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:
- 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.
- 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.
- 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.
- Mezzanine debt is largely private and unpublished - mezzanine debt represents private loans and the total volume of the industry largely goes unpublished.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:
- 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?
- Data - do you have any data sources that demonstrate total volume of mezzanine debt? Even better, specific to property type or even location?
- 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?
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