CAPITAL MARKETS: MEZZANINE FINANCING

APARTMENT FINANCE TODAY • MARCH 2008

Caught in the Middle

Developers need bigger pieces of mezzanine financing to make deals work, but it’ll cost them.

By Jerry Ascierto

Mezzanine financing is readily available for multifamily developers, but not nearly as affordable as it was this time last year.

Since senior lenders have grown more conservative in their underwriting, providing much less leverage on deals than they did a year ago, mezzanine financing is covering a broader part of most deals today. But developers struggling to afford senior debt will have an even harder time penciling out the mezzanine component of their deals.

The number of mezzanine providers has grown in recent years. Many traditional equity investors are seeing less risk and better returns on financing mezzanine debt, and institutional investors such as Heitman, LLC, and Principal Real Estate Investors are opening mezzanine funds.

“There’s a lot of money out there for mezz, which is good for developers and investors,” said Richard Gallitto, executive director at mezzanine provider Tremont Capital. “The bad news from their perspective is that it’s going to be underwritten much more conservatively, and it’s going to cost more.”

Higher prices, lower leverage

The pricing on mezzanine debt has increased significantly in the wake of the turbulence in the capital markets. For stabilized properties, rates for mezzanine financing at this time last year ranged from 9 percent to 11 percent. That figure has since grown by as much as 350 basis points, to between 11 percent and 14 percent. For transitional, unstabilized properties, the story is more brutal. What was priced between 13 percent and 15 percent a year ago is now between 16 percent and 19 percent.

Many lenders can still do mezzanine financing at 1.05x debt-service coverage ratios (DSCRs) for strong borrowers in strong markets, but higher DSCRs have become the norm. The current pricing and underwriting situation is familiar to industry veterans. Rates are back where they were before aggressive financing instruments like collateralized debt obligations (CDOs) grew popular in 2006 and drove the cost of capital down.

“The historical mean, both in terms of leverage levels and in terms of pricing, is where we’re headed, and I think we’re almost there,” said David Valger, vice president at RCG Longview. “There has probably been a 250 to 350 basis point widening across the board in the B-piece/mezzanine parts of the capital stack” over the last nine months, he said.

As prices rose, volume slowed, mezzanine lenders report. Tremont Capital processed about $80 million in mezzanine financing in 2007, but the bulk of those deals were done in the first half of the year. And CWCapital has also seen less mezzanine activity since the capital markets grew turbulent in mid-2007.

“Obviously transaction volume is down, but there isn’t a lot of current cash flow coming out, and so being able to afford the mezz seems to be difficult,” said Michael Berman, president of CWCapital.

CWCapital provides mezzanine financing for Freddie Mac’s High Leverage program, but Berman said demand has been slim. The company provided about 20 mezzanine loans through that program in 2007. The High Leverage program combines a Freddie Mac senior loan with mezzanine financing from CWCapital that covers up to 85 percent loan-to-cost (LTC) for borrowers purchasing stabilized assets.

Rehab booms

Like Freddie Mac’s High Leverage program, Fannie Mae’s DUS Plus program combines a permanent Fannie Mae loan on conventional multifamily properties with mezzanine from an outside party, RCG Longview. DUS Plus hasn’t seen much volume, especially since it came along as the commercial mortgage-backed securities (CMBS) and CDO markets were taking off and conduit lenders began undercutting Fannie Mae on pricing.

But in June 2007, Fannie Mae and RCG rolled out the Community Investment Mezzanine Moderate Rehab (CI Mezz-Mod Rehab) product, which, unlike DUS Plus, targets repositioning deals. The product came at the right time, as many developers began concentrating on rehabilitation deals and flocking back to Fannie Mae as the CMBS market declined.

“We launched at the end of May and did a tremendous amount,” said Valger, who declined to release specific figures. “We doubled our goal for the first six months, and I’m looking to double it again in 2008.”

RCG processed $450 million in mezzanine financing last year, and it plans to increase that figure to $600 million in 2008 mainly due to the success of the CI Mezz-Mod Rehab product.

The rates for the CI Mezz-Mod Rehab product are negotiated on a case-by-case basis and can be locked up to four months prior to closing. The mezzanine portion of the product has a fixed interest rate for the initial five-year term and then converts to a variable interest rate based on a predetermined fixed spread over the three-month London Interbank Offered Rate.

The CI Mezz-Mod Rehab product can go as high as 95 percent LTC, although Valger said the typical deal these days runs to 80 percent LTC. Another attractive feature of the product is its flexible prepayment options. As developers finish work on repositioning deals and raise rents, they can use Fannie Mae’s supplemental loan program to replace the more expensive mezzanine debt, without having to refinance the entire loan.

Back where we started

The rising mezzanine prices are likely to stabilize by the end of the first quarter, but the rest of the year will be characterized by tighter underwriting standards, lenders report.

Repositioning deals, where developers take a Class C property up to Class B, will still be underwritten with the assumption that rents will increase. But rent growth projections on stabilized assets will be less aggressive in 2008. “There’s going to be a lot more scrutiny by lenders on operating expenses and on reserves than there has been in the past,” Gallitto said.

Still, the tighter standards and higher pricing are a return to historical norms. “Five, six, seven years ago, the expectation on the [interest rate] pricing was mid- to high teens,” said Gallitto. “So really, it’s come back to where we thought it should be.”