Property company financing: Select few operate under the radar on the mezzanine level

Senior debt revival has not dented niche mezzanine providers’ business, reports Lauren Parr

Mezzanine deals tend to be arranged quietly, so a lack of publicity doesn’t mean they aren’t taking place. Borrowers as well as specialist mezzanine lenders say a perception that the European mezzanine lending market is floundering since the revitalisation of senior lending and ‘whole’ loans is just plain wrong.

Certain property company borrowers are finding mezzanine an accretive financing tool for the right deals, especially as it is cheaper than it was. “There is strong evidence that mezzanine finance is being used,” says Luca Giangolini, a Cushman & Wakefield Corporate Finance partner. He says a few established mezzanine providers are steadily deploying capital:  “Deployment of second vintage funds from key mezzanine lenders is progressing well.

“There’s a place for mezzanine, now priced at a level more accretive to equity returns, so it makes sense to borrow,” he adds. “Pricing fell from 15% to around 11% or 12% a year or two ago. It is now around 8-10% for many deals and there is evidence of some UK mezz lending at sub 7%.”

Strong appetite for mezzanine

At the same time, leverage is getting higher, with mezzanine now up to 80-85% loan-to- value levels, though this is reflected in higher pricing. Tom Stenhouse, head of finance for the UK and Ireland at German investment firm Patrizia Immobilien, agrees that “there is a lot of mezz out there and strong appetite (for it)” from opportunistic investors looking to drive returns. He also notes: “pockets of capital are coming in at even tighter pricing, but it’s got to be a ticket above £30m and for the right quality assets and sponsor to get that interest.”

Patrizia and joint-venture partner Oaktree Capital Management secured a £43m mezzanine loan from the Korean Teachers’ Credit Union (KTCU), arranged by Europa Capital, to help finance their £245m purchase last summer of the IQ Winnersh business park near Reading, at a margin a little over 6%. The debt was tied in with a £175m whole loan arranged by Barclays.

“Mezzanine debt’s pricing is not necessarily the main constraint,” says Evans Randall chief executive Kent Gardner. “The market is competitive and, for the right asset, generally well priced. A bigger issue for borrowers is the amount of mezzanine debt required, given the much lower loan-to-value ratios  offered by senior lenders compared with a few years ago. Mezzanine funding’s viability will vary, largely depending on the quality of the asset and the existing capital structure.”

Middle Eastern investor Abanar’s rationale in using mezzanine to partly refinance three Huddersfield and Sheffield student housing  blocks last July was that it was “not massively keen on putting in (a lot of) equity”, recalls Adnan Shaikh, legal director at South Street, which manages the assets for Abanar. This was set against a more difficult senior debt market in Q4 2012, when the deal kicked off.

Renshaw Bay provided a £12.3m mezzanine loan, priced at around an 11-12%  internal rate of return, alongside £45.8m of senior from Deutsche Bank. The lenders liked “the asset class, our track record and the 100% occupancy”, says Shaikh. As for the borrower: “We’d never had a mezz provider, but it worked smoothly with little duplication of work for us.”

More mezzanine providers have entered the European market in the past 18 months, both European and North American, with  Asian investors such as KTCU less common. They include banks, fund managers, hedge funds, insurance entities and sovereign wealth funds.

To refinance Königsbau Passagen shopping centre in Stuttgart, Evans Randall picked DRC Capital “from a number of interested parties, [as it] offered a competitive, well-structured package”, Gardner says. The genesis of the refinancing was “to take advantage of historically low interest rates offered by senior debt lenders, which we achieved with a seven-year loan from Allianz Real Estate, at 3.5% per annum.

“For high-quality assets with an income- generation track record, cash flow, good lease lengths and a clear value-adding asset management strategy, a good range of competitive [mezzanine] options are available. We have also seen flexibility from providers in structuring lending to suit a particular asset, such as varying the proportion of cash coupon and roll- up interest.”

Heath Forusz, co-founder of pan-European lender Tyndaris, says more US funds are eyeing Europe, “as yields compress in their home market. But Europe is a different beast; it is not a single market. Each jurisdiction has its own legal framework and commercial dynamics. What works in one country often cannot be repeated in the next.

“Deal sizes tend to be smaller, making deploying capital more time and resource-intensive. For funds looking to cherry pick larger transactions, Europe will prove to be a more challenging opportunity.”

