The Re-emergence of Mezzanine Finance in the Property Industry

Mezzanine finance in the property industry all but disappeared in the days of easy credit and commercial mortgage backed securities. In their eagerness to compete with each other, lenders offered increasingly aggressive funding terms at ever lower margins, ultimately pushing mezzanine lenders out of the market. With senior debt gearing as high as 90% on commercial investments and wafer thin margins, mezzanine players simply had nowhere to go and the period between 2005 and 2007 gradually saw the disappearance of what had once been a most useful tool in the structured financier’s kit. Bernard Frazer, Partner at Red Chilli Structured Finance looks into the resurgence of this much needed tool.

Mezzanine in Commercial Property Finance

Mezzanine finance used to play a very important role in real estate funding as it covered a critical part of the capital structure. With the increasing liberalisation of the finance markets and a growing appetite for higher returns on the one hand, and property investors’ desire to improve return on their capital on the other, mezzanine finance boomed in the early part of the decade to bridge the gap between traditional senior debt and equity. By 2006, most large institutions had pulled together very substantial mezzanine funds to capitalise on growing market demand. In the days where senior lenders would typically baulk at gearing in excess of 70%, there was a natural slot for a debt provider prepared to be pushed up the risk curve for the right price while still ranking ahead of the borrower whose equity would bear the brunt of risk.

With the advent of CMBS and off balance sheet lending, senior lenders aggressively pushed the gearing boundaries. With very keen yields (sub 5% being the norm in most asset classes) and cost of funds at or over 5%, debt service cover ratios were being driven down to dangerously low levels squeezing mezzanine out of the market. And by 2007, mezzanine risk which would have typically attracted margins of 4% to 10% was regularly met by senior debt charging margins in the sub 2% range. Most mezz players ended up pulling out of the market.

Mezzanine Finance Post Credit Crunch

What a difference two years make. With extremely tight liquidity in the financial market and banks fighting to recapitalise their balance sheets, senior debt finance has retreated to timid gearing levels not seen in years. The uncertainty surrounding the broader economy and the property markets has led lenders to reduce their LTV ratios well below 70%, and that is when they are willing to lend. In parallel (and as a direct result of the crunch), yields have weakened significantly while costs of funds are now at historic lows so, with yields regularly over the 8% mark and 3 to 5 year swaps currently hovering between 2.5% and 3.3%, the debt service cover ratios are looking to be in rude health.

Ironically, this is now leaving a very wide gap in the capital structure where mezzanine would once have fitted nicely and, on the strength of current ratios, could have been serviced very comfortably. Unfortunately, the market has been deserted by most mezzanine funds and a potentially very large demand is being met with great difficulty.

A number of small institutions has however spotted the gap in the market and have grown very active over the last 10 months or so. Red Chilli has been working hand in hand with a few such lenders to develop a number of products targeting various types of mezzanine needs in the commercial property market. The new breed of mezzanine lenders remains small in numbers andfaced with great demand will be choosy as to which projects they agree to back, but back the right projects they will. And because they are small and tend to be entrepreneurial, they are generally able to move quickly and, although their pricing reflects the current lack of liquidity at the sharper end of the capital structure, they are very effective and can be extremely useful in a variety of ways.

In an environment where yields are higher and costs of funds have dropped significantly, most investments have sufficient surplus to service a mezzanine loan. Some senior lenders are still prepared to offer interest only facilities for the first few years, leaving ample room for highly geared junior facilities. In the anticipation of yield compression and of a loosening of financial markets and of gearing criteria over the next 3 to 5 years, many investors are prepared to resort to mezzanine. Even though it is expensive, it allows them to sweat their equity and acquire more investment properties than they would otherwise be able to in what is arguably the best buyer’s market in a generation. There are however limits as to how far mezzanine will stretch and it is clearly not suitable for all investments. For the right opportunities though, gearing of 85% and possibly higher is achievable.

Typical uses for mezzanine finance in the current market

The interesting aspect of the new mezzanine market is that the lenders come from different walks of life including:

• reconverted property equity funds
• bridging finance specialists
• corporate venture capital providers
• frustrated investors struggling to secure investment opportunities who are willing to inject mezz slices into other parties’ projects
• and of course a few were into mezz lending all along.

