Mezz Debt’s Steady Advance in Risk

It’s no secret that investors seeking yield are flooding the private real estate debt market with capital for mezzanine loans. There’s no shortage of capital anywhere in the commercial real estate market. But mezzanine lenders, who supply the capital tranche between senior mortgages and equity that often allows deals to get done, are finding themselves on the front lines of a steady advance in risk as yields continue to retreat. In fact, 2015 may be the year mezz lending reaches a town—or a townhouse—near you as investors head for secondary and tertiary markets and commit capital to projects that fall below official minimum investment thresholds.

“More players are entering the mezz space, resulting in increased competition to win deals,” says Max Friedman, senior vice president at Dekel Capital, a Los Angeles–based merchant bank focused on commercial private equity real estate and complex financing structures. “GPs are expanding their lending to include projects that involve construction or a heavy value-add component, while lenders and investors are also going below traditional thresholds with respect to investment sizes.” Returns are the big draw for investors. While there’s no central source of data on mezz rates, recent deals give some indication of the potential. Apollo Commercial Real Estate Finance, Inc., for example, recently obtained mezz debt on projects secured by senior housing and a hotel; the loan-to-value ratios were 70 percent and 74 percent, and will yield approximately 10 percent to 11 percent. There’s no escaping the major trend in the real estate industry. With private equity managers already sitting on record dry powder across all strategies—data provider Preqin says uncalled capital rose $30B in 2014 to $217B—fund managers report more competition for capital, and investors, managers, and consultants alike say it’s harder to find attractive investment opportunities.

Michael Hurst, co-managing director of real estate lending with Karlin Real Estate, a Los Angeles–based family office and real estate investment firm that provides senior and mezzanine financing for the acquisition and refinancing of opportunistic and transitional assets in the U.S., says something has to give. “Here is the simple truth,” says Hurst. “The one thing that doesn’t change is the cost of capital. Most investment vehicles, especially those with institutionally driven capital, have return targets that don’t change.”   As a result, Hurst says, investors will do one of two things. Some will “take more risk in the asset by going to tertiary markets, using higher leverage, or financing more transitional assets.” Others will “take advantage of more aggressive capital markets and seek more leverage from line lenders or senior tranches.” Either way, “some lenders inevitably will cave in to pricing pressure and accept tighter yields,” he says. Although many investors are pursuing mezz opportunities, some are bound to be disappointed. “It takes a surgical focus on strategy, with a dedication to the space, to be successful,” says Hurst. In the meantime, as long as benchmark Treasury rates remain low, “we should expect to see further yield compression,” says Friedman. “Especially as mezz lenders seek to deploy capital.”