High-yield lenders target returns down the risk curve

Alternative lenders recognise the level of opportunity in front of them in today’s real estate financing market, as rising interest rates force traditional bank lenders to lower their leverage appetite. However, many in the non-bank lending market are hesitant to offer high leverage.

Hanno Kowalski, managing partner at Berlin-based manager FAP Invest, which operates a mezzanine lending fund, says mezzanine lenders that have provided higher than average leverage to sponsors now face the risk of default as capital values fall.

“Mezzanine lenders are subordinated in the capital structure, and if the value of the underlying property falls, they can be hit.

“In recent years, mezzanine in the German market started at 80 percent, and went up to 95 percent in cases. We have even seen 100 percent financing on ground-up development. Those lenders have definitely been hit by current conditions.”.

Kowalski argues some high-yield lenders have in recent years exposed themselves to equity risk. “I think they did not get the right returns. They did, however, attract capital at 12-14 percent. But they did not fully factor in the risk of default,” he said.

Since rates increased sharply last year, Kowalski has not seen managers raising capital for higher leverage mezzanine lending. He believes investors are cautious about investing in higher leverage mezzanine strategies because of the defaults they have seen in the market.

“We had a few investors who have invested in similar funds, saying they are better off allocating to  a product that pays them 6.5-7 percent return and is sustainable over time. That provides regular income on a steady basis, rather than mezzanine at the higher risk,” he said.

Florent Albert, head of commercial real estate loans and commercial mortgage-backed securities at Berlin-based credit analyst Scope Ratings, says because of the lowering loan-to-value appetite from bank lenders, the opportunities for mezzanine players are vast. As a result, he does not see mezzanine players targeting the higher leverage deals – because they do not need to do so to guarantee investor returns.

Mezzanine lenders are opting to write lower LTV loans since rates spiked, he says, because the higher cost of debt means they can earn similar returns to previous years, in lower risk positions.

“As long as they will have these other opportunities, I’m not sure they will have an appetite for higher leverage,” he says. “What we can see, is this kind of sub-mezzanine type of strategies with high returns [compared with historical mezzanine returns] in exchange for LTVs at 75-80 percent,” he adds.

He explained that current mezzanine loans are being provided at 60-70 percent LTV, with margins up by 100-150 basis points.

Whole loan structures

Richard Fine, managing director at London-based capital advisory firm Brotherton Real Estate, said the firm sees most financing transactions being done through whole loan structures currently.

“We’re seeing senior retrench because base rates are now so much higher, there’s less cash available to service interest and coverage ratios are under pressure – even before you take into account value declines. So, borrowers cannot get as much debt from traditional senior banks,” he says.

“We’ve not seen a huge number of opportunities for mezzanine deals yet, largely because we’re finding debt funds that will write a whole loan and it still works out cheaper and easier than the senior/mezzanine blend for borrowers,” Fine adds.

“We’re also seeing borrowers, particularly if they’re under pressure to close a deal, being anxious about the time and effort it takes to get a mezzanine deal done, where you have two parties and two sets of lawyers and two investment/credit committees, although we expect this to change and the opportunities for mezzanine to increase.”

Frankfurt-based alternative lender Prime Capital launched its first commingled property credit fund, the Prime Capital Whole Loan Fund, as reported in April, with a €500 million target. For Prime, it represents a first move into the whole loan space after previously focusing solely on mezzanine loans.

Stefan Futschik, head of private debt at Prime Capital, told Real Estate Capital Europe that transaction volumes in the real estate market are lower now due to a variety of factors, including rising interest rates and lowering asset valuations. He believes transaction speed is a consideration for borrowers in current conditions, alongside loan pricing.

“The benefits of the whole loan, from a borrower’s perspective, is for sure that it’s easier. You only have to talk to one party, you don’t need an intercreditor agreement and you can execute faster than if you had a bank and debt fund, providing senior and mezzanine.

“So, execution is faster with the whole loan. Also, the pricing for the blend between senior and mezzanine will be higher from a borrowers’ perspective. However, some classic bankable assets will still be financed in the banking market with complementary mezzanine financings provided by alternative lenders,” he adds.