Research. Bridging the Gap: Mezzanine Financing PREI. Executive Summary

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1 PREI Bridging the Gap: Mezzanine Financing March 2009 Research Peter Hayes, PhD Director of Research, Europe London Office Tel +44 (0) Fax +44 (0) Executive Summary Mezzanine lending involves commercial real estate assets that are at least partly secured. Its place in the capital structure is sandwiched between the senior debt and the equity. Mezzanine financing is attractive to borrowers because it provides them a source of funds with higher leverage and a potentially lower overall cost of capital, without significantly diluting shareholders control. As a rule, mezzanine finance can be used on any real estate asset. Lenders are attracted to mezzanine financing for its versatility. Mezzanine debt can sit anywhere within a real estate investors portfolio, and loans can be structured precisely to each investment opportunity, which can help reduce the risks. Mezzanine lending appeals to investors because it offers the yield of an equity investment with the protection of being in a creditor position. However, it can be difficult to categorize because of the differences in individual transactions with respect to the characteristics of the underlying real estate asset, the structure of the loan, risk management and expected returns, which can vary between 10% and 20% or more. Ultimately, mezzanine deals are complicated, so it is vital for investors to perform detailed due diligence and draft airtight documentation, such as inter-creditor agreements. Financial expertise and real estate know-how are both key components of success, particularly in deals that are further along the risk spectrum. Introduction 8 Campus Drive Parsippany, NJ USA Tel Fax Web The commercial real estate debt markets are undergoing a monumental shift in Europe. Gone are the days of cheap and easy credit that prevailed in the leadup to the global credit crisis. Banks are broken, and it may take three to five years to repair balance sheets. What s more, banks must sort through new regulations such as Basel II, which makes it too expensive for them to write high-leverage debt. The upshot is a debt shortfall that has helped paralyze the transactions market and push prices of class A properties down more than 30%. However, the shortfall also presents an opportunity for investors to provide mezzanine financing in place of banks that are now averse to the risk. The lack of supply of mezzanine capital is so severe that it has created an unusual situation in which some tranches of debt have an extraordinarily high return relative to the return on equity. The supply shortage could indicate a deficiency of investor knowledge about the product. This paper will provide

2 basic information on mezzanine lending in the context of European real estate, why it is attractive and what type of structures are likely to be used in the market. Mezzanine Lending Mezzanine debt encompasses lending against commercial property that is at least partly secured and sits between the borrowers equity and senior debt in the capital structure. When properly structured, it is less risky than investor equity but more risky than senior debt. But mezzanine lending is different from both because of its versatility. Loans can be tailor-made to address the risks and returns associated with individual transactions. For the lender, repayments can be coupon-driven or dependent on the profits of the equity investor, or some combination of the two. Because of where it sits in the capital stack and how it is structured, mezzanine lending offers the yield of an equity investment with the protection of being in a creditor position. Exhibit 1: Mezzanine In the Capital Stack Stylized Capital Structure for a Real Estate Asset with Mezzanine Debt Stylized Risk-Return Trade-off with Mezzanine Debt Investor Equity Return Investor Equity Mezzanine Debt Senior Debt Senior Debt Mezzanine Debt Risk The Case for the Borrower Mezzanine provides another source of capital for borrowers. It enables them to use higher leverage and maximize returns on equity, without diluting shareholder control. And it can be structured in a way to suit their needs. Borrowers can take out multiple layers of mezzanine financing on individual properties, each with a different claim on the asset. The flexibility makes mezzanine a potentially superior form of financing than senior debt or equity. A lower cost of capital increases profits and makes viable projects that otherwise might be too costly to undertake. How can mezzanine financing reduce the cost of capital? It has to do with the limits to senior debt and equity. For senior debt, the cost of borrowing is fixed regardless of the loan-to-value (LTV) ratio (up to a maximum). Equity investors typically demand a high minimum return on their investment. This means for any given transaction, there can be a large gap between where the cost of debt stops and where 2

