Restructuring the Capital Stack: Super Mezz to the Rescue
By: Robert (Bob) H. Voelker Over the last decade, many real estate transactions were financed with a three part "capital stack" involving a small amount of developer equity, a conventional bank loan and a third component — a "mezzanine loan" that, due its subordinated lien position (or lien only against the ownership interests in the entity holding the real estate), functioned as equity for the banks' loan-to-value calculations. Given the higher risk profile of this mezzanine loan position, the mezzanine loan received a higher rate of interest than the bank debt, and also had a participation feature in development profits (either directly on the mezzanine loan or through a separate preferred equity investment by an affiliate of the mezzanine lender). A representative deal might have 10% developer equity, 60% bank debt and 30% mezzanine loan/equity. Frequently, the mezzanine lender was the real estate investment arm of a Wall Street investment bank, and these funds were raised from pension fund or life insurance company investment allocations to real estate. These real estate allocations are typically capped as a percentage of the overall value of the pension fund or life insurance company investment pool (the "real estate allocation cap"). The presence of the mezzanine lender/equity partner was comforting to conventional bank lenders for two reasons. First, the subordinated feature of this investment lowered the banks' exposure as a percentage of the total development cost or value. Second, the banks felt that these institutional investors would be better capitalized than most developers and would put up additional funds if needed to support the investment and keep the first lien loans current. The current recession is testing these presumptions. As the value of stock and other investments in their portfolios have plummeted, dragging down the overall value of their investment pools, these institutional investors are bumping up against their real estate allocation cap (the so-called "denominator effect") and cannot continue to prop up their real estate investments that need additional capital. And with decreasing rents and sales volumes drying up, owner/developers are facing cash shortages of their own. In the midst of this turmoil, there are reportedly billions of dollars of real estate capital sitting on the sidelines looking to capitalize on distressed real estate, but banks are unwilling to write down and sell loans, resulting in a huge bid/ask differential where the capital wants a higher rate of return (lower purchase price) than what current distressed owners and their lenders are willing to accept. Lenders are working with their borrowers to avoid writing down these loans by entering into forbearance agreements and loan modifications/extensions. For the last year to 18 months, this exercise has largely been "triage," literally putting band aids on walking wounded real estate developments hoping that the patient will survive until the economy turns. Lately, banks are starting to exert more pressure on real estate owners to pay down loans and provide additional reserves to carry the development through this extended recession. In many cases the property cannot be sold, at least in the current environment of very little new lending, for anywhere near the balance of the first lien and mezzanine loan/equity. The developer has very little cash, and the mezzanine lender is refusing (or is unable) to lend additional funds. The banks do not want to foreclose as they will likely end up holding the property for an extended period of time, and banks are historically not efficient at maximizing the value of real estate. If the property is worth more than the first lien loan (which may be a problem for many properties developed or acquired in the last three to five years), an emerging resolution to this stalemate is for this sidelined real estate capital to come "into the middle" of these transactions — providing a "super mezzanine" loan with a high rate of interest and equity stake in the profits of the development — in exchange for the old mezzanine lender/equity partner subordinating its interest to this new money. In essence, the new “super mezzanine” lender takes a second lien position and the old mezzanine lender is "pushed down" in the capital stack and its lien priority moves from second to third position. The new money is sometimes used to make a small pay down of the principal of the first lien loan and set up an interest/taxes/insurance reserve with the first lien lender — giving the first lien lender a reason to extend/modify the loan. The funds can also provide capital to the owner for operations, tenant finish out, leasing costs, etc. |