The liquidity crisis has opened a window of opportunity in mezzanine debt where investors can get equity-style returns without taking equity-style risk, as Adam Calman reports

Cushman & Wakefield Corporate Finance has  recently completed an in-depth study on the commercial real estate mezzanine debt funds market place. It is arguably one of the most topical and contemporary real estate finance issues of the moment.

The opportunity to invest specifically in such a choice of mezzanine-specific funds is a recent phenomenon, previously only partially achievable through investment into an opportunity fund. The current turbulence in the financial markets has created an opportunity to invest in the global mezzanine sphere and allows equity-style returns without taking equity-style risks.

The research undertaken by Cushman & Wakefield has uncovered more than 40 funds actively raising equity in Europe, Asia and the US specifically, as well as a variety of global mezzanine opportunities.

Severe disruption in the real estate credit markets since mid 2007, most particularly in the US and parts of Europe, has led to a general repricing of risk and a corresponding reduction in liquidity. This has been driven by the backlog of unsecuritised debt still sitting on the balance sheets of those issuing banks and the increasing costs of inter-bank lending rates.

Senior loans secured against real estate now require lower loan to values (LTVs) and higher interest cover ratios, resulting in mezzanine or subordinated debt now being more senior in the capital structure.

Additionally, substantially wider margin pricing, stricter loan covenant packages and other structural features, together with higher arrangement fees, are now commonplace. The recent significant improvements in lending margins are allowing so-called ‘mezzanine' debt to provide equity-style returns without equity-style risks.

This is expected to continue for the foreseeable future - 18-36 months in our view - both as a result of the exit of real estate collateralised debt obligation (CDO) operators who were the most active buyers in this arena as well as the ongoing constraints provided by the requirements of Basel II, which have made it extremely unattractive for banks to hold loans above 50-60% LTV on their balance sheets.

In addition, it is expected that it will take some time for the commercial mortgage-backed securities (CMBS) market to re-open in any significant fashion and the commonly held view is that, when it does, the terms will be much more conservative than in the recent past, and with wider pricing.

There is therefore the opportunity to both acquire existing commercial real estate debt and to write new loans such as B-Notes, mezzanine loans and CMBS bonds at  around 60-75% LTVs, each supported by high-quality and performing real estate at attractive absolute returns.

With gearing of more than 60% available on the less risky tranches, net IRRs (internal rates of return) to investors (after all fund management fees and promote structures) should be available in the 12-15% range.

What is real estate mezzanine? In its simplest form, any mezzanine loan is a loan that covers the gap between where a senior lender is willing to lend and the amount of equity an investor is willing to provide. It is therefore more risky than a senior loan but less risky than equity and should, as a consequence, receive a return somewhere between the two.

Cushman & Wakefield has recently identified approximately 40 funds in various stages of fund raising, where a significant proportion of their capital is destined for investment in these mezzanine pieces. Funds specialising in distressed debt (so-called ‘loan to own' funds) and those investing in largely investment grade debt are not included, although they are also significant. If all of these funds were fully successful the amounts raised would be as illustrated in figure 1.

If all debt, preferred equity, distressed debt and opportunistic funds explicitly mentioning mezzanine are included there is perhaps an additional $25bn or so of equity trying to be raised, almost all for investment in the US. The total US CMBS market is estimated to be around $750bn, giving a total market size of $3,000bn, assuming CMBS comprises 25%1 of the total.

Figures 2 and 3 indicate CMBS issuance since 2004 together with their final maturity profiles. A related, but potentially somewhat more complex problem, it is the profile of the vintage of these expiries that is providing existing borrowers with the most concern, especially given the current potential reluctance or inability of their lenders to roll or refinance those loans. More than $700bn of CMBS has been issued since 2004, although only $12bn was issued in H1 2008.

Market size - Europe

The total European commercial real estate loan market is estimated to be over €1,300bn.2 European CMBS market share is estimated to be c.10% of the loan market.
Current and anticipated pricingSince the credit crunch, the typical capital structure has changed. The movement in margins and re-alignment of LTVs are show in figures 4 and 5 for both the European and US debt markets.

US senior loans are now priced at 250-400bps margins compared with only 80-100bps before the credit crunch with LTVs largely unchanged. In Europe, margins for senior loans have risen from 90-125bps to 125-175bps with LTVs now around 15% lower.

Pricing on new mezzanine loans or B-Notes is also highly attractive with margins of 400-1200bps now available in the US (cf 175-400bps) with similar pricing available in Europe. Although margins have not widened in the same proportion as for CMBS, significantly better arrangement fees, covenants and other structural features are now available in compensation.

BBB tranches of CMBS debt in the US have been trading for much of the current year at margins of 1400-1600bps compared with their historical average of some 200bps and have recently traded at historical highs of around 2275bps or 11x the average. This would provide unleveraged project level IRRs of around 20% for loans held to term, assuming no defaults. Similar pricing is also available in Europe.
Key performance drivers
It is important to understand the key performance drivers for successful mezzanine investing. They include:

Avoidance of default on the loan itself; Recovery rate on principal of the loan; Margins and effective margins; Early exit from the loan; Gearing/leverage on the loan; Asset management charges and performance fees.

The primary key to successful subordinate investing is to avoid defaults. Even a 10% margin for three to five years will not cover the principal loss in a default, unless the recovery rate is very high. Investors must also appreciate the principal risks to achieving their targeted IRRs, which can be categorised as: Deal sourcing risks relating to the manager expertise and market presence; Defaults on underlying investments during the investment term; Gearing and re-gearing risks; Forced exit on loan positions held and their timing; Pressure to reinvest fund capital close to the end of the fund life; Interest rate and currency risks.

How long will this opportunity last? There is a widely held view that the opportunity to invest in non-investment grade debt, CMBS, mezzanine debt and/or B-Notes will last for the foreseeable future, which in our view is 18-36 months.

It is also clear that once the backlog of existing/warehoused CMBS tranches is cleared, the current disparity between CMBS and B piece pricing is unlikely to be sustained for a significant time frame, unless economic conditions worsen significantly.
There are a number of compelling reasons to consider an investment into the real estate debt space.

The projected risk adjusted returns of 12-15% provides a potential investor with attractive equity style returns without taking equity risk. There are a number of funds currently actively raising funds to capitalise on this window of opportunity, many of which are experienced fund sponsors with strong track records.

Similar mezzanine-style returns should generally be available in both North America and Europe, providing a diversified investment strategy. The choice of manager should be driven by the quality of the sponsor, the ability to source attractive deals and the ability to  correctly analyse, value and manage investments.

1 Goldman Sachs
2 Prudential M&G

Adam Calman is partner, capital markets, 

Cushman & Wakefield LLP