3 PREI the cost of equity starts. Mezzanine finance can break up this inefficient divide, because the costs of capital are not totally aligned with the risks of investing. An investment position between senior debt and equity that carries a yield between the two can provide for a better alignment of risks and a lower blended cost of capital. Exhibit 2: Mezzanine Financing Reduces the Weighted Average Cost of Capital Cost of Capital Equity Cost Cost of Capital Equity Cost Cost Savings WACCINITIAL Debt Cost Senior Debt (65%) Equity (35%) WACCINITIAL WACCNEW Debt Cost Senior Debt (60%) Mezz (20%) Equity (20%) LTV LTV Exhibit 2 helps explain the cost of capital argument (taken here as the weighted average cost of debt and equity). The illustration on the left assumes the senior lender and the borrower each require a minimum fixed return for offering a 65/35 split in financing the acquisition of a real estate asset. The line WACC INITIAL represents the combined cost of capital to the borrower. The illustration on the right portrays a different formula in which the property is capitalized 60% with senior debt, 20% with mezzanine financing and 20% of equity. If the savings from using less equity is greater than the higher cost of mezzanine over the senior debt, the new cost of capital, WACC NEW, will be lower. The cost savings is given in the chart by the area between WACC INITIAL and WACC NEW. 1 1 The WACC is simply the weighted average of each component in the capital structure multiplied by its corresponding cost. The computations for the traditional case and the new case are as follows: WACCINITIAL = [(0.65)*Debt Cost] + [(0.35)*Equity Cost], WACCNEW = [(0.60)*Debt Cost] + [(0.20)*Mezzanine Cost] + (0.20)*Equity Cost]. For more details see Mezzanine Finance: Completing the Market, May

4 Exhibit 3: Capital Stack and LTV Exposure of Real Estate Mezzanine Capital Structure of Asset Investor Equity Possible Structure of Mezzanine Returns A Capital-driven returns (equity style) LTV Mezzanine Debt Mezzanine Debt B Combination: income and capital returns Senior Debt C Income-driven returns (bond style) The Case for the Lender For real estate investors, the attraction of mezzanine finance is clear. The potential returns are high, and for any given investment the risks can be reduced relative to the return. The repayment is structured in relation to the performance of the underlying real estate asset. One appealing feature for the lender is the ability to structure the loan to fit its portfolio needs. Mezzanine debt can be structured in various combinations involving fixed income (like a bond or senior debt investor) and participation (or exit fee), in which returns are linked to the performance of the asset (like an equity investor). In keeping with its position between senior debt and equity, mezzanine returns can be set at any point along the entire income and capital-based spectrum. Aside from the performance of the underlying asset, mezzanine loans are also drawn up with reference to other factors such as lender risk and return preferences, time horizon, choice of the LTV segment and the exit strategy, all of which makes it difficult to generalize about a typical mezzanine loan. 2 However, it is possible to outline the main issues and different styles of investing. In turn, we look at the characteristics of the underlying asset, the structure of the loan, risk management and expected returns. 1. The Characteristics of the Underlying Asset Generally speaking, mezzanine lenders have no particular preference regarding asset type. Each asset is an investment opportunity that helps determine the structure of the loan and the expected returns. This is an important point. No how matter how the deal is structured, mezzanine finance may be appropriate for any real estate asset. 2 More specifically, factors that influence the deal include, the size and tenor of the senior debt tranche, the amount of equity within a given structure, the nature of the business plan for the particular property or indeed portfolio, the potential upside from a given property/portfolio and how much profit participation is negotiated, the cap rate profile of the property income, the required tenor of the mezzanine layer and the lenders relationship with the borrower. 4

