Once upon a time, balance-sheet lenders walked the earth. These were slow, bulky creatures burdened with pouches full of loans, including both the first-mortgage and secondary-financing varieties.
When times were good, these prehistoric animals would hit earnings targets by receiving income from the debt service payments on performing loans. In bad times, they would experience losses on nonperforming loans and lending would constrict until problems were resolved and the balance sheet was cleared again for fresh lending.
In the case of traditional mezzanine lenders, they understood downside scenarios and had real estate experts who could step in and solve property-level issues. They did not leverage their loans and were not dependent on warehouse lines of credit. Then came the paper traders.
Sometime after 2001, the collective impact of aging populations in developed countries and worldwide economic growth kicked in, and enormous sums of capital began scouring the world for yield. Foreign and domestic investors, their fixed-income allocations overloaded with U.S. Treasuries, demanded an alternative.
Wall Street was, of course, more than willing to innovate and accommodate. The securitization industry rapidly grew its offerings of residential mortgage-backed securities (RMBS), commercial mortgage-backed securities (CMBS), collateralized debt obligations (CDOs) and structured investment vehicles (SIVs).
By pooling, selling and re-securitizing larger and more diverse pools of assets, Wall Street assured investors that risk was sufficiently dispersed in this new recipe for alphabet soup as to justify ever-increasing prices for ever-riskier investments.
Meanwhile, many lenders were running hard to keep up with expectations for yield. If they could goose returns with leverage and tap deeper into the securitization market, they could earn fees by churning loans and keep balance sheets clear to avoid the nastiness of any future downturn.
Thankfully, even the most creative securitization shops and their advisors couldn't sell rated bonds above certain nosebleed loan-to-value (LTV) levels. Yet loan borrowers were standing at the gates, insisting upon more leverage to hit their expected returns.
Wall Street firms and specialty finance shops responded with the following idea: "Hey, we could securitize the higher LTV stuff, too!" The market began issuing more secondary loans to meet borrower demand for proceeds. CDOs began including stacks of bridge loans, mezzanine loans, B-notes and preferred equity.
These trends were a boon for loan-selling sponsors utilizing warehouse lines of credit to juice returns pending a securitization exit. Balance-sheet mezzanine lenders, particularly those of the unleveraged variety, struggled to win business when mezzanine interest rates reached single digits.
Investors in these higher-risk securities and whole secondary loans enjoyed the yield but were largely financial investors (not real estate operators) that were unprepared for the downside events of default and property-level workouts. And they were often leveraged to the brim.
CMBS distress
These mechanisms for removing loans from originating lender balance sheets worked well as long as default rates were low and investors were willing to buy paper. Hedge funds swallowed the largest amount of real estate paper by, for example, increasing their shares of new purchases of BBB-rated CMBS paper from 25% to 70% over a five-year period.
Yield was king, almost without regard to underlying fundamentals and risk. Then we began hearing the word "subprime" on the nightly news. The great unraveling had commenced. Losses on subprime put pressure on leveraged buyers of all other types of asset-backed paper, reducing demand for new securitizations.
Existing warehouse lines were called in, forcing distressed sales of securities. Access to new warehousing facilities for leveraged buyers was virtually eliminated. Almost overnight, the cost of capital for the movers of loans was approaching or exceeding the cost of capital for loan storage companies.
In today's environment of tightening credit and weakening economies, we are seeing the importance of paying attention to the old fundamentals of real estate.
Lender focus has returned to considerations of supply and demand, strength of sponsor, location, physical quality, debt service coverage ratios based on actual in-place income (not projected income), and to ensuring that borrower exit strategies are possible through refinancing (not only sale) of the property. In other words, prudent underwriting standards have been reinstated.
Unfortunately, it appears that the capacity of first-mortgage balance-sheet lenders may be insufficient to fill the gap in a retrenching market caused by the sudden near absence of conduit lending. CMBS lenders issued $230 billion in the U.S. in 2007. During the period of January to March 2008, this domestic production had fallen to $6 billion.
CMBS lenders constituted nearly 30% of the overall commercial and multifamily mortgage market in 2007, while life insurance companies were only 9% of the market in 2007. This estimate includes all loans, meaning the measurement includes the recourse bank market, constituting somewhere around 40% to 45% of all commercial and multifamily loans.
Of the institutional, nonrecourse market, the market share of CMBS was substantially greater. That leaves a rather large debt hole to fill, especially considering that average LTV ratios, meanwhile, have fallen dramatically.
As an illustration, it was quite possible in early 2007 to source 90% LTC first-mortgage financing. Today, many borrowers will struggle to find nonrecourse loans in excess of 70%.
For borrowers and lenders attempting to close mutually beneficial transactions during the balance of 2008, there will likely be a greater need for mezzanine financing, preferred equity, B-notes and transitional/bridge loans. From a borrower's perspective, certainty of execution and cheapest cost of capital will prove paramount, and likely in that order.
