As conduit lenders tighten underwriting standards on senior loans, developers will need to borrow more mezzanine money to complete their financing packages.
This is bittersweet news for developers: They’ll have to pay a higher rate on a larger portion of the overall loan, but the increased competitive focus on mezzanine translates to quicker deal cycle times.
The overall slowdown in the real estate industry, led by a plague of subprime loan foreclosures, has pushed Wall Street lenders in a more conservative direction of late, industry watchers say.
“CMBS lenders are facing much higher underwriting standards; the B-piece buyers and ratings agencies are putting a lot of pressure on the securitized lenders,” said Dennis Walsh, a senior director with Tremont Capital. “It’s going to make borrowers rely more on mezzanine and preferred equity and less on senior proceeds to get to 90 percent financing.”
In the past, many deals were split 80/10 between the senior debt and mezzanine components to reach 90 percent financing. “Based on the way that Wall Street is underwriting now, it may be 70 to 75 percent [on the senior loan],” said Tremont’s Walsh. “If the borrower is still looking for 90 percent, the senior lender is going to have to rely on selling a piece of paper with a bigger mezzanine piece in it than it might’ve had a year ago.”
As a result, many senior lenders now are opening mezzanine funds and adding mezzanine capital to large transactions in order to offset yield losses on the senior debt piece and increase their overall returns.
“It’s still quite competitive,” said Dan Walsh, who heads the private equity group at Key Bank Real Estate Capital. “We continue to see new entrants in the market as everybody continues to look for yield.” And it’s not just traditional senior lenders, but insurance companies, private hedge funds, and REITs that also have entered the mezzanine fray in recent years, he said.
With the emergence of the collateralized debt obligation market and its ability to finance transitional assets (as opposed to the CMBS market, which focuses on stabilized assets), borrowers increasingly are able to get 80 percent nonrecourse financing “on deals that are highly transitional in nature, whether they’ve just completed construction or significant acquisition rehab,” said KeyBank’s Walsh. “This is good for borrowers.”
Due to this increased competition, mezzanine deals are getting turned around more quickly than they have in the past. “The time you need to commit and close is a lot faster than it was a year ago,” said Tremont’s Walsh. “Most deals [take] 15 to 30 days start to finish, which has probably been the biggest change in the last year.”
The most highly sought-after deals are getting done even faster, in between 10 and 15 days, with due diligence rights waived as a matter of course, said Walsh. “People now work backwards and get involved in it that much earlier,” he said. “They’re actually underwriting and screening these deals before the borrower even gets control of the asset so that the borrower can close on them in a more shortened timeframe.”
In such a heated environment, it’s easy for the borrower to shop for a rock-bottom price. But you often get what you pay for, lenders warn.
Flexibility is a key consideration for borrowers. While many conduit lenders offering securitized money feature aggressive pricing, borrowers give up certain things by going that route. For instance, once a mezzanine loan is securitized, the borrower’s contact for the loan is a servicer disconnected from the initial deal.
“The servicer on these conduit deals has no reason to pick up a phone and talk to you about anything,” said Tremont’s Walsh. “But with a portfolio lender, you can call the same person that closed the deal, and if anything changed, you could have an opportunity to expand the loan, or pay it off early—there’s more flexibility there.”
When structuring the senior loan, borrowers would do best to negotiate the ability for subsequent buyers to insert mezzanine financing into the overall loan, even if the senior lender isn’t providing the mezzanine financing. That way, a subsequent buyer assuming the loan has the ability to bring in a mezzanine or preferred equity investor as well if the buyer chooses. “If it’s not negotiated in the docs, then they could be constrained on their ability to bring it in later,” said Tremont’s Walsh.
Including specific language in the senior loan agreement that states a mezzanine lender could come in at up to a certain loan-to-value ratio is a smart but sometimes overlooked move. “It’s an effective way for that borrower to be able to sell his asset with the debt in place,” while allowing the new borrower the chance to add a mezzanine or preferred equity piece later, Walsh added.
Borrowers should also work out an assumption clause on mezzanine financing so that any subsequent buyer can assume the existing terms “just like they have on the senior loan, where there are assumption rates; but many times it doesn’t cross their mind,” said Walsh. “They should negotiate those points as well to make sure that, if they want to sell the asset, then the new buyer can also assume the mezzanine loan. That’s not always a given.”
Prepayment flexibility, in particular, is a key provision in repositioning deals, since it allows the developer to sell the property more quickly, said Jim Thompson, an executive vice president at Countrywide Commercial Real Estate Finance, Inc. For stabilized assets, though, it’s better to forego prepayment flexibility to help achieve the lowest rate, he said.
Early last year, Countrywide formed its Advantage division, focused on small loan sizes for the multifamily industry. “A lot of lenders will do mezzanine loans, but they’ll only want to do them at larger loan sizes,” said Thompson. “We’ll go down to a $100,000 mezz piece or B-note, so we offer it for small loans.”
According to Countrywide, developers would do well to go to a one-stop shop for financing rather than arrange the layers of capital piecemeal. “Traditionally, a lot of lenders that don’t offer mezz will bring in another provider, and then you’ve got a two-party negotiation going on, which is not efficient,” said Thompson.
If procuring mezzanine financing from a lender other than the senior lender, developers should ensure that the loans are in lockstep, “that it’s integrated pretty well with the first mortgage, and that the prepayment structure fits with the first mortgage financing,” he said.
The Advantage program produced about $160 million in small loans to the multifamily industry in 2006, and this year, the company has expanded the business. At the end of May, the company had already done between $300 million and $400 million in multifamily, and expects to grow its market share further next year. The company has opened eight new offices this year, partly to deal with the increased mezzanine transactions.