5 PREI Exhibit 4: Characterizing Mezzanine Investing in a Real Estate Portfolio Efficient Frontier: Mezzanine Investor in Real Estate A Return B Value-Add (combination capital and income returns) Opportunistic (capital - driven returns) C Core (income-driven returns) Risk Efficient Frontier: Real Estate Investor Return Opportunistic Value - Add Core Risk In general, there need not be any relationship between the characteristics of the underlying asset and a mezzanine loan s structure, although there is a temptation to think of returns in varying combinations that correspond to core, value-add or opportunistic styles of investing. A mezzanine loan with a fixed coupon can be originated on an opportunistic investment, and a capital-driven return can be structured against a core investment. Nonetheless, in the mezzanine industry the terms core, value-add and opportunistic are sometimes used to describe the different styles of investment, but they have little to do with the type of assets mezzanine loans target. This then begs the question: Where exactly does mezzanine investing sit within a real estate investors portfolio? The answer is anywhere. But it will depend on how the loans are structured. Generally, they are part of the value-added segment offering a combination of high income and potential for capital returns (point B in Exhibit 4). The average mezzanine asset will be based around at least some repositioning, while offering immediate cash flow. 5

6 2. The Deal Structure The structure of mezzanine loans is linked to the performance of the underlying asset, investor preferences and the expected risk-return trade-off. The market risk determines what part of the capital stack a lender will play in, how to divide the income and capital returns components, what sort of income charge to implement and the cost. Obviously, the market plays a big part in dictating these roles. Exhibit 5: Three Possible Profiles of Mezzanine Funds 3 Mezzanine returns more dependent on capital Frequency Distribution C Core B Value-Added A Opportunistic Expected Returns As a result, market conditions often determine which lending style is likely to dominate at any one time. Core funds, those based around an income return with little or no capital appreciation (or participation fee, point C) will focus on relatively lower risk loans with an LTV ratio of 50-75%. This type of investing is likely to dominate when market risks are considered high. At the other end of the spectrum sits opportunisticstyle mezzanine funds, which are more dependent on capital appreciation and represent 75%+ LTVs (point A in exhibit 5). This type of investment is more prevalent when market risks are low. Such categorizations are useful, but in the end market risks are just one factor among many. At any given time, mezzanine funds will hold loans that span a wide variety of the risk/return spectrum. Even in the most severe of downturns, some loans will be a lot less risky than others. 3. Risk Management Real estate risks move up and down, which means that expected outcomes can turn out better or worse than expected. Mezzanine financing is no different. But risk management focuses on the downside. For the borrower, the downside risks center around not being able to meet the terms and conditions attached to the mezzanine loan. It is another lien held against the asset, another layer of terms and conditions, and another increase in management costs. So although mezzanine financing can be attractive 3 Of course, the mezzanine deal might incorporate any aspects of these three styles. It is also possible for two or even all three styles to be held against the asset at the same time. 6

7 PREI to the borrower, it can also be used as a last resort when its own resources have been exhausted or there is no senior debt to call on. The mezzanine lender must hold a vetting process to separate out poor mezzanine investment opportunities, such as declining properties with uncertain cash flows, or assets in poor or deteriorating markets or those with poor management teams. The lender s downside risks center on a decline in property values. There is some protection in terms of where the mezzanine piece sits in the LTV ratio, although incentivizing an equity investor who has taken losses can become a problem. Like equity investing, successful mezzanine investing depends on effective market- and asset-specific risk management. This includes scrutinizing such factors as the quality of the underwriting and the assumptions behind projections. Mezzanine investors have an advantage over equity investors in that loans can be tailored and structured in ways to manage these risks. But mezzanine investing is also different because of additional challenges it brings. A mezzanine investor can be one of several lenders staking a claim on an asset. Because it is subordinate to senior debt in the capital stack, it is imperative that mezzanine investors have in place agreements specifying processes and procedures relating to management and control of the asset in the event of property or borrower non-performance. This means that any fund must focus on due diligence to limit the downside risks, and make plans to recover funds or assets should the equity investor fail. Because mezzanine investing is labor-intensive and can get complicated quickly, savvy financial expertise is a necessary ingredient for success. It also helps explain why a broad portfolio is more cost-effective than individually brokered deals. As mezzanine transactions become increasingly risky, the need for solid risk management and financial expertise increases accordingly. The mezzanine lender must understand and properly analyze senior debt and equity documentation and tailor the mezzanine loan accordingly. The mezzanine documents must reflect the business plans of the underlying asset and capture any potential weak points/stresses with forward-looking covenants, cash deposits or traps and cash sweeps. The covenants of the mezzanine loan must be tighter than the senior loan to ensure that any potential defaults are captured well before they impact the senior loan. One way to accomplish this is to establish a formal agreement with the senior lender(s) to determine a course of action in the event that the borrower violates terms and conditions of the senior debt. Intercreditor agreements establish the rights of the mezzanine investor and potential remedies, such as rights of notice and cure that give the mezzanine investor the right to take possession and cure problems in the event of default on the senior debt. Other examples include a requirement for senior lenders to notify the mezzanine lender of any payment default, allowing the mezzanine lender to buy senior indebtedness at par, forbidding the senior lender to transfer senior indebtedness, prohibiting the terms of the senior debt to be amended without the prior written consent of the mezzanine lender, or granting the right of the mezzanine lender to transfer the loan. A subordination agreement must also be negotiated with the senior lender(s) to determine how the assets should be managed, or how the sponsor s equity (what is left) is distributed in the event of a default. This might mean, for example, taking control of the remaining investor equity (as in a cash sweep) or ownership of the asset through enforcement of share security. 7

