More lenders are entering the mezzanine lending space, which means savings for owners and developers, but that doesn’t mean there aren’t still risks involved.
REPORT FROM THE U.S.—Mezzanine lending has become more prevalent, and as more lenders enter the space, it’s become more competitive, leading to lower prices for hotel owners and developers.
Senior lender advance rates have been coming down for a variety of reasons, from regulatory pressure to balance sheet management, said Michael Fleischer, SVP at Related Fund Management. Because of that, sponsors have the choice to use more equity or a combination of mezzanine lending and equity.
“Mezz should still be less expensive than equity, and even for sponsors that don’t want high leverage, they may be receptive to mezzanine debt that caps out at 65% to 75% (loan to cost) when faced with senior loans in the 44% to 55% (loan to cost) range,” he said.
While the mezzanine market was somewhat nascent in 2014 and 2015, said Peter Berk, president at PMZ Realty Capital, many players have entered the market in the past year—particularly in the last six months.
“There’s a ton of mezz out there,” he said. “There’s more lenders, more competition, so pricing on mezzanine paper is significantly less than in the recent past. It’s available not only for stabilized hotels, but also we’re seeing mezz lenders looking at the construction space, as well as to fill in the gap where the mortgage loan is going to 65% and taking it up to 70%. If fixed rate is going to 70%, mezz will go up to 80%.”
It’s a recent phenomenon, he said, but part of the reason for it is the conduit market has become extremely competitive. Borrowers can’t get the yield they want, so they’re turning to a different position in the capital stack. There’s more risk involved, but there’s a lot more yield involved, as well.
In the prior cycle, senior lender advance rates were significantly higher than they are in the current cycle, Fleischer said. As a result, mezzanine financing had higher points of attachment and detachment, he said, and it typically represented a smaller percentage of the overall debt stack. If mezzanine debt occupied the 65% to 80% loan-to-cost tranche then, today it may occupy the 50% to 75% tranche—a wider range, lower in the capital stack.
“Mezzanine capital should still reduce the (weighted average cost of capital) for the entire capital stack—including equity— but the blended cost of debt alone may be more heavily weighted towards the cost of the mezz debt than in the past,” he said.
Where is mezzanine headed?
Some say the hotel industry is at its peak, Berk said, but those people were saying the same thing in 2015. Eventually something will rein it in, but he thinks it’ll more likely be a macro event in the economy rather than oversupply in the hotel industry. At the moment, the economy is stronger, people are traveling and gas prices are relatively low. Occupancy and average daily rate depend on gas prices, he said.
As long as lenders are getting their yield and not running into a lot of defaults, this will continue, he said. But if the economy starts to change, it will probably dry up pretty quickly.
Mat Crosswy, president at Stonehill Strategic Capital, agreed. He doesn’t foresee much change over the next 12 months, but if the administration of President Trump continues in its current direction, there could be some surprises.
As the industry moves later and later into the cycle and construction continues to grow, Crosswy said, banks will become more conservative.
“Groups like us, with the value we bring, you will see more and more preferred equity opportunities as banks pull back what they’ll allow in terms of mezz in the capital stack,” he said.
The drivers may change over time because of regulatory limits on senior lender advance rates or sponsor demand for higher leverage, but there will always be a place for mezzanine lending, Fleischer said. Capital markets are dynamic, he said, and capital market sponsors are expected to continue to modify their offerings to respond to current market conditions.
“At the end of the day, mezzanine lending plays an important role in the capital markets and will continue to do so, although the key attributes (rate, leverage, covenants, remedies, etc.) will change over time,” he said.
What to keep in mind
Owners and developers applying leverage should go up in the capital stack, Crosswy said, but the industry is late in the cycle, which will eventually shift downward. Something could happen within the next year or two, he said, and when it does, it’s important to be aware of the coupon paying on the total.
“Banks are aware of that, too,” he said. “It’s why they prefer equity over mezzanine.”
Those borrowing should be aware of who their capital or equity partners are, he said, and have a strong understanding of the space and how to manage through a downturn by working with the sponsor.
Mezzanine financing can be a great way to improve financial performance, Fleischer said, because it is less expensive than equity and can help fill an ever-increasing gap in the capital stack as the senior lending community pulls back.
“That said, sponsors should always keep in mind that, unlike equity, mezzanine debt typically has a maturity date,” he said. “Sponsors should be realistic about their ability to repay their debt stack upon maturity, whether by sale, refinancing or equity recap.”
Mezzanine lending can work well for ground-up and value-add projects where there is significant value creation, which simplifies the path to refinance, he said, but it can be risky for stabilized assets or light value-add transactions if the refinance strategy is dependent on projected market rent growth rather than contractual rent bumps.
“In the hotel space, sponsors should be mindful of the cyclical nature of the hospitality and should look for extension options even if tied to amortization requirements,” he said.