No risk of oversupply

He adds: “More capital is focused on the mezzanine market than 18 or 24 months ago, but I do not believe we are close to a state of equilibrium or oversupply of capital in comparison to the market opportunity.

“The situation varies widely by deal. For clean central London assets, the market is pretty efficient, but add complexity to the location, asset, business plan or structure, and that situation quickly changes and sometimes capital is very hard to come by.”

Stenhouse agrees that for smaller deals, “mezz is pretty tight in terms of availability and pricing is back in the 12% range”. Whole loan lenders such as M&G Investments say they are financing a mix of  new acquisitions and refinancings. Their competitive advantage is simplicity and speed of execution, although blended pricing is typically higher. “Senior debt has become ever cheaper since mid 2012; margins have fallen from around 300 basis points to 150 bps on prime,” says C&W’s Giangolini. “This makes the senior/mezz solution more competitive versus whole loan providers.”

What is new is that “the mezzanine market has more definition; there’s not just one kind of mezz”, says DRC managing partner Dale Lattanzio. Blackstone Real Estate Debt Strategies, for example, is known  for having the broadest mandate, while ICG- Longbow targets mid-market deals and smaller borrowers (see bottom table).

Andrew Radkiewicz, Pramerica Real Estate Investors’ co-head, Europe, says: “The  word ‘mezzanine’ has 10 different mean-ings to 10 different people.” Some managers, such as Pramerica and M&G, have raised separate funds targeting higher and lower levels of risk and returns.

John Barakat, M&G’s head of real estate finance, says: “Can you achieve the same returns today as two years ago on a 75% LTV secured against a high-quality, well-let CBD office in London or Paris? Absolutely not. But that doesn’t mean investors will be disappointed; they’re kept informed as to what the fund is taking on in terms of risk profile.”

Tyndaris’s Forusz uses the word ‘stratifi-cation’ to describe what is happening in the European market. Each lender has its niche, with preferences and/or restrictions on asset concentration, investment size, geographies, leverage limits etc. “Compared with those looking at distressed debt and loan portfolio sales, we bump into less competition on any single deal. We like this dynamic.”

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Prey may be scarce for smaller 10-15% return hunters

Senior debt lenders say the “clock is ticking” for smaller mezzanine finance providers targeting 10-15% returns. The 30-40 names that (supposedly) raised money for mezzanine will have “a hard time putting it to work”, Citigroup managing director Tom Jackivicz told CREFC Europe’s conference on 3 April.

Pricing has clearly fallen for ‘prime’ mezzanine. Equally obvious is that senior debt liquidity is back in abundance, so there is less need for mezzanine, arguably. “As senior goes higher up the curve, the space for mezz has come down a bit,” says Thomas Tolley, European legal counsel at Starwood Capital Europe Advisers.

Pramerica’s Andrew Radkiewicz disagrees: “We’re not seeing a dramatic increase in banks’ appetite to lend up the capital stack, primarily driven by the original reason for mezz funds: Basel II and III regulatory changes. They’re restricted to investment-grade lending up to the 60-65% level.”

He adds: “The more the deal volume, the more a proportion of that business will require mezzanine. It’s also easier to underwrite when markets are moving well and exits are better defined. Every year people say ‘there are no mezz deals around’. As long as the market continues thinking that, it’s good for us. The deals are there, but the market’s not hearing about most of them because we’re dealing direct with counterparties.”

Pramerica closed Pramerica Real Estate Capital III and IV last year, bringing the total capital in the junior debt investing business to over €2bn. Some €1.2bn of mezzanine loans have been written to date. This year and next provide a great opportunity to expand the business, he insists. This month, Pramerica announced a first closing of PRECap V – a dedicated fund aimed at the Netherlands, with €265m of capital mainly coming from Dutch pension fund APG.

“If a manager hasn’t viewed the second half of 2013 and the first half of 2014 as a fantastic opportunity in this market, I’d be surprised,” adds Radkiewicz. “We’ve been around a long time doing a lot of repeat deals with people. We have seen both deal flow and scale increase considerably and that business momentum means we can provide certainty to our clients.”

The perception is that first-generation mezzanine providers that started out in 2010 are probably better positioned than new entrants. “The four or five bigger guys, with relationships with borrowers, are set apart,” Citigroup’s Jackivicz acknowledged.