8 The Expected Returns 4 The expected risks will not only factor into the expected returns on mezzanine deals, but also the form they take. Part of the risk management process includes limiting downside risks, which will shape how dependent returns are on income. Borrowers pay a high cost for subordinate debt. The performance of loans structured toward capital returns are clearly correlated to the success of the underlying asset. Exhibits 6a through 6c illustrate the various possible returns from financing a real estate transaction over time, linked to our three different styles of mezzanine investing: core, value-add and opportunistic. Aside from how the returns are structured, each style is defined by where it sits in the LTV segment. For core, we assume an LTV ratio of between 50 and 75%, for value-add we assume a 60-85% LTV, and for opportunistic we assume a 75-90% LTV. In each case, we compare the returns against the equity investor, whose initial return on acquisition of the asset is dependent upon appreciation. The downside risks to the equity investor are significant. If the asset falls in value by more than the amount of equity, the property owner can lose the entire investment. But the upside can be significant. In Exhibit 6a, a core-style mezzanine lender gets a fixed income return. There is no upside to returns if the asset appreciates in value, because all of the gains would go to the equity investor. At the same time, the mezzanine lender is protected on the downside. In our example, the investor s position is protected even if the asset value falls by 35%, which in this example we assume helps cover losses in mezzanine capital to 65% LTV. Returns turn negative if the value falls further, and the mezzanine lenders capital is completely wiped out if the property value falls by 50%. Exhibit 6a: Core Mezzanine Returns versus Equity, 50-75% LTV IRR 40% 30% 20% 10% 0% -10% -20% -30% -40% -50% -60% Mezzanine Investment Equity Investment Assumptions Property Value 100 Acquisition Costs (% of value) 6.0% Initial Yield 7.5% Asset Management Fees 0.0% Senior Debt LTV 50.0% 3 YR SWAP RATE 2.5% Senior Debt Margin 2.0% Mezzanine Debt LTV 75.0% Mezzanine Coupon % 12.0% Minimum Exit Fee 0.0% Profit Share 0.0% (for illustrative purposes only) Value Index Holding Period 3 yrs In 6b, we represent the value-added investor. Here the LTV ratio is slightly higher than the core investor, making the loan more risky. Returns in this segment are a mixture of fixed income (typically at a rate below a core investment), which gives some downside protection, and capital appreciation. This trade-off can be attractive. The value-added segment is probably the most representative of a typical mezzanine loan, 4 There can be no guarantee that expected returns will be achieved. 8

