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Foreign Capital Eager to Invest in US Mezz Debt to Fill Construction Lending Gap

Korean, Chinese Groups Institutional Groups Lead the Charge as New Players Rush to Offer Mezz, Preferred Equity Platforms
July 6, 2017
The Moinian Group, one of the developers of Hudson Yards, earlier this year launched Moinian Capital Partners, in part to tap into the hot market for subordinated debt.
The Moinian Group, one of the developers of Hudson Yards, earlier this year launched Moinian Capital Partners, in part to tap into the hot market for subordinated debt.
Non-bank lenders are rushing into the commercial real estate debt market to meet demand for mezzanine and preferred-equity loans from developers piecing together construction financing for new projects while the current real estate expansion still has legs.

With prompting from regulators, banks are becoming more cautious when it comes to construction and acquisition lending, and there are fewer financing options available in the downsized CMBS market. As a result, developers have turned to an expanding number of private lenders and funds, including foreign capital groups in Asia and the Middle East eager to invest in U.S. real estate through bridge and mezzanine debt rather than higher-risk direct equity investments.

"Investors have come to feel that the subordinated debt space may be a good place to go as we've gotten deeper into the cycle, on a relative-risk basis," said Brian Ward, CEO of Atlanta-based asset manager and loan servicer Trimont Real Estate Advisors.
Brian Ward, CEO of Atlanta-based asset manager and loan servicer Trimont Real Estate Advisors, said low capital costs has been a major driver of CRE's long upcycle.
"There's definitely more opportunity and that's reflected in the expanding number of private debt providers who are raising mezz or preferred-equity funds," Ward added.

Competition is fierce for financing deals of all kinds as investors continue to flood the market with capital, even as tighter regulatory oversight and warnings from federal regulators about potential overheating in the CRE development, particularly in the multifamily sector, has caused banks to tighten underwriting standards and decrease construction loan volumes.

NYC Developer Launches Debt Platform

"As we move later in the cycle, it makes sense for banks to be more cautious and pull back on certain development lending," said Jonathan Chassin, a former Morgan Stanley executive who now heads Moinian Capital Partners, a lending division launched by prolific New York City developer The Moinian Group to offer senior mortgages, mezzanine loans, preferred equity and construction loans for large institutional hotel, office, retail, land and residential assets.

Such loans typically bridge the 'gap' between what a traditional lender is willing cover and the equity that the developer is willing to invest.
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"We're seeing a significant number of opportunities for development deals with good sponsors in good markets, either through whole loans or mezz capital structures, where a bank may be only willing to finance 45% of construction loan to value (LTV), where in the past they would finance up to 65%," Chassin added.

Moinian Capital Partners chief Jonathan Chassin said players that weren't very active in the debt space in the recent past are getting back into the mix.
Additionally, most mezz loans have shorter terms than a typical 10-year conduit loan, increasing their chance of being taken out through a recapitalization or refinancing and further decreasing risk to the lender, Chassin said.

With a major influx of capital from sovereign wealth funds, insurance companies and other foreign capital sources driving down yields, "We see relative value in lending on projects rather than buying equity at 4% or below cap rates," notes Chassin.

"We're perfectly comfortable lending on construction deals, as we have experience managing all the complexities of construction financing," he added. Moinian is currently building 3 Hudson Blvd., a 66-story, 2 million-square-foot tower in Hudson Yards, along with several Manhattan residential projects under construction or in the pipeline.

More SWFs Targeting Private Debt

Almost 40% of sovereign wealth funds now invest in private debt in an attempt to boost returns, with 70% of respondents in Preqin's 2017 Sovereign Wealth Fund Review citing mezzanine debt as the most attractive instrument over the next 12 months. About 63% of wealth funds plan to target distressed debt, with 53% seeking direct lending.

The rising popularity of mezz debt is reflected in this year's fundraising and joint venture transactions with foreign investors from China and South Korea eager to make lower-risk investments in U.S. real estate projects.

Och-Ziff Real Estate Credit Fund raised $735 million from investors, including the Industrial Commercial Bank of China Asia, in the final round of capital raising for the fund which invests in mezzanine debt related to distressed land, casinos and senior housing, according to recent published reports.

TH Real Estate, a division of pension fund investment manager TIAA Global Asset Management, earlier this year announced plans to expand its U.S. real estate debt platform through a new joint venture with the Korean Teachers’ Credit Union targeting investment of up to $1 billion in CRE loans.

"The low interest rate environment has investors looking for yield and for defensive investments at this mature stage in the real estate cycle. We continue to see strong demand from foreign capital looking for opportunities in the U.S.," noted Jack Gay, global head of debt for TH Real Estate. "Mezzanine loans in particular hold the potential to offer returns that are very close to equity returns."

Private equity firm KKR & Co., global alternative funds manager TPG and alternative investments adviser Franklin Square Holdings also launched initial public offering to form publicly traded mortgage REITs to tap into demand for non-CMBS and non-bank debt capital by developers or over-leveraged investors hoping to take out maturing mortgage loans in the latter stages of the real estate cycle.

Benchmarking High-Yield Mortgage Debt

With so much investment activity in the mezz space, mortgage banker John Levy and investment manager Michael Giliberto recently devised a new benchmark to track subordinated debt performance. After compiling the Giliberto-Levy Commercial Mortgage Performance Index for first-mortgage loans over the past 25 years, they are now rolling out a new index for gauging and comparing returns on mezz loans, preferred equity and B-notes, along with high-yield senior mortgages.

"All of a sudden, the high-yield debt business has gotten kind of trendy. People want to invest in mezzanine debt or preferred equity," said Levy, head of John B. Levy & Co., a Richmond, VA-based brokerage and advisory business. "The industry is maturing fairly rapidly and investors want a high-yield index."

Levy said his index is already tracking $8.5 billion in 250 separate high-yield commercial mortgage debt transactions involving well-known money managers, insurance companies and other institutional investors.

"This has been four years in the making," Levy said. "Tracking mezz debt, which is usually part of a larger financing structure, is very difficult. There are more moving parts in high-yield mortgages. We happened to release this index at a time when everyone wants to do high yield, but don't know how to raise the money. Now they have a benchmark."

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