Moritz Kraneis, CEO and co-founder of Deutsche Zinshaus Group, writes how things are from the perpective of a mezzanine investor when things go wrong.
'The low interest rate years were a golden era for many mezzanine financiers and other alternative capital providers operating in the real estate markets: Actual prices were way ahead of regulatory loan-to-values. Not least for regulatory reasons, banks limited themselves to senior loan tranches with low loan-to-value (LTV) and low liability risk, while many investors tried to optimise their equity returns with a high proportion of debt.
The resulting financing gap was readily filled by junior and mezzanine lenders. The returns were comparatively high and the risks were considered by many to be of a rather theoretical nature.
However, the situation has now changed significantly. Triggered by the sharp rise in interest rates, numerous projects have run into difficulties.
Many a mezzanine financier, credit fund or institutional investor with a direct lending portfolio is now faced with challenges. Existing properties are being devalued, in some cases significantly, and many project developments are no longer profitable.
Consequently, some are now unexpectedly finding themselves responsible as (partial) owners.
However, not everyone is willing or able to take on the intensive asset management required for this. In the worst-case scenario, their capital is at risk of disappearing just like that of the equity investor.
The higher interest rates have also caused capitalisation rates on the real estate markets to rise. This has been mirrored by a fall in purchase price factors, which, as multipliers of rental income, play a key role in determining the valuation.
If this cannot be counteracted by increasing rental income, the valuation falls almost automatically. If the equity ratio is too low, equity can quickly be eroded. Then the subordinated or mezzanine capital provider is unintentionally at the very front of the so-called liability cascade.
The situation is even more challenging for ongoing project developments. In many projects, construction and financing costs are rising, while at the same time it will probably no longer be possible to realise the previously anticipated sales prices.
If unforeseen delays or cost increases occur, the original project company must inject additional capital, which it may no longer be in a position to do. In the worst-case scenario, however, the construction work will then come to a standstill - and the costs will get even further out of control.
Mind you, this is a development that affects the real estate markets in general, but particularly so in project developments and in cases of (too) tightly calculated financing for existing properties. But what can impacted lenders do?
Swift action is essential
First and foremost, alternative financiers and mezzanine capital providers affected by such imbalances must act quickly, if only to avoid unnecessary and expensive construction delays.
Moreover, the mezzanine share of the total financing is often not particularly large and can also be used up quickly. The senior tranche, on the other hand, which has priority and is secured by the land register, is held by the credit institutions, and once this has to be liquidated or even become insolvent, mezzanine lenders are usually faced with a total loss.
Acting quickly means actively and constructively exchanging ideas with the senior lender, who also wants to avoid insolvency at all costs, adapting the financing structure and if necessary, seeking new financing partners.
In practice, this may mean taking on the role of sole owner or assuming responsibility for the project as such together with a new joint venture partner.
Suddenly assuming the role of owner - expertise is required.
The mezzanine lender then unexpectedly finds itself in the role of portfolio holder or project developer. However, many providers, such as debt fund managers or semi-professional and smaller institutional investors, reach the limits of their business model and abilities: a portfolio property and even more so an ongoing project development require professional and experienced real estate asset management, which they are often unable or unwilling to provide.
It's like an accident: the plan was never to own and manage a property or even an entire portfolio, but simply to finance it over a manageable period and on fixed terms.
Furthermore, if the project developments are stagnating or if there are stranded assets involved, "simple" asset management will not suffice.
Restructuring experience is then essential, but hardly any mezzanine investors can provide this in-house. Expertise in handling non-performing loans (NPLs) and workouts is certainly helpful. But it is precisely this emergency situation that needs to be prevented with targeted restructuring measures.
If the unexpected real estate owner does not want to have to sell his asset in this current market, he needs real estate expertise above all.
Mezzanine lenders who lack this real estate asset management expertise basically have three options. Firstly, they can sell their asset and realise losses in value up to a potential total loss; in many cases, the worst case scenario.
Secondly, they can look for a joint venture partner and therefore reduce the loss in value but they must also continue to share control in future.
Thirdly, they can come to terms with this unexpected property ownership and secure the requisite real estate expertise from an external partner. This will enable them to gain the time they need to have their asset professionally restructured and to sell it in a more favourable market phase.'
