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Yield-Seeking Investors Switch Gears from Owning Property to Owning Mezz Debt

Fewer Property Deals and Influx of Subordinate Debt Pushing Mezzanine Capital Into More Markets Outside Top Coastal Metros
July 10, 2013
As more lenders join in, and more borrowers look for greater loan leverage, competition for mezzanine capital pieces in investment deals has increased dramatically since 2011, especially in the nation's gateway markets.

Overseas investors from the Mideast, Asia and Canada have piled in, joining a growing list of mezzanine loan specialists, private equity firms and hedge funds competing with more traditional providers such as institutional investors, insurance companies and mortgage REITs to offer CRE borrowers funding to bridge the gap between what banks have been willing to lend and the equity investors are willing to put at risk.

Notably absent from the bidding are the banks themselves, still suffering from the aftermath of the huge losses taken on mezzanine loans and other types of financing in the downturn.

The larger number of players is making it more difficult to pocket returns on traditional mezz loans, prompting lenders to offer different types of structures on different types of projects, including loans for from-the-ground-up development. Lenders that would have summarily dismissed such opportunities a year or two ago are now swooping into a wider number of secondary markets outside the top-grade coastal metros.

"As a debt and equity placement mortgage broker, we get calls daily from investors who say they’ve got a new bucket of capital for mezzanine debt," said Dustin Stolly, a mortgage banker and executive vice president at Jones Lang LaSalle.

"The market for larger tranches of mezz financing in major markets like New York City is extraordinarily competitive," Stolly said. "We see interest rates of anywhere from 5% - 7% for office mezz debt."

JLL has been very active in the space, including a deal in progress to place $165 million of mezzanine debt as part of a loan assumption in the sale of 237 Park Ave., currently being acquired by a partnership of RXR Realty and Walton Street Partners.

Stolly declined to discuss the details of the financing, which is expected to close soon. However, he said the mezzanine piece “was aggressively and heavily bid by all types of lenders - traditional mezz lenders as well as life insurance companies and mortgage REITs,” which he called a reflection of the keen demand among lenders for capital pieces in quality buildings in major gateway markets.

Spreads on mezzanine debt backed by equity on core assets in top coastal markets have compressed significantly in recent months, forcing most mezzanine players to step further out on the risk spectrum and offer to lend money on smaller assets in secondary markets to achieve the double-digit returns they promised to investors when they raised the capital, Stolly added.

Although credit markets have freed up considerably in the face of record-low interest rates and more financially healthy qualified borrowers, cautious first-mortgage and construction financing lenders haven’t flooded into the market.

However, with developers finally in the market for leverage for the first time in several years, mortgage bankers and CRE capital markets experts expect more lenders to unveil mezzanine products.

Case in point: Related Cos., one of the nation’s most prolific real estate development and investment firms, is partnering with Highbridge Principal Strategies (HPS) to invest in gap financing for commercial and residential projects across the U.S.

Related and Highbridge will invest $800 million in the joint venture, which will invest in first lien mortgages, mezzanine loans and preferred equity positions in both land deals and non-stabilized assets, focusing on transitional real estate investments, such as re-development, conversions and new construction.

"We’re in a niche of the mezz market, so we’re generally not going to finance cash-flowing stabilized assets. The returns for that type of mezzanine are a little bit on the low end because there’s plenty of capital available for those types of assets," said Justin Metz of Related Capital Management.

"There is no securitization market for those types of assets - land and half-completed buildings," Metz added. "And there generally is no type of bank financing that goes past about 60% of the capital structure, so effectively there are no bids. We and a couple of other groups are effectively creating that market."

With buyers bidding the prices of property assets up in primary markets, institutional buyers have responded to the lower returns on equity by shifting their yield expectations to returns on risk-adjusted investments.

For example, Blackstone Group recently reported that it was two-thirds of the way to its $3 billion goal for its Blackstone Real Estate Debt Strategies II launched a year ago. The debt fund, one of the market’s largest, will focus primarily on high-yield new origination and purchases of existing loans and CMBS securities loans on commercial properties in North America and Europe.

But the giant private-equity firm’s fund mandate also includes non-direct investments through loan purchases and originations, including junior B-note debt, mezzanine slices in addition to whole loans, CMBS, participation notes and preferred equity.

Harnessing the power of well-placed mezz financing deals and focusing on its financing business is one of the factors that has helped SL Green (NYSE: SLG) New York City’s largest office owner, overcome slower leasing activity. SL Green’s finance book "is likely to see more net investment versus direct property acquisitions, which we view as a positive at this point in the cycle," said Alexander Goldfarb, analyst for Sandler O’Neill Partners. Today’s lower loan-to-value ratios versus before the credit crisis provide more of a cushion for mezzanine tranches and yet retain the same all-in yields, wider spreads with more coverage.

Earlier this year, SL Green announced a $925 million bridge financing that constituted 84% of total capital for the $1.1 billion purchase of the Sony Building at 550 Madison Ave. In addition to $175 million in senior mezzanine debt originated by SL Green, the loan includes a $600 million senior loan originated by Bank of China. SL Green sold the senior loan to a private investment manager, and sold half its interest in the junior mezz debt after the financing was complete.

"The more Sony Building-type financing transactions SLG can do - buy wholesale, sell retail -- the juicier the all-in yields, the aggregate of the base coupon plus the associated fees," Sandler said.

"We have confidence in management's knowledge of the market to understand where the investment opportunities are best to allocate between direct ownership versus financing."

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