Mezzanine loans are similar to U.S. military conflicts: They are fairly easy to get into, but much more difficult to get out of. You can get a mezzanine loan from many places, but the art of the business is structuring a loan with a defined exit strategy, the appropriate structure, and pricing that reflects the risks of the transaction for all parties.
When analyzing mezzanine loans, our company always begins with the exit in mind. We divide mezzanine loans into two types: stabilized transactions or value-added properties.
Stabilized properties, which are at least 90% leased and have a well-diversified rent roll, are much easier to underwrite for mezzanine loans. This type of mezzanine financing is most common at the time of origination of a long-term, fixed-rate first-trust loan. In these loans, lenders are not looking for anything “good” to happen; they are just hoping nothing bad happens to the already stabilized property’s cash flow.
Mezzanine loans for value-added properties are more difficult to underwrite because cash flows are not stable, and typically the repayment is contingent upon something “good” happening at the property level that will increase the project’s cash flow. In these situations, the lender must underwrite the property or market-level “event” that is going to lead to an increase in the net operating income (NOI). The lender is counting on “good things” to happen, so that the NOI will increase and a loan will be in a position for permanent refinancing or the property will be sold.
Consider the risks
In mezzanine lending there are only three types of exit strategies a lender can plan for: refinance, sale and self-amortization.
A refinance exit is the most common and preferred exit strategy for mezzanine lenders. The refinance strategy typically will be underwritten to commercial mortgage-backed securities (CMBS) standards, which provides a level of market certainty. The biggest risks in a refinance exit strategy are the property’s achievement of its pro forma results and the interest rates of the refinancing loan at the time of maturity.
Because interest rates are unpredictable, value-added mezzanine lenders will protect themselves by “stressing,” or increasing, their underwritten interest rate above the market rate at the time of underwriting. The amount of this stress depends on the term of the loan and the current interest rate environment, but most mezzanine lenders will add 50 to 100 basis points per year.
The sale exit generally works when the refinance exit won’t. It is predominately used when developers have borrowed more than 85% or 90% of the capital structure. Sale-exit transactions will typically command higher pricing because the repayment possibilities are more limited and riskier (see sidebar). These risks include whether the market is hot when it’s time to sell, the strength of the capital markets after the sale, and the cap rate at the time of the sale. Your mezzanine lender for a value-added transaction likely will underwrite to a stressed-exit cap rate to mitigate the risks.
A self-amortization exit involves the full repayment of the loan from the property’s cash flow. This strategy is not typically used because most projects do not have sufficient cash to repay the loan in full over a relatively short period of time, and most lenders do not want to make long-term mezzanine loans.
When underwriting a mezzanine loan, a lender will need to be comfortable with the underlying senior financing. A mezzanine lender will prefer the first trust loan to be fixed rate, thereby providing some certainty to the debt service and cash flow available to pay the mezzanine interest and/or amortization.
The mezzanine loan that is hardest to get underwritten and is the riskiest is a value-added mezzanine loan behind a floating-rate first-trust loan. In this case, your mezzanine lender must underwrite the value-added plan of the property, the interest-rate risk of the first-trust loan, and the interest-rate risk of the mezzanine loan.
Beginning with the exit in mind is a good practice for those seeking mezzanine loans. If this is done correctly, both the borrower and lender will be happy with the outcome and will reduce the chances of the loan ending up in the work-out department.
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