All debt instruments are sensitive to swings in interest rates. As real estate investments, though, mezzanine loans carry some protection against rate increases. A strong economy and inflationary pressures often lead to rising rents and property values, which work to the benefit of the lenders by increasing the value of the assets underlying the loan.
Impact Of The Financial Crisis
Mezzanine debt attracted little notice until the 2008 credit crisis. In the lead-up to the crisis, commercial lenders—like their residential counterparts—became more aggressive in underwriting loans. Instead of underwriting loans based on a property’s current income, some lenders originated loans that could only be paid back if property income increased in future years. When the economy slumped, those assumptions proved too optimistic, producing a deluge of defaults.
Investors who participated in the lending bubble, especially in high-yield segments, were hit hard by defaults of loans originated in the frothy 2005-2007 period. Loans originated since then have performed well, for several reasons. One is that lenders learned the lessons of the crisis and have underwritten loans more conservatively—and without the borrower-favoring features that became so common during the bubble.
Another reason is that most of the financial engineering has been taken out of the system. In the middle of the lending bubble, loans were written to sell to investors who were more concerned about structure and price than the underlying real estate. After the crisis, most of the financial engineers left the market, while more experienced real estate managers remained. Even so, investors must be careful to make sure that lenders have the requisite experience in real estate investing.
Why Mezzanine Today?
Demand for mezzanine debt from property owners is set to intensify over the next few years due to a confluence of trends. Mortgage financing for commercial real estate is in limited supply. Securitizations, which supplied a large share of mortgage money prior to the credit crunch, have decreased dramatically and now provide only a fraction of what was available in 2007. Commercial banks, constrained by new regulatory capital requirements, have reduced overall lending and adopted more conservative lending standards.
Against this backdrop, $1.7 trillion worth of commercial mortgages will mature between 2015 and 2019, according to analytics firm Trepp. Many of these mortgages will expire with larger loan balances than can now be financed with new senior loans. The shortfall between mortgages that will mature and the amount available for new mortgages is estimated by Prudential Real Estate Investors to total between $610 billion and $825 billion. This funding gap creates an unprecedented opportunity for real estate mezzanine lenders. Those with experience and expertise can capitalize on opportunities to provide mezzanine loans for high-quality properties and borrowers on very favorable terms. This will allow them to lock in high rates and generate stable current income into the future. Unlike most fixed-income instruments, mezzanine real estate debt yields more today than it did in 2007.
By several key measures, today's higher yielding mezzanine debt is actually a lower risk investment than it was in 2007. Property values in all but the top markets are below pre-crisis levels and usually well below “reproduction cost.” Borrowers are making larger equity commitments, and lenders are making loans for a smaller percentage of a property's value than was previously the case. Senior and mezzanine lenders combined now typically lend up to 75 percent to 80 percent of property value compared to 90-plus percent in 2007. Thus, the equity cushion protecting mezzanine principal is now often 20 percent to 25 percent of asset value compared to 10 percent or less at the peak of the last cycle. With the combination of higher yields, more secure loans and more realistically valued collateral, real estate mezzanine debt offers attractive risk adjusted returns.
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