In today’s low interest rate environment, individual investors face a stark choice: buy equities or junk bonds that offer high return potential and high risk or choose safer fixed-income instruments that generate low returns. Investments that provide healthy dividends and minimal risk of principal loss seem to be few and far between.
But there are other alternatives. Mezzanine debt, backed by commercial properties such as offices, apartments, retail shops and hotels, can provide substantial dividends with lower volatility than junk bonds and many equities.
Mezzanine debt offers a number of potential benefits to investors. For example, it carries high single-digit to low double-digit coupons, higher than most junk bonds or REITs, making it attractive to yield-hungry investors. It is backed by hard assets, which provides a degree of default protection. And it occupies a segment—commercial real estate—that can help advisors diversify client portfolios. Moreover, dubious lending practices that plagued the sector during the early part of the decade have been addressed, lowering the sector’s risk profile.
Historically, investing in mezzanine debt has been largely the province of institutional investors such as pension funds and sovereign wealth funds, which invest either directly 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 an upcoming wave of commercial mortgage maturities and the thirst for yield among investors of all types.
Mezzanine Basics
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% of asset value on a commercial real estate transaction; mezzanine debt adds another layer of 10% to 20%, with equity representing the remaining portion.
The primary advantage of investing in 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.
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 considered a hard asset; 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 high-yield products such as junk bonds. If a mezzanine loan defaults, the lender has the right to seize the underlying property.
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.
Rate Watching
Investing in a mezzanine debt fund can provide diversification, add exposure to underweighted sectors and boost income. Like all investments, though, mezzanine lending comes with risks. This includes interest rate risk, since an increase in Treasury yields would reduce the value of a debt fund.
Any downturn in real estate performance is also a risk factor. If demand for commercial space, such as offices, apartments and malls, decreases because of a weak economy, technological advances or some other factor, that could lead to rising vacancies, reduced property income and increased risk of defaults.
Because the sector is so specialized, advisors who explore it for their clients need to look for 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, including experience in originating loans.
• Funds with holdings that are diversified by location, property type and borrower.
• Loans that are not overly structured and do not have too much leverage.
• Funds with transparency, with detailed information about assets, tenants, rent rolls, etc.
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 from about 2005 to 2007—leading up to the collapse of the mortgage market in late 2008. Loans originated since then have performed well, partly because lenders learned the lessons of the crisis and have underwritten loans more conservatively—without the borrower-friendly features that became so common during the bubble years.
The mezzanine loan sector has put more emphasis on the underlying real estate involved in a transaction rather than the financial engineering aspects of the loans. 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. Since the crisis, however, experienced real estate managers have exerted more influence in the sector.
Why Mezzanine?
Demand for mezzanine debt from property owners could intensify over the next few years because of a confluence of trends. Mortgage financing for commercial real estate is in limited supply. Securitizations, which supplied a large share of mortgage money before the credit crunch, 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. 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 less risker 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. Senior and mezzanine lenders combined now typically lend up to 75% to 80% of property value compared to more than 90% in 2007, increasing the equity cushion protecting mezzanine principal. With the combination of higher yields, more secure loans and more realistically valued collateral, real estate mezzanine debt offers attractive risk-adjusted returns.
Bruce Batkin is CEO and co-founder of Terra Capital Partners, a New York-based real estate capital management firm focused on bridge and mezzanine loans and preferred equity investments backed by commercial properties.
