Mezzanine debt originators are fielding more calls from senior lenders and sponsors to help bridge gaps in the capital stack for acquisitions, refinancings and construction loans.
The activity is coming as the debt markets are feeling the impact of more than a year of a hawkish Federal Reserve stance that has raised the target interest rate to a range of 5-5.25 percent; global geopolitical and economic volatility; and senior lenders’ attempts to lower the loan-to-value ratio of new and existing loans.
Samir Tejpaul, a managing director at San Antonio, Texas-based investment manager Affinius Capital, notes that while junior and subordinate debt have always been a major part of the capital stack of many commercial real estate loans, current market conditions mean senior lenders are more focused on reducing their leverage.
“The reason why leverage has come down is a response from the most efficient capital providers to the interest rate environment,” Tejpaul says. “Banks and life insurance companies and prudent alternative lenders [are] recognizing that they need to adjust their underwriting so that their debt yields, their debt service coverage ratios and their underwritten LTVs produce hurdles that are acceptable to syndication and refinance counterparties as well as their own internal investment committees.”
The current landscape means a greater role for alternative lenders and other providers of subordinate debt. “In times of volatility, when there’s more conservatism out there from the most efficient cost of debt providers, it’s going to be a tremendous opportunity for alternative whole loan and subordinate debt lenders to execute transactions that were not previously available for them. As a result, they will be able to grow their business and take market share,” Tejpaul says.
State of play
A year-end report from Dallas-based advisory CBRE anticipates the cumulative debt gap between sponsor equity and senior debt in the more volatile office and retail sectors will reach $52.9 billion and $3.1 billion over the next three years. This gap could mean widespread funding gaps for sponsors unable or unwilling to invest additional cash – and for the lenders holding these loans.
“Lenders will face losses in some cases due to falling property values and illiquid markets,” the report states, adding that this gap notably opens the door for equity investors entering joint ventures and mezzanine lenders looking for renewed opportunities.
Michael Boxer, managing director at Plymouth Meeting, Pennsylvania-based investment manager CenterSquare Investment Management, says the firm is already starting to field inquiries from sponsors and lenders. There is a particular story that the firm is seeing: sponsors that need more time or need to reduce leverage.
“The current dynamic is, transactions are happening for those owners and operators whose hands are being forced,” Boxer says. “Said differently, they have a loan that’s coming due, and their old lender is telling them, ‘Either pay me off, or I will give you an extension, so long as you [put in capital to] pay my old loan down to a new, appropriately sized level.’”
Lauren Gerdes, senior real estate analyst at RSM US, says the Chicago-based accounting firm has seen its clients increase allocations of capital toward short-term mezzanine debt and preferred equity positions. The capital is going toward established funds previously focused solely on equity deals and toward launches of new alternative funds.
In tandem, Gerdes says distressed debt has seen a significant drop in investment.
“Although valuations have not fully sorted themselves out between buyers and sellers, the trend moving from distress to mezzanine indicates the market is still finding durable cash flow deals sufficient to cover the senior loans and gap funding even at the higher borrowing cost,” she notes.
Mezzanine at work
Tejpaul – who is responsible for sourcing, negotiating and structuring transactions at Affinius and managing its banking and warehouse relationships – says alternative lenders will be able to find a space within the capital stacks of bridge and construction lends as well as fixed-rate insurance company loans. Alternative lenders will also be able to originate preferred equity positions.
Affinius is focusing its mezzanine debt originations on asset classes including data centers, media studios, multifamily, industrial and life sciences. “We gravitate toward newer institutional-quality real estate that we think users will also gravitate to whether they are residential or commercial users,” Tejpaul says.
Tejpaul says construction continues to be the best way to create value in the firm’s view, be it through debt or equity. Affinius’s ideal transactions are where it can provide mezzanine debt to ground-up construction loans, refinancings and recapitalizations.
In recent months, the firm has joined forces with Little Rock, Arkansas-based Bank OZK on multiple construction deals and financing packages, including a $334 million recapitalization in May for an Amazon-leased logistics center in New York and a $160 million construction loan in January for an industrial development in Phoenix, Arizona.
CenterSquare is similarly focused on industrial and multifamily for most of its mezzanine lending. Boxer says the debt team will look at all major asset classes including office if risk-reward levels are appropriate. Medical offices and retail resilient to e-commerce disruption are also mezzanine lending areas of interest for CenterSquare.
Last year, the short end of the US Treasury yield curve spiked almost immediately as the Federal Reserve started to raise interest rates to control inflation. “That spike in short-term borrowing has had a material effect on every short-term floating rate borrower out there, and that has forced everyone in the marketplace to re-evaluate their cost of debt and targeted level of debt going forward,” Tejpaul says.
Tejpaul says loan coupons have become increasingly important in today’s market, with other important factors including fee structure, term and performance tests. Floating-rate coupons especially have felt the brunt of the shift seen from steady interest rate hikes.
The cost of interest rate caps are similarly a cause of concern, with negative leverage – which happens when the cost of debt surpasses the underwritten yield on cost, unlevered yield, or debt yield – are another cause of concern, Tejpaul adds.
Boxer sees a bifurcation between leveraged and unleveraged mezzanine lenders, with the former finding their business plans have become somewhat untenable because of the current market conditions keeping them sidelined. “Over the last six months, we have seen decreased competition from other mezzanine lenders who rely on various forms of leverage, such as repo-financing or securitizations, to generate their returns,” he adds.
Pullback from senior mortgage lenders is allowing mezzanine debt providers to be more selective around business plans, asset classes and loan terms that the debt providers find to be most viable, Boxer says.
“We get paid to make intelligent bets, and this is exactly what we think that we are doing,” Boxer says. “To take it one step further, the way we look to further mitigate risk – and now with less competition, [fewer] lenders in the space – is we lend to the level we want to in terms of loan-to-value or last dollar of exposure.”
CenterSquare has opted to concentrate its efforts on the value-add multifamily space, which the firm likes because of the ongoing supply-demand imbalance in this part of the market.