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CRE Mezz Debt Market Heats Up on Rising Construction, Refi Activity

Mezzanine, Bridge Debt Increasingly Attractive as Investors' Quest for Yield Shifts Into Overdrive
January 21, 2015
From REITs to the largest private-equity and hedge funds, major players in the real estate capital markets are responding to a growing appetite for mezzanine debt at current attractive interest rates to recapitalize existing loans and fund new construction projects.

Driving the surge in demand for mezzanine debt are the growing numbers of investors searching for creative ways to enter commercial real estate investments throughout the capital stack, said Brian Ward, president of capital markets for Colliers International.

"We're seeing an increase in mezzanine lending volume, both from companies that really know the business well and from new participants. We're seeing it in primary and secondary markets, and on a broader range of asset classes," Ward tells CoStar News.

"Mezz lenders are feasting" as competition heats up among both conventional and non-conventional financing players, said Lee Silpe of Berko & Associates. "Quality developers are drooling. The market can substantiate these much-higher leverage scenarios (due to rising property values), and they are being placed night and day."

A lot of investors who would ordinarily be purchasing assets at this point in the cycle have gone into making bridge and mezzanine loans, said Jonathan Aghravi, senior director with Eastern Consolidated in New York City.

"Cap [capitalization] rates are so low, they don't love what's out there; they think it’s overpriced," said Aghravi. "If they can come in and offer a mezz piece, they can get good returns on their money and if something happens in the market again, they can be in a good position to take over the property. There's a good supply of mezz and preferred equity money in the market."

REITs such as SL Green Realty (NYSE: SLG) and Essex Property Trust (NYSE: ESS) ESS continue to see opportunities to recycle capital and invest in mezzanine debt as private developers and acquirers fill gaps in their capital stacks.

At the semi-annual NAREIT conference in November, executives with Essex Property Trust said they see potential for $250 million to $300 million in mezz lending activity at 10% yields as banks and other conventional lenders remain strict on construction loans, lending only in the 60% - 65% LTV range.

Likewise, nearly 40% of insurance companies said they planned to invest in private commercial real estate mezzanine debt over the next three years, according to a recent global survey of insurers by BlackRock Inc.

The search for higher returns among investors is expected to interest in non-core assets as insurers redefine liquidity in their investment portfolios, according to David Lomas, global head of BlackRock's Financial Institutions Group.

"In pursuit of uncorrelated returns in diversifying assets, such as infrastructure, mezzanine debt, and CLOs, insurers will take a more holistic approach to portfolio construction," Lomas said.

Leading investment bank Morgan Stanley announced last week that its merchant banking and real estate investment division has raised an aggregate $1 billion for Morgan Stanley Credit Partners II, L.P., the firm’s second investment vehicle targeting corporate mezzanine debt and related instruments issued by middle market-companies in North America and Western Europe.

Institutional participation in the fund is more than double the size of its predecessor fund, and the fund has already invested more than $144 million in four portfolio companies.

"Our clients recognize that mezzanine debt presents a compelling investment opportunity, and we are pleased with the strong support we have received from a wide range of investors," said Hank D’Alessandro, managing director and head of Morgan Stanley Credit Partners.

In additional to big banks, private equity, hedge funds and even family offices are also making some the most high-profile mezz debt plays.

Last week, private equity firm KKR & Co. LP recruited a team of debt professionals from Miami-based Rialto Capital Management, with plans to launch a new property debt investment operation. The team led by Matt Salem will be responsible for investing KKR’s balance sheet into mezzanine, preferred equity and other forms of junior credit, according to multiple reports.

Mack Real Estate Group and Peter Sotoloff, a former Blackstone Group unit executive and one of the nation's top CRE debt experts, announced in late October that they plan to create a new debt platform that will initially focus mostly on mezzanine, preferred equity and first mortgage loans.

CEO Richard J. Mack cited favorable yields on gap funding as the top reason for establishing Mack Real Estate Credit Strategies (MRECS) in the current market.

"We believe that the returns currently available for loans secured by transitional assets in the U.S., and for almost all European assets located outside of the very few top-tier cities, will be superior to most other real estate investments on a risk-adjusted basis," Richard Mack said. "Unlike our development business, where we plan to hold real estate assets with institutional partners indefinitely, we believe that real estate debt investments with finite maturities are well suited for limited-life investment vehicles."

"High-yield debt vehicles, when prudently managed by a firm with the proper combination of extensive lending experience and substantial real estate development and operational capabilities, will have the potential to provide investors with better risk-adjusted returns than other comingled vehicles that participate in the [CRE} investment market."

Mack pointed out that many firms that partner with Mack Real Estate share that view and are also seeking real estate debt opportunities to provide "much-needed liquidity to borrowers, while mitigating downside risk."

Private lending has a major role to play in today’s real estate debt markets, which have experienced "seismic changes" since the financial crisis, noted Sotoloff, who previously co-founded and served as managing director and head of originations for Blackstone Real Estate Debt Strategies.

"The landscape for borrowers is completely transformed. Financing options for transitional assets can be limited. As a result, we see tremendous demand for flexible, experienced lenders in that segment of the debt financing market, and limited competition."

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