Guest Post : The Basic Risks of Real Estate Mezzanine Financing
Occasionally we get that educational post from an industry expert that is a stroke of luck for us and readers because such information and explanation is never generally available especially, in plain English.
Our luck is extraordinary this week with a concise write up on mezzanine real estate loans which is not the typical product marketed to us by our bankers but rather common in the larger world of private finance.
Wikipedia Definition : In finance, mezzanine capital is any subordinated debt or preferred equity instrument that represents a claim on a company’s assets which is senior only to that of the common shares. Mezzanine financings can be structured either as debt (typically an unsecured and subordinated note) or preferred stock. https://en.wikipedia.org/wiki/Mezzanine_capital
Mezzanine loan information is rather difficult to procure given that they are transactions done at arms length between the borrower and lender possibly with unique terms and clauses that could work against the favour of shareholders.
Given the lucrative interest rates that some of these loans pay out, private investors will find them attractive over other debt instruments.
Our contributor today, Small Office Rent Guy, has summarised the risks and rewards for us.
The Senior Loan for any Commercial Real Estate asset is generally given by a Bank. There is almost without exception, a mortgage placed on the asset. This is straightforward. The Banks, or Senior Lenders, lend a percentage of the value (loan to value or LTV) on the property. This generally ranges from 50 percent to 75 percent.
If the loan is non-recourse, Banks will typically lend less LTV. So if a borrower needs to borrow more money, he will turn to Mezzanine Loans. Typically Mezzanine Loans can take the borrower up to 85% or even 90%.
Senior loans range generally range as a spread from 100bps to say 300bps over SIBOR or SOR. Mezzanine or Junior loans usually range from 10-18 percent flat.
Can the mezzanine debt get a 2nd lien on the property? Technically yes, through an inter-creditor agreement. The inter-creditor agreement governs the relations between the senior and the junior lender, and may even allow for a buy-out clause of the senior loan. Unfortunately, in practice this hardly happens in Singapore because the Senior Lender refuses. Firstly, this is rare in Singapore and secondly why should the senior lender care? It’s basically the borrower’s problem.
So how is Mezzanine debt then structured if there is no second lien? A pledge on the equity of the SPV is usually effected in this case.
In an event of default, the lender has the rights to the proceeds of the sale of the equity of the SPV.
Getting to the monies is a little more remote than immediately meets the eye. As a mezzanine lender, you do not have the right to step into the shoes of the SPV, nor take over the property upon default. You have to sue for event of default, and then seek to enforce the pledge. But the mezzanine lenders cannot enforce the pledge directly. A receiver or liquidator has to be appointed to administer this enforcement. A receiver operates as a professional services firm and generally charges time-based fees. The function of a receiver is to exercise the powers of sale and management to bring about the repayment of the mezzanine debt. The receiver owes the duty to exercise his powers in good faith and for proper purpose to obtain the true market value when he exercises the power of sale.
The borrower may challenge the appointment of the receiver. This will take further legal time and money. Each step of the way that the receiver does can be challenged. [Do also note that receivers generally charge on time costs. The longer the proceedings, the higher his charges.]
So how do you get your money? Unwinding a pledge of shares in default will require the shares to be sold. There is absolutely no ready market for private shares. This is unlike a pledge of listed shares, where you can sell the shares on the exchange.
Now, think about the opacity or lack of information on these shares. In an event of default, the governance of the company may be poor. Information may be lacking, or may not be forthcoming. Buyers may be afraid of additional liabilities. As opposed to listed shares, the disclosure requirement on private companies may be much lower. Accordingly, fewer buyers may bid for the shares.
Worse: if ownership changes, this might trigger a change-of-control clause in the senior loan which might immediately come due. Now the new buyers will have to refinance the senior debt. This might create a further deterrence for potential buyers.
What if the Senior Loan is also in default? In that case, you would have an even more complicated situation, where the Senior Lenders are contemplating their own options, including effecting a long drawn-out sales process on the property itself. This introduces yet more uncertainty.
And the Mezzanine Lenders, in the absence of an inter-creditor agreement, only can appeal to the good graces of the Senior Lenders or alternatively make an offer/proposal which creates value for the senior lenders. Precisely because Mezzanine Lenders are much lower down the food chain, acceptable actions of the Senior Lenders can affect them drastically and there is little they can do. Consider also that the Senior Lenders may not be actually be too happy either at this moment, and often, control of the loan may have passed to surlier loan recovery officers who are generally less friendly than relationship managers.
Now what if the Mezzanine Lenders are spread out? This is even more troublesome. First there are problems on information rights to get to know other lenders. Most documents are silent on this. Next, organizing the steering committee may be troublesome. Next which Mezzanine Lender funds the legal action (and cost recovery) is another issue. But nothing beats the fact that perhaps the best option left to the Mezzanine Lenders is for them to stump up a lot of cash to purchase the property, to secure their interests.
High risk. High reward.
Small Office Rental Guy (SORG)