‘Loan-to-Own’ Play Is Often the Outcome If Not the Strategy as Short-Term Lenders Acquire Equity Stake in Strapped Borrowers
Preferred equity and mezzanine financing is filling some -- but by no means all -- of the gaping holes left in the commercial mortgage market by the collapse of commercial mortgage-backed securities (CMBS). In addition to the return of the traditional mezzanine lenders, some of the largest and most deep-pocketed real estate investment companies are getting in on the action by scooping up pools of existing mezz loans.
In an example from the hotel and restaurant sector, last month, Ashford Hospitality Trust Inc. said it would joint venture with Prudential Real Estate Investors on a $400 million partnership for U.S. hotel investments. Ashford, a REIT, will contribute $100 million, with the remainder coming from investors in a Prudential-managed fund. Ashford’s piece includes a $21.5 million mezzanine loan secured by interests in properties in Arizona and South Carolina. The joint venture plans to buy or originate loans and preferred equity for various hotels across the U.S.
In an even higher-stakes deal, pricing is expected this week on $9.15 billion in four tranches of an $11.75 billion mezzanine loan syndicated by a group led by Bear Stearns as part of a $20 billion real estate debt package to back Blackstone's $26.9 billion buyout of Hilton Corp. Within the next several weeks, the securitized portion of the debt package is expected to bring one of the largest CMBS issuances ever -- an $8.5 billion offering that the market will watch carefully for clues about how the conduit market will fare through the end of 2008.
For borrowers, the availability of mezz financing may be the key to their survival -- or demise. New York developer Harry Macklowe has until the end of this week to refinance a mezz loan used to buy seven buildings in Manhattan last year from Blackstone. Deutsche Bank, which supplied a $5.8 billion loan for the transaction a year ago, faces a credit hit if Macklowe can’t refinance and the bank has to take over the properties, whose falling values will likely not cover the cost of the debt. Vornado Realty disclosed in a filing late last year it bought positions in two mezz loans totaling nearly $160 million collateralized by four Macklowe’s properties. Those loans are also coming due this month.
It’s not the first nor the last time major investors and borrowers will tap the mezzanine space, which exploded in 2004-'05 only to overheat and go into hibernation 18 months ago, eclipsed by more attractive yields from senior debt and lower-cost private equity funds.
But with the shutdown in the conduit market which had offered mezz debt at cheap spreads, owners and borrowers are now scrambling for replacement capital -- and turning back to traditional mezz lenders for help.
"The good news is, the boutique bridge lenders and equity providers who were running their own money are getting more opportunities than they used to, because they’re not getting shut out by the big Wall Street firms with a cheaper cost of capital," said William Procida, principal and CEO of New Jersey-based investment and advisory firm Palisades Financial.
The bad news is, capital is far from plentiful or competitively priced. Capital availability was a major concern of nearly 200 CEOs surveyed for the "Leading the Enterprise 2008" state of the industry survey by The Real Estate Roundtable and FPL Advisory Group, which met last week in Washington, D.C. In an unpredictable market, "it’s tough to deploy capital," said one respondent. "The large amount of equity capital seeking investment opportunities makes this even more challenging." Lamented another executive: "Too much of this capital is fee-based with those controlling investing the dollars not having enough of their own skin and dollars at risk. This historically has been an invitation for disaster."
A popular source of this fee-base capital is mezzanine capital/debt, which refers to high-yield, unsecured subordinated debt or preferred stock. In a mezz loan, only a borrower's shareholders have a claim on assets that is senior to the lender. Mezz lies in the middle of the risk scale for lenders, between senior bank debt and equity-based financing.
Firms that provide mezzanine capital receive an equity stake or warrant attached to the debt obligation, in addition to receiving interest payments on the debt. Mezzanine debt, secured by a company’s equity rather than its collateralized assets, is more expensive for the borrower than secured or senior debt because they pay higher interest or surrender an equity stake to offset the higher risk of default.
As the CMBS and private equity markets have dried up, mezzanine debt has proven to be a relatively safe and reliable vehicle for deploying capital, with higher interest producing double-digit rates of return -- and an equity stake or outright ownership of the property if the borrower doesn't make payments.
Will the resurgence in mezz loans be enough to give capital markets a jump-start? Most observers think not.
"We continue to see reasonable amounts of mezzanine capital -- but the supply of senior, low-lost capital has fallen dramatically, so you have a period where transaction volume is going to stay low until we solve that equation," Jay Sugarman, CEO of mortgage REIT iStar Financial, told analysts last week at a Citigroup investment conference.
Borrowers Face Margin Calls
With senior debt providers underwriting no more than 70% on a first mortgage -- a good 15 points below year-ago levels -- borrowers are having to tap mezzanine lenders to close deals, and then hoping they can refinance into other mezz or permanent loans.
Consider Macklowe in Manhattan, where office rents are among the nation's highest, but have been falling lately. The developer is struggling to stay afloat, facing a deadline this week to raise financing to cover $7.1 billion in senior and bridge debt he borrowed to buy seven New York buildings from the Blackstone Group last year. He’s among many borrowers who made short-term loans in last year’s heady real estate market expecting to refinance with cheap-and-easy CMBS debt, which has become one of commercial real estate’s most notorious oxymorons since the credit market tanked last year.
Landlords like Macklowe are now calling lenders for new mezz loans to refinance existing mezz loans, or just keep the buildings or development projects operating until they can be sold or leased up. Most of the bridge loans now carry double-digit interest rates. If they can’t refinance, owners have only a few choices, none of them very good: sell the property, find a joint venture or equity partner or enter a workout process with lenders.
