The credit yield impact of CRE mezzanine lending

RMA Journal, The, Dec, 2003 by George J. Pappadopoulos

A series on real estate investing and risk management premised on the belief that a more analytic approach delivers reduced risk-based capital requirements, improved profitability of real estate investment activities, and growth in the capital allocated to real estate.

The attraction of high yields has led many commercial real estate mortgage investors to consider an allocation to the mezzanine sector. As the intermediate financing piece in the capital structure, a mezzanine investment is expected to provide a return exceeding that of the senior debt. As with many financial instruments, the increased return comes at the expense of increased risk. The key question is what level of excess return is appropriate compensation for the excess risk (increased downside exposure).

Mezzanine loans provide financing that bridges the gap between a senior mortgage and borrower equity. As such, the security of the mezzanine lender is subordinate to the senior mortgage. That is, the mezzanine investor will bear losses ahead of the senior lender, and the downside protection of the mezzanine loan is smaller. Generally, overall leverage available to borrowers from mezzanine financing is typically in the 75-85% range, although it can reach as high as 95% of the capital structure in some cases.

Borrowers are willing to pay more for the increased leverage available from mezzanine financing. In fact, there appears to be a very sizable market as senior lenders have become more conservative over the past several years and typical loan proceeds have decreased. Mezzanine investment returns can range from the low double digits to the mid-teens, depending on how much of the capital structure is covered.

This level of return is certainly attractive, especially in today's environment. The question remains, however, as to the level of net returns after default losses. Being higher in the capital structure means less cushion from loss (higher loan to value). That is, the borrower's equity slice is smaller, so mezzanine investments can encounter losses earlier and to a larger degree than senior mortgages.

Another important factor regarding the risk of mezzanine investments is that they are inherently levered. That is, being a smaller slice of the capital structure (typically 5-20%) and being subordinate to other financing means that full mezzanine principal loss ensues before the first dollar loss occurs to the senior position. In other words, a 100% loss could ensue for mezzanine, whereas it would be highly unlikely for the senior mortgage to have 100% principal loss. For example, if a $100 property has a $75 senior lien and an additional $10 mezzanine loan, then a $50 default recovery as a result of decline in the property value means complete principal loss for the mezzanine loan but only a 33% principal loss for the senior loan (($75-$50)/$75). The smaller the piece of the capital structure represented by the mezzanine tranche, the more severe this issue becomes.

Obviously, quantification of expected loss is a critical component in understanding the risk of mezzanine loans. Since individual metropolitan-level and property-type cycles are a major driver of default, our goal is to assess credit risk through the integration of three key systematic risk factors: 1) metropolitan-level and property-type volatility, 2) expected metro and property-type growth for NOI and value, and 3) loan structure protection. By calibrating a model based on systematic factors influential in determining the performance of the underlying real estate collateral, it appears that meaningful expected losses can be assessed. Such critical considerations as various levels of debt service coverage ratios (DSCR) and loan-to-value (LTV) ratios, assorted changes in the ratios through time, and a diverse range in the uncertainty of such changes all play an essential role in the analysis of a commercial mortgage portfolio. The model allows us to develop an informed proactive opinion about the relative riskiness of different loan structures in different markets and property types. (1)

The approach also takes into account the impact of loan seasoning and allows the determination of a time series of expected loss for any particular loan structure across market and property type. Figure 1 outlines the expectations for a newly originated 75% LTV 1.30 DSCR apartment loan in Los Angeles. Each bar represents the expected percentage loss for that particular quarter. The cumulative expected loss for the life of this loan is 175 basis points, but note that expectations vary at each point in time. This "seasoning curve" is very typical of credit derivatives, and commercial mortgages are no exception. A newly originated loan will have very low default expectations early in its life. Those expectations increase until they reach a peak, which typically occurs between the third and seventh years, and then fall off.

[FIGURE 1 OMITTED]

A major benefit of this output is that the impact on the instrument's expected yield can be assessed. Certainly, a default occurring earlier in the life of a loan is going to have more of a negative effect on the loan's return than a default occurring much later on. Since our approach outlines a time series of periodic loss expectations, we can appropriately assess the expected yield degradation. By applying loss expectations for each period, we can calculate the risk-adjusted cash flow stream. The internal rate of return for the risky cash flows is the risk-adjusted yield, and the difference between the risk-adjusted yield and the non-risk-adjusted yield is the yield degradation.