In today’s low interest rate environment, individual investors face a stark choice: put their money in instruments like equities or junk bonds that offer high return potential but come with high risk or choose less risky fixed-income instruments that generate low returns. Investments that provide healthy dividends and minimal risk of principal loss are few and far between.
There are other alternatives. Commercial real estate mezzanine debt, backed by commercial properties such offices, apartments, retail shops and hotels, is a little-known product that provides substantial dividends without nearly as much volatility as equities or junk bonds.
Mezzanine debt has a long list of virtues. It carries high single-digit to low double-digit coupons, higher than most junk bonds or REITs, and thus is a boon to investors starved for yield. It is backed by hard assets, which provides some protection in the event of default. And it occupies a segment—commercial real estate —in which virtually every individual investor is under-allocated. Moreover, some dubious lending practices that plagued the sector during the early part of the decade have been eliminated, meaning risks are much lower than they were in the past.
Historically, investing in mezzanine debt has been largely the province of institutional investors such as pension funds and sovereign wealth funds, who invest either directly in deals or through so-called opportunity funds, which are commingled pools of money set up to pursue specific strategies. More recently, certain money managers have launched real estate investment funds open to accredited investors that focus on mezzanine debt alongside senior loans. Over the next year, the first “pure play” mezzanine funds open to individual investors are expected to come to market, reflecting the upcoming wave of commercial mortgage maturities and the thirst for yield among investors of all types.
Mezzanine Debt: An Introduction
Mezzanine loans, long a staple of the commercial mortgage market, are used by property owners as a financing tool that is less expensive than equity but more expensive than senior debt. Senior loans typically represent 60 to 65 percent of asset value on a commercial real estate transaction, and mezzanine debt adds another layer of 10 to 20 percent, with equity representing the remaining portion.
The primary advantage of commercial properties over single-family homes is that they generate rental income. The income from tenants is used to pay the senior lender first and the mezzanine debt second, with the remaining portion retained by the equity holder. Careful mortgage lenders typically underwrite loans to ensure that there is more than enough income to service all the debt as well as an equity cushion to support the debt.
A Closer Look
Mezzanine debt is a fixed-income product that produces a consistent dividend yield. Because it is subordinate to the senior loan, the coupon is much higher, although the absolute rate depends on a number of factors, including the amount of leverage, the type and location of the property and the quality of the tenant and the sponsor. Generally, the coupons range from the high single digits to the low double digits.
Mezzanine debt is a “hard asset” investment; in other words, it is secured by the borrower’s interest in the underlying property. This gives investors a greater degree of protection and transparency than in other high-yield products such as junk bonds, which are based on corporate credit. If a mezzanine loan defaults, the lender has the right to seize the underlying property, which has intrinsic value. Commercial real estate loan portfolios also provide layers of diversification: a portfolio of loans encompasses different property types, geographic locations and multiple tenants.
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.
Diversified Investment Portfolios
We all know the importance of diversification in an investor’s portfolio. The American Association of Individual Investors recommends that bonds should account for between 30 percent and 50 percent of the portfolios of all but the most aggressive investors. Moreover, many advisors recommend that 5 percent to 10 percent of investors’ portfolios be allocated to alternative investments, such as commercial real estate. However, the vast majority of investors are underweighted in categories such as real estate and high-yield fixed income products.
Again, investors are hard-pressed to find products that produce significant income without a large amount of risk in the current low interest rate environment. Investments that protect capital, such as government bonds or money market accounts, also provide razor-thin yields. Growth in personal wealth since the recession has largely come from the equity market, which has had a remarkable run-up in recent years, leaving many investor portfolios overly skewed toward equities and badly in need of rebalancing.
Risks
Investing in a mezzanine debt fund can help solve multiple issues: It can provide diversification, add exposure to underweighted sectors and boost current income. Like all investments, though, mezzanine lending comes with risks. One is interest rate risk, since an increase in Treasury yields would reduce the value of a debt fund.
Investors have been warned about the prospect of rising rates for several years, but it increasingly appears that rates will remain low for an extended period because the conditions that produced them are unlikely to waver in the near future. Demand for U.S. government-backed securities is robust from non-U.S. investors who are seeking stability while much of the world faces economic or political uncertainty. Meanwhile, despite signs that the U.S. economy is picking up, income growth remains weak, and there remains a persistently high number of underemployed workers.
Another risk involves a downturn in real estate performance. If demand for commercial space, such as offices, apartments and malls, decreases due to a weak economy, technological advances or some other factor, that could lead to rising vacancies, reduced property income and increased risk of defaults.
There are factors at work to prevent this from occurring. The financial crisis led to increasing vacancy rates, but it also shut down the supply of new construction. Each property type and each market has its own dynamics, but in general over the past few years, commercial space has slowly been absorbed and rents are now slowly increasing amid very little supply in most sectors. With banks staying cautious, speculative construction is rare. The one sector in which construction has returned to historical norms is apartments, but that is a response to record-low vacancy rates and a severe shortage in many markets.
There are segments of the market that may be over-valued, such as central business districts in major metropolitan areas and certain urban and suburban multifamily properties. But for the most part, the commercial real estate market is in a period of slow recovery, with few signs of overheating.
Because it is so specialized, advisors who explore the sector for their clients need to focus on these characteristics when selecting a mezzanine fund and fund manager:
· A demonstrated track record in the space.
· A background in real estate rather than financial engineering; they should originate loans, not buy them.
· Funds with a broad diversification by location, property type and borrower.
· Loans that are not overly structured and do not have too much leverage.
· Funds with transparency—those that provide detailed information about the assets, tenants, rent rolls, etc.
The Opportunity
Mezzanine debt is a product with a long history in the commercial real estate market. Demand for high-yield subordinate loans is expected to increase in coming years due to the wave of loan maturities set to hit the market, while at the same time, banks have reduced their lending on commercial property due to increasing capital requirements. For a savvy investor, mezzanine debt can be a valuable way to earn high current income without taking on undue risk, while at the same time diversifying into a traditionally underweighted market segment.
Bruce Batkin is CEO and co-founder of Terra Capital Partners, a New York-based real estate capital management firm focused primarily on originating, acquiring and managing bridge loans, mezzanine loans and preferred equity investments backed by commercial properties.