9 PREI because it provides income plus potential capital appreciation. In our example, the mezzanine lender will earn a positive return even if the value of the asset falls by 20%. We assume income return will compensate for any loss in appreciation beyond 15%, but if values drop just over 20%, the mezzanine lender starts to lose capital and returns turn negative. Exhibit 6b: Value Add Mezzanine Returns versus Equity, 65-85% LTV IRR 50% 40% 30% 20% 10% 0% -10% -20% -30% -40% -50% -60% Mezzanine Investment Equity Investment Assumptions Property Value 100 Acquisition Costs (% of value) 6.0% Initial Yield 7.5% Asset Management Fees 0.0% Senior Debt LTV 65.0% 3 YR SWAP RATE 2.5% Senior Debt Margin 2.5% Mezzanine Debt LTV 85.0% Mezzanine Coupon % 10.0% Minimum Exit Fee 5.0% Profit Share 20.0% (for illustrative purposes only) Value Index Holding Period 3 yrs Exhibit 6c illustrates the returns for an opportunistic style mezzanine deal, in which the returns are almost entirely dependent on capital appreciation. There is still some downside protection. At an LTV of 75%, the mezzanine loan is safe until the asset value declines more than 10%. Unlike core and value-add styles, there is little income return. Exhibit 6c: Opportunistic Mezzanine Returns versus Equity, 75-90% LTV IRR 50% 40% 30% 20% 10% 0% -10% -20% -30% -40% -50% -60% Mezzanine Investment Equity Investment Assumptions Property Value 100 Acquisition Costs (% of value) 6.0% Initial Yield 7.5% Asset Management Fees 0.0% Senior Debt LTV 75.0% 3 YR SWAP RATE 2.5% Senior Debt Margin 3.0% Mezzanine Debt LTV 90.0% Mezzanine Coupon % 6.0% Minimum Exit Fee 5.0% Profit Share 35.0% (for illustrative purposes only) Value Index Holding Period 3 yrs 9

10 Summary Exhibit 7 draws together the key points behind each style of mezzanine lending, although it is a simplified table to help explain how mezzanine lending works. Individual loans do not necessarily fit neatly into one of the three categories. In each case, mezzanine loans are defined according to: The characteristics of the underlying asset. The deal structure, including the position in the capital stack (LTV), the duration and the structure of payment. The underlying real estate risks. The IRR expectations are purely indicative, but they give an idea of the potentially attractive returns for mezzanine lending, which are a function of the risks taken in each deal. Exhibit 7: Characterizing Real Estate Mezzanine Deals Mezzanine Investment Type Real Estate Characteristics Typical Deal Structures IRR Expectations A Core (Income Driven) 10% - 12%+ B C Value Added (Income and Fees with Some Reliance on Capital Appreciation) Opportunistic (Limited Income, Reliance on Capital Appreciation) Existing / long-term cash flow Fully leased, good quality tenants Minor repositioning Some cash flow Re-leasing risks Moderate repositioning Not fully cash covered Occupancy risks Refurbishment / Development Business plan Distress 50-75% LTV Fully / current paid coupon No upside participation 3-7 year term Exit through refinance or mortgage amortization 65-85% LTV Part paid, part accrued coupon Minimum IRR exit fees with participation in upside 18 month - 3 year term Exit through refinance or sale 75%+ LTV Mostly accrued capital Capital / profit share 18 month -3 year term Exit through refinance or sale Added value delivers expected income and capital return 12% - 15%+ 15% - 20%+ 10

11 PREI Closing Thoughts With banks apparently in a long-term retreat from real estate lending, there is a growing opportunity for non-bank investors with real estate know-how and financial expertise to originate mezzanine financing in Europe. The opportunity is attractive not only for the potentially high returns, but because of the sheer breadth of possible loans structures and the ability to tailor specific deals. Mezzanine finance by its versatility is designed to meet the variety of challenges and opportunities of real estate markets. Mezzanine finance is often referred to as offering equity-style returns for bond-style risk, but it is much more than that. The type of asset, the structure of the deal, the risk management process and the returns all vary in some way from deal to deal. Market conditions will dictate which type of loan or fund is likely to dominate the market at any given time, as players try to meet the demand of both the borrowers and the lenders. More than other types of lending, mezzanine offers a better risk and return alignment for real estate investors looking to access the market. 11

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