, in general, have been a lot more disciplined this cycle, the real reason banks have been conservative is because they have been forced to by HVCRE. That's an important point that you're missing. That's practically the main reason all these players came into the space in the first place. They filled a void that was left by the banks who could not do what they did in the previous cycle. Two years ago Ozarks was one of the only active construction lenders and they were lending to 50% LTC. Mezz lenders came in to 65% at the time which was a very attractive position for double digit returns.
Yes there are deals were mezz/pref comes in to 90%. I just funded one last week. Why did we do it? Strong sponsor, we're getting equity returns from a protected position, and the basis was so good we'd be happy to own at that level. We also have a piece of the upside. Hell has to freeze over for us to lose any principal on this deal. When I stress tested it they would have to miss NOI by over 25% AND cap rates would have to blow out by over 100bps for us to be in the red - that's an 08 magnitude collapse. Cost overruns are not our problem either. So you tell me, on this deal, who's the idiot if the recession hits?
I don't disagree with you that there are plenty of bad sponsors and bad high yield lenders to match, but if you're saying that they're gonna cause the next recession I don't think that's an idea with real legs. If I've learned anything in my time in the business, I frankly think mezz lenders are some of the smartest guys in the biz.
national cap rates are at the lowest level ever just above 5% for Multifamily right now if you think cap rates cant blow out by 100bps, which would put it at 6%, you must be very young......
btw cmbs b-piece buyers earn 14% yield + special servicing fee, and their loss come after mezz position....so mezz lenders are putting themselves at the very first loss position and earning less return than the guys in the next loss position, still think they are the smartest?
I'm aware, I work for a top 5 multi b-piece buyer so we do a lot of that and I agree that b-pieces are more attractive returns from a risk-reward perspective. I can't put out enough money just buying b-pieces though. Also kinda boring. How many b-pieces you buy on construction loans? Wait can you do that?
ALSO - note that I said cap rates blowing out 100bp AND missing NOI by 25%. I literally capitalized it. Read carefully.
Thank you for your response and giving me feedback from the debt side of the equation. It doesn’t feel like your comment touches on any of my main points however.
I was very careful with my wording above, I do not believe this is enough to cause a recession on a stand-alone basis - merely that it is an underrated factor within our industry that could accelerate a decline and open up opportunities for liquid operators if property level risks come to fruition.
I agree with you that there are many (and maybe the majority still are) smart players in the space. That being said, if there is still as much demand (as you indicated in your HVCRE section) and the underwriting is as bulletproof as you outlined here then there are assuredly less experienced players entering or already in this space to capitalize on these high yields. They are likely not set up to be great operators if they need to step into deals (to capture all of that juicy upside) and it may ultimately fall into the hands of the banks who will eventually need to offload the assets (or it is the mezzanine debt owners offloading them).
Given that high level data on this industry is largely unpublished, it is difficult to understand the total volume and effect this could have.
Additionally, your comment elsewhere in the thread about “getting money out” is exactly the human behavioral element that leads to downturns. Deals aren’t making sense or admittedly don’t pencil yet human nature and the dynamic of most developers or investment shops having large fixed costs and the need for asset management fees to fund them combined with a large supply of money chasing yield leads to asset prices ballooning to what we see today.
Interested to hear your thoughts though, saw your previous posts and clearly you are dialed in and knowledgeable in this space so thank you again for the feedback.
While I am not specifically at a shop that holds on to mezz debt (we originate the entire cap stack and syndicate out the mezz), I had a few thoughts and i'd love for folks to opine further:
-Most mezz lenders/investors are super sophisticated: This includes some of the biggest PE shops out there that are involved in RE, and now includes industry veterans who have left banks to set up their own platforms. I'm sure there are shops out there that arent as savvy, but the folks we interact with often are usually pretty experienced (speaking to floating rate debt on bridge/construction/pre-dev stuff)
-Mezz Yields arent necessarily lower than B-Piece yields: Assuming you are talking about conduit B-Pieces - i'm sure you know this but there are barely any deals that have not taken losses so while the yields right now are in the low-mid teens - adjusted for losses they will be lower. Not to mention the time it takes to UW each B-Piece. In contrast, I've seen mezz yields on construction deals that are in that neighborhood. Even for lower yielding paper, remember that the mezz lender also gets an origination fee (often a point) and sometimes other fees such as an exit fee
Owners are 'selling' their properties to lenders: Cant get the sale price you want? No problem! just get an appraiser to appraise it for higher than your required sale price, pull your equity out and STILL own the asset! This is really where mezz lenders come in to provide 80% LTV (which in reality is likely 100% LTPP if the asset were to really trade).
Can you give a quick example of your last point? Are appraisers really writing value at 120% of the would be purchase price?
Sure - my point really was that appraisals (especially nowadays) are bullshit - you'll notice that especially in hot markets right now. I am not saying 'every' appraisal/er is going to be like that. More that in order to win business and ensure repeat clients, appraisers will often really 'stretch' the value. Oftentimes banks have independent groups that review values and make sure they are okay, but in todays environment its not uncommon to see appraisals that don't make any sense, even in context of the data and assumptions used in the appraisal.
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