"For lenders, the mezz and the equity yields are pretty attractive," Adam Petriella, senior director of Finance & Investments in Marcus & Millichap Corp. Capital’s West Los Angeles office, tells CoStar Advisor
. "There’s a gap in the market, and it’s being filled by mezzanine or preferred equity. There were people expecting to do CMBS-type executions, but that market is gone, so they just hit a wall.
"If they can go out and get a portfolio lender to do the loan, they’re going to need an equity partner or some mezzanine debt to fill the gap because today’s lending limits are much lower, the LTVs are lower."
If a borrower was expecting to get full leverage from a CMBS lender at 5%, they now can’t do more than 65% at 7%, he said. They’ve either got to write a check for the difference or go out for mezz or preferred equity financing.
Borrower Distress Or Timing Issue?
Are the mezzanine loan portfolios being accumulated by investors over the last few weeks a de facto type of distress fund? Most borrowers won’t acknowledge it, just as most mezzanine lenders and loan purchasers won’t acknowledge that there’s a "loan-to-own" component to their exit strategy.
"Just in the last three or four weeks, I’ve had five or six different developers who needed an equity partner and some sort of mezzanine or preferred equity," Petriella said. "I bet if you talked to them, they’d say they’re not distressed. But at the end of the day, the reason they’re in the market -- it’s because they’re distressed. Their deal is not making sense, they can’t get conventional financing, they’re not selling out or leasing up like they thought they would or should."
Other mezz borrowers and developers, however, are willing to make the payments and wait until the market cycles up and projects start selling out again in exchange for the badly needed capital.
"They would say it’s a timing issue, and it’s not disingenuous to say that they think they can ride out the cycle for 24 to 36 months. There are a bunch of players willing to do that," Petriella said.
On the other hand, some lenders are all too happy to make a loan and collect high interest until the borrower loses the deal, he acknowledged. "They’re kind of licking their chops, and sure, they will loan to own," Petriella said. "There are others that just want to put out the money, they don’t want to own it. They’re yield driven, not prepared to take on the aspects of ownership. Those are the ones that are going to be a little more careful about who they’re lending to."
Petrialla says most of the lenders he has talked to recently say taking over assets is not their stated objective, but "they may, in the back of their mind, not mind owning it," he said.
In other big mezzanine transactions recently:
On Jan. 30, KBS Real Estate Investment Trust Inc. purchased interests in two mezz loans totaling $175 million provided by Wachovia Bank to Cabi Developers for the purchase of a 33-property office portfolio of 60 buildings totaling 4.55 million square feet from Arden Realty Inc. Newport Beach, CA-based KBS bought the interest in two of the finance package’s four loans for $144 million plus closing costs, according to a document filed with the Securities and Exchange Commission. Wachovia provided a total of about $1.5 billion in financing for the acquisition by Cabi, the U.S. subsidiary of GICSA, Mexico's largest developer.
San Francisco-based Shorenstein Properties LLC has recently increased its newest fund by $700 million to $2 billion, by stepping up investments in mezzanine loans. Shorenstein has acquired six loans totaling nearly $260 million since last fall, including loans on the 22-story 1180 Avenue of the Americas in midtown Manhattan; 660 Madison Ave, which houses Barneys New York; the Moffett Towers development in Sunnyvale, California; and two office buildings in Washington D.C.
Long Beach, CA-based HCP Inc., the former Health Care Property Investors, paid $900 million for a $1 billion mezzanine loan from JPMorgan Chase that was used to help fund Carlyle Group’s $6.3 billion acquisition of Manor Care Inc. The loan is subordinate to senior debt issued to Carlyle by the same lenders and backed by the equity in 339 Manor Care properties.
Investment banker Carlton Group has acquired eight loans, including first mortgages, B-notes and mezzanine loans, with a value of about $300 million, in partnership with an unnamed real estate investment firm. The acquisition was funded with debt provided by Goldman Sachs. Carlton Strategic Ventures, a unit of the New York investment banking firm, was launched in 2006 to make opportunistic investments and is looking to invest $1 billion in subordinate debt.
American Realty Advisors last month announced the origination of a mezzanine loan secured by a 499,206-square-foot property comprised of nine industrial buildings on 33.5 acres in Milpitas, CA.
Mezz Providers Become Loan Buyers
Some lenders who were traditional providers of mezz debt and preferred equity have now switched gears during the credit crunch and are buying it. For example, Philadelphia-based private equity lender LEM Mezzanine last month purchased $85 million of mezzanine loans and B-notes in four separate transactions collateralized by 10 New York multifamily properties, a Miami office building and a Marriott hotel located in Westchester County, New York. The loans were underwritten and closed within three weeks.
"LEM has been active in purchasing subordinate debt positions," said Herb Miller, a founding partner of LEM. "We want to help provide liquidity for holders of existing mezzanine loans. Our equity base gives us liquidity to buy positions and to continue lending in this environment. Hopefully we can help senior lenders, brokers and borrowers get transactions closed during this tough period."
LEM still has more than $200 million of equity to invest from the fund it raised last year.
"As first mortgage loan proceeds decline, borrowers will need more mezzanine financing to complete their transactions and LEM is geared up to fill that need," added Jay Eisner, also a founding partner, in a release.
LEM is originating new mezzanine and subordinate debt financings and although it typically invests on a longer-term, fixed-rate basis, it has also done many floating-rate transactions, executives said. LEM is also active providing preferred equity in transactions where the senior loan must be assumed and the borrower needs more leverage, including support of CMBS, Fannie Mae, Freddie Mac, insurance companies, banks and other senior lenders.
The firm’s mezzanine loans, preferred equity and B-note financing typically ranges from $1 million to $20 million for commercial and multifamily properties nationwide, but will write larger deals on larger portfolios or in "special situations," LEM says.