Abundant equity
These new rules may be especially true for borrowers of bank construction loans coming due over the next few years. The math here is troublesome, even for projects on track to meet lease-up objectives.
Take, for example, a bank loan taken out one year ago for construction of a new retail center. Assume the total cost is $10 million and the borrower sourced an $8 million first mortgage. Further assume the borrower has leased the project to target occupancy at market rents, resulting in a 7.5% return on cost (NOI yield).
Then, the borrower goes to the market for a permanent take-out loan. The new first mortgage lender decides to use an 8% cap for appraisal purposes and will only fund a 70% LTV mortgage in the new credit environment.
Setting aside vacancy allowances and other reserves to keep the math simple, the lender would value the property at $9.375 million and the quoted take-out loan would equal $6.56 million, leaving a nearly $1.44 million refinancing shortfall. For the borrower and lender to avoid a foreclosure or difficult workout process, this gap would need to be filled by fresh borrower equity or third-party preferred equity or mezzanine debt.
This story will likely be repeated across an unfortunately large percentage of construction loans maturing over the next few years, putting further pressure on the traditional banking sector.
Because much of borrower demand for mezzanine financing was being filled over the past five years by purely financial investors seeking yield, it remains to be seen whether the combined debt and equity capital in the market will be sufficient to fill these refinancing shortfalls.
Most industry observers share the general sense that we are witnessing an environment of abundant equity waiting for reasonable risk-adjusted returns, contrasted with a market struggling to locate sufficient first-mortgage debt proceeds.
While some financial buyers (hedge funds, banks, foreign investors) have reorganized themselves as distressed-debt buyers, it's fair to say that overall hedge fund interest in new CMBS issues has declined precipitously.
At the beginning of this decade, very few CMBS issues contained mezzanine components. By mid-2007, nearly one-third of CMBS transactions were structured with a built-in piece of secondary financing, whether in the form of stand-alone mezzanine loans or B notes structured within the first mortgage.
In contrast to the early days of mezzanine financing, most recent-vintage loans were issued by leveraged buyers planning a securitization exit. Commercial real estate CDO markets have been selling $30 billion to $50 billion of paper in recent years. The CDO market is almost completely stalled as of this writing. Estimates for full-year-2008 domestic U.S. CMBS issuance generally range from $50 billion to $75 billion (again, compared to $230 billion in 2007).
Selectivity
We could be looking at a hole created by the slowdown of the securitization markets totaling over $200 billion. And this doesn't account for the huge impact of reduced LTV ratios being offered by first mortgage lenders still actively closing loans. In the case of most life companies and bank lenders, actual LTVs have dropped from 80% to 65% or less from 2007 to 2008.
While the market seeks a new level, one positive sign for those concerned with liquidity comes from the number of large value-added and opportunistic funds that have decided they prefer the risk-adjusted yields on secondary financing to that of their traditional equity investments.
Some estimates peg total commercial high-yield debt funds operating today at $35 billion. To the extent that these groups bring operating expertise to the table, this trend can only help to strengthen the fundamentals of the marketplace. Unfortunately, this still leaves a large overall gap in the debt markets. Some of the gap will be filled with equity, and some borrowers may have significant trouble sourcing cheap capital for new acquisitions and refinancing transactions.
Correspondingly, for mezzanine lenders with capital available, deal flow is continuing to increase. Prevailing interest rates have increased from the low teens in 2007 to mid-teens today (for difficult assets, upper-teen rates are possible). Mezzanine LTV ratios have in many cases decreased from mid-nineties to mid-eighties or lower.
In addition, mezzanine lenders are becoming more selective, seeking quality borrowers, well-located projects and shifting away from development and toward existing, income-producing properties.
If you are a first-mortgage lender interested in protecting your existing loan collateral, it is time to pay attention to the possible exit strategies for borrowers of maturing loans. For new originations where borrowers require proceeds above those available from first mortgage loans, the qualifications of the mezzanine provider are increasingly relevant.
Borrowers are seeking mezzanine financing to increase or maintain existing leverage; on the flip side, senior lenders are seeking out mezzanine partners to assist them in dialing down their first-mortgage exposure. Mezzanine lenders with strong balance sheets and operating capability will prove helpful to borrowers by filling capital gaps and to senior lenders by providing a layer of insulation and acting as a back-up borrower in the event of further deterioration in market conditions.
Commercial real estate lending is returning to its roots. The balance-sheet lenders are back.
Rance Gregory is CEO of NBS Real Estate Capital, a Portland, Ore.-based investment management firm that provides equity, preferred equity and mezzanine financing throughout the western U.S. As the discretionary manager of the Morrison Street series of funds, NBS Real Estate Capital places investment capital on behalf of pension funds, foundations, trusts, and high-net-worth individuals and families. Gregory can be contacted at (503) 952-0745 or rgregory@nbsrecapital.com.
