Mezzanine lenders
It is said that Mezzanine loans are very similar to U.S military conflicts. They are very easy to get into but much more difficult to get out of it. So before analyzing such mezzanine loans, you should always begin with the exit in mind. You can get a mezzanine loan from any place, but the art of the business is structuring the business with a definite exit strategy, the appropriate structure, and pricing that reflects the risks of the transaction for all parties.
We generally divide mezzanine loans into two types: stabilized transactions or value-added properties.
STABILIZED TRANSACTIONS
Stabilized properties which are at least 90 percent leased and have a well diversified rent roll, are much easier to underwrite for mezzanine loans. This type of mezzanine financing is common at the time of origination of a long-term, fixed-rate first-trust loan. In these types of mezzanine loans the lenders do not look for good things to happen but they just hope that nothing bad happens to the already stabilized propertys cash flow.
VALUE ADDED PROPERTIES
Mezzanine loans for value-added properties are more difficult to underwrite because cash flows are not stable, and the repayment is contingent upon something good to happen at the property level that will increase the projects cash flow. It is said that under such situations, the lender must underwrite the property or market level or an event that is going to increase the net operating income (NOI). In these types of value added properties the lender counts on good things to happen, so that the NOI will increase and a loan and a loan will be in a position for permanent refinancing or the property will be sold.
CONSIDER THE RISKS
In a mezzanine lending there are generally three types of exit strategies that a lender can plan for: refinance, sale and self- amortization.
The most common and the strategy that is mostly preferred for mezzanine lenders is the refinance exit strategy. This strategy typically will be underwritten to commercial mortgage-backed securities or the CMBS standards that provides a level of market certainty. The biggest risks that are considered in a refinance exit strategy are the propertys achievement of its pro forma results and the interest rates of the refinancing loan at the time of maturity.
As the interest rates are unpredictable, the value added mezzanine lenders tries to 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 of the mezzanine lenders will prefer to add 50 to 100 basis points per year. The sale exit strategy generally acts when the refinance strategy exit wont act. This type of sale exit strategy is predominantly used when developers have borrowed more than 85 to 90 percent of the capital structure. The sale exit strategy commands higher pricing because, the repayment possibilities in this type of transactions are more limited and riskier.
These risks include whether the market is hot when its time to sell, the strength of the capital markets after the sale, and the cap rate at the time of the sale. In order to mitigate the risks, your mezzanine lender for a value-added transaction likely will underwrite to a stressed-exit cap rate. In the third type of exit strategy which is the self-amortization type, it involves the full repayment of the loan from the propertys cash flow. This strategy is very rarely used because most projects do not have sufficient cash to repay the loan in full that also over a very short period of time, and most of the lenders do not prefer to go for such long term mezzanine loans.
A mezzanine lender will always prefer the first trust loan to be fixed rate, thereby providing some certainty to the debt service and cash flow which is available to pay the mezzanine interest or amortization.
The mezzanine loan that is perhaps the hardest to get underwritten and is the riskiest is a value-added mezzanine loan behind a floating-rate first- trust loan. In such a 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. So I would like to conclude by considering the fact that, the exit in mind is a good practice for those seeking mezzanine loans. If this is done correctly both the lender and the borrower of such mezzanine loans will be happy and the outcome of this is that it reduces the chance of the loan ending up in the work-out departments.
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