This makes for a very interesting mix of lenders with appetite for different types of projects. Most share a very pragmatic approach to evaluating opportunities and are a far cry from the institutional mezzanine lenders of old with rigid investment criteria. This has opened up opportunities for property professionals in search of highly geared funding. Red Chilli has been working with those mezzanine lenders present in the market and introduced a number of products. A few are listed below.

• New investments where the principal does not have enough capital to top up the senior facilities offered by timid lending institutions.
• Investments where an existing long term senior facility has reached its term and whose exit gearing cannot be matched in the current climate
• Ongoing investments where breached covenants cannot be repaired by cash poor principals
• Ongoing investments where, given current swap rates, it would be beneficial to lock in at a new lower rate, but doing so means losing a highly geared facility and replacing it with a lower geared loan and/or breaking the swap at a cost the principal cannot afford.
• Bridging commercial loans (open-ended or closed)

The lenders the Red Chilli team is working with can be flexible in the way they structure their involvement, whether they act as mezzanine providers or enter a formal JV with the borrower, require a high fixed coupon or a smaller coupon with additional look back IRR, no coupon but an equity stake, convertible loans etc… They will look at most asset classes and also consider quirky opportunities where the real value of the deal may be in a planning play.

Mezzanine for development funding

Another positive development in the property markets has been the re-emergence of mezzanine for property development. As there is growing belief that property values are now stabilising, particularly in the residential sector, a number of the smaller mezzanine lenders have started venturing into development funding either supporting new projects or coming to the rescue of distressed projects.

Mezzanine for new residential development projects:

For those developers that have limited equity to inject into a new project, a mezzanine loan may be the best way to stretch funding options. Gearing of up to 70%-75% of GDV can be achieved but this clearly comes at a cost. The mezz slice can be priced in a number of different ways from a fixed rolled up coupon to a look back IRR, a fixed priority exit fee or any combination of the above. This type of structure is very flexible and allows developers to spread their equity more thinly without having to pledge a portion of their profits. The number of mezzanine lenders in the current market is nevertheless limited and they tend to be small institutions with well defined lending criteria. Pre-sales are always going to make a residential development project more attractive and help a borrower achieve higher gearing, however, provided demand is healthy, they are not necessary. It is fair to say that different lenders will have appetite for different types of projects but Red Chilli can help borrowers find the appropriate funding partner for their project.

Mezzanine for new commercial development projects:

In the current market, it will surprise no-one that speculative commercial developments are extremely difficult to fund, if at all possible. However, a pre-let or pre-sold development can attract reasonably aggressive gearing from a mezzanine lender provided they can get comfortable with the developer’s track record and the strength of the parties guaranteeing the exit. Any lender will always insist on the developer leaving a reasonably substantial hurt slice but gearing of up to 80% of costs is generally achievable. The pricing mechanism for this type of loan can vary but will tend to be along the same lines as for loans for residential developments.

Mezzanine for distressed development projects:

In the current economic environment, an increasing number of development projects are experiencing financial difficulties due to the fall in property values (and therefore often the breach of LTV covenants) or a lack of equity. Some lenders have identified an opportunity to inject cash into such projects. They are willing to get involved and work hand in hand with the lenders in place to restructure existing facilities and provide the necessary resources to bring projects to fruition. They target developers who anticipate difficulties in the completion of a project, but also lenders who may no longer be able to continue funding a project or find themselves in a position where they may have to step in.
There are no typical terms for such loans as they will depend highly on the level of distress, geography and sector but it is very encouraging that mezzanine lenders are prepared to fill what is likely to be sustained demand for the foreseeable future. The fact that senior lenders are now pro-actively soliciting Red Chilli and its mezzanine lenders for amicable rescue solutions allowing existing developers to remain involved in their projects rather than pursuing a more litigious solution is also a very positive development.

In conclusion, the re-emergence of mezzanine lending is very good news for the UK property market as it likely to bring some badly needed liquidity into the market by providing pragmatic solutions to delicate situations or simply fostering an overall resurgence in activity in both the investment and developments arena.

Bernard Frazer is a Partner at Red Chilli Structured Finance, an independent property finance advisory firm specialising in arranging funding for property projects in the UK and Europe.

He can be contacted on 0845 210 5000
www.redchilli.com

Red Chilli Structured Finance
Minories House
2-5 Minories
London EC3N 1BJ

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