The pending sale of a steeply discounted mezzanine loan on Parkmerced, the largest apartment complex in San Francisco, and the potential sale of another substantial mezzanine position on a Pittsburgh office, are highlighting the critical role mezzanine investors can play in a workout.
Apartment Investment and Management Company is preparing to sell a $275 million mezzanine loan on Parkmerced, the largest apartment community in San Francisco, to an undisclosed buyer for $167.5 million, while a $4.7 million mezzanine loan on Parkway Center, a Pittsburgh office building, is in the market. Both loans are part of outstanding commercial mortgage-backed securities deals.
These situations are significant for two reasons, according to Stav Gaon, head of securitized products research and strategy at Academy Securities. First, these sales can provide an idea of potential valuations in a market where transaction activity has been slow. And more importantly, sales could introduce new stakeholders to a commercial real estate capital stack where they could pursue a different strategy than a previous owner – including foreclosure
This all means that in situations of distress, there is more to watch than simply the interplay between the senior mortgage lender and the borrower. “The mezzanine lenders, they’re very important,” Gaon said.
How it works
A mezzanine loan sits in the middle of a commercial real estate capital stack and bridges the gap between a sponsor’s equity and a senior mortgage. Unlike a senior mortgage, which is secured by the property, mezzanine debt is secured by a borrower’s pledge of equity.
This structure gives the mezzanine lender certain rights varying from curing defaults to foreclosing and forcing the sale of a property. But mezzanine lenders must determine if there is still value beyond the outstanding mortgage before moving forward, Gaon added. This is because a steep decline in the valuation of a property could wipe out a mezzanine lender’s interest.
The mezzanine lender on Gas Company Tower, a landmark Los Angeles office building on which Brookfield DTLA Fund Office Trust Investor defaulted in February, could influence a potential workout of the loans, depending on valuations, Gaon said. The fund, a Brookfield Properties subsidiary that owns and manages a portfolio of high-quality office buildings, did not exercise an option to extend a $465 million loan on Gas Company Tower at its February 9 maturity.
“If the mezz lender concludes that there is still a value of Gas Company Tower, and they don’t want to lose that value because of mortgage foreclosures, they may look to exercise the cure right or the purchase right. And if they exercise their cure right, the default completely goes away,” Gaon said.
Intercreditor agreements
The relationships between the senior mortgage and mezzanine holders are usually governed by an intercreditor agreement that defines a mezzanine lender’s rights, said Alex Killick, managing director at CW Capital.
“If there’s a default on the senior loan, the mezzanine holder is going to have the right to purchase the senior loan at a fixed price that [may or] may not include some of the penalties associated with the default,” Killick said.
In other cases, mezzanine debt holders often can foreclose, though they may need to put up a guarantor or assume certain obligations such as making whole unpaid amounts on the senior loan.
“There’s a scenario where [the mezzanine lender] may have to put money in, but what they have is typically a much quicker path to exercising their remedies than the senior [lender] does,” said Killick. He continued that mezzanine debt holders can pursue foreclosures under the Uniform Credit Code, which usually takes a much shorter time than a judicial foreclosure governed by state laws.
In addition, the exercising of various mezzanine lenders’ rights will depend on factors including the business goals, expertise and capital capacities of the investor.
“Sometimes mezzanine lenders lend on troubled situations, and they take into account the possibility that they will take [over] the property,” said Gaon, adding that some mezzanine lenders are willing to make risky investments in exchange for high coupons and yields.
When the mezzanine debt holder is not ready to take over assets, there are other options. “Maybe [the mezzanine lender will have to] sell their position to somebody who’s better equipped to take over the asset, or sell to the sponsor,” Gaon explained.
Killick also noted that some offshore investors in mezzanine loans may also opt for selling the loans should problems arise.
“We see a lot of mezz [loans] get sold in Europe and Asia as a high-yield product. It can sometimes be a problem in that mezz lender is not likely to take an active hand,” he said.
Determining value
The defining question on the actions a mezzanine lender takes is the value of the underlying asset and the recoverable value of their mezzanine loan as well as their ability to take over the asset, according to Ed Shugrue, portfolio manager at New York-based RiverPark Capital.
If a CMBS loan is defaulted, “someone needs to step up and cure the default. Typically, the equity holder will buy out or restructure mezzanine loan, [or] the mezzanine loan forecloses out the equity and cures the default, or the CMBS trust moves to foreclose on the property, and thereby wiping out the subordinate lenders and equity,” Shugrue said.
An analysis of the senior loan on Parkmerced, which was securitized in a 2019 single-asset CMBS deal, MRCD 2019-PARK, gives some insight into the property’s performance. A November report from Fitch Ratings affirmed the ratings for the class A and class B bonds from the deal but has a negative outlook on the class C and class D bonds due to concerns over declining occupancy and cash flow. The property is only 70.5 percent occupied, a dip from 92 percent at the time of securitization. The mezzanine debt on the deal was held outside of the CMBS trust.
Though mezzanine lenders don’t usually disclose prices of a sale, the fact that there is clarity around a potential sale price for AIMCO’s Parkmerced loan may provide some data points that can be used for further valuations of the property. “Maybe an upcoming appraisal can take into account the sale price of the mezz debt,” Gaon added.
CW Capital’s Killick also noted the reduced price of a mezzanine loan sale may suggest value degradation on the market.
“If there’s real capitulation around value, which hasn’t happened yet, you may see some mezz positions get sold for pennies on the dollar just to create a position within a deal [where] people want to try and monetize,” he said.
He continued: “We’ve seen a fair bit of mezz [loans] come to market either nonperforming or with anticipation of nonperformance. It’s in anticipation of further weakening, particularly in the office space.” Because mezzanine loans are not considered as liquid assets, they’re usually sold for a reason, he added.
Having said that, Killick noted market participants would prefer to get a deal done when navigating loan defaults or terms modification. “No one’s in a rush to foreclose,” he said. “If we can get a deal done, we would like to.”
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