Wednesday, December 19, 2007

More on mezzanine loans

I have been writing a bit lately about a trend I am seeing toward more and more mezzanine debt being put on properties as a gap between the LTV required by a bank and the equity a buyer brings to the table.

The Wall Street Journal sees the trend too, as evidence by a story today. Novices may ask: what is so attractive about mezz loans? Think of it like a second mortgage. For the buyer that does not have the larger amounts of cash to do a deal in this market, it means the ability the lever yourself into a deal you could not otherwise do while still being able to get high returns on the back end. If you are the lender, it means getting higher rates of return than a first lender on the mezz loan, plus the ability to wipe out the buyer and take over the property dirt cheap (insert groan here) if the buyer defaults on the mezz loan. That is why you are seeing seasoned, big-name investors doing mezz deals. If the buyer performs you it a double; if it fails you could hit a home run.

(Update: But as Doug Cornelius rightly points out in the comments and here in his excellent commentary, mezz lending is not for the faint of heart, nor is it, as the article (and perhaps my post) might surmise, a guaranteed win. Negotiating with the lender and good legal documentation are also critical.)

16 comments:

Doug Cornelius said...

David -

I think WSJ oversimplified the mezzanine loan relationship.

Mezzanine loan sprouted up in the mid-nineties when banks cut back on the debt service coverage ratios, leaving borrower short of capital.

This current feeding frenzy over mezzanine loans was brokers trying to deliver the full capital stack to buyers. They would couple the securitized mortgage with a mezzanine loan. Then dump the mezzanine loan into a CDO.

Those treading into mezzanine loans simply to get a better return need to realize there is much more risk and much work that this article lets on.

You can read my posts on mezzanine loans:
http://realestatespace.blogspot.com/search/label/mezzanine%20loans

David Stejkowski said...

Doug:

Great points you are making. It has been ages since I have done any significant mezz loan work because that market largely dried up (at least in my world) when lenders got more aggressive a few years ago.

I would agree 100% (and have updated the post accordingly) that it is not a "no risk" deal; if it was we'd all be doing it. But for the risk-takers it can be an interesting and potentially profitable strategy -- almost like betting the don't pass line at craps. The article does perhaps make it seem too good to be true.

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