Construction and rehab lenders continue to be cautious, keeping leverage levels modest. And that forces many developers to play a game of “fill in the blanks” when it comes to the capital stack.
The mezzanine financing market was constrained during the downturn, but the good news is, there’s plenty of capital out there. The bad news is, that money is pretty expensive since demand is so high.
Increasingly, institutional apartment owners like Behringer Harvard and American Campus Communities are using mezz investments as a way to generate yield as well as new acquisition opportunities. As cap rates and development yields continue to shrink, mezz investments often hold more upside for these firms. With a mezzanine loan, the lender has the option of taking an equity stake in the project if the initial loan isn’t paid back in time.
According to Mark Alfieri, COO for Addison, Texas–based Behringer Harvard Multifamily REIT, the need for mezzanine financing is particularly acute in the nation’s secondary and tertiary markets.
“It’s so tough to finance in these types of markets nowadays,” says Alfieri. “When it comes to mezzanine, we are seeing 15 percent rates because of that.”
Recently, Behringer Harvard Multifamily made a mezzanine investment in its own backyard by providing a loan for a 444-unit luxury development in Dallas, which broke ground in August. The investment was made through a long-standing joint venture between Behringer Harvard and PGGM Private Real Estate Fund, a Dutch pension plan.
American Campus Communities is another REIT active in mezz investment. In September, the company used its mezz program to acquire The Retreat, a cottage and townhome-style community about a half mile from Texas State University. The firm is also in the process of acquiring a 608-bed community adjacent to Kent State University called University Edge, through its mezz program.
But the mezz market also has its share of private traditional financiers like RCG Longview and Pearlmark Real Estate Partners. In fact, Pearlmark recently made a three-year, $22.8 million mezzanine loan for The Marke @ South Coast Metro development in Santa Ana, Calif., being built by Lyon Communities. According to Mark Erland, a director at HFF who represented Lyon Communities, the mezz loan had “a very competitive yield structure, especially as compared to JV equity.”
The underwriting process continues to be stringent, as investors first concentrate on the strength of the borrower before even considering the real estate itself.
“Since our originations are typically associated with development projects, we assess the potential borrower,” says M. Jason Mattox, COO of Behringer Harvard Holdings. “With a satisfactory conclusion on collateral, credit, position in the capital stack, and debt structure, we then thoroughly evaluate the relevant real estate fundamentals of the planned community.”
In many cases, the performance of a debt investment can be influenced by variables that generally can’t be predicted or controlled by the lender, says Mattox. That’s why they often don’t even attempt to forecast returns.
But that doesn’t mean there isn’t tremendous upside in providing these types of loans.
“Mezz financing can provide institutional investors like us with an income stream that complements the return profiles of other types of portfolio assets,” says Mattox. “Mezz debt investments also can enable investors to participate in a broader range of opportunities at a more attractive basis than other investment options.”