The Housing Chronicles Blog: Say goodbye to mezzanine debt

Monday, February 23, 2009

Say goodbye to mezzanine debt

Over the last decade, a type of debt for development projects called 'mezzanine' -- which filled in the financial hole between a borrower's equity and the first mortgage -- was responsible for funding many residential and commercial development projects. But given the high default rates in the commercial sector, 'mezz' has become a four-letter word and may not return for a long time. From a Wall Street Journal story:

Firms made an estimated $50 billion to $75 billion in mezzanine -- dubbed "mezz" -- loans, debt that fills the gap between the borrower's equity and the first mortgage. Billions of dollars already have been lost and the figure is likely to balloon as the steep downturn in the commercial-property market deepens.

The losses are sending shock waves through the rough-and-tumble world of office buildings, shopping centers, hotels and other commercial properties, which are only now facing the full brunt of the recession. Mezz debt was one of the biggest culprits that enabled commercial real-estate investors and developers to participate in the broader speculative binge on Wall Street...

The attraction of mezz debt to investors was twofold: the rate of return on such debt -- once levered up -- was in the teens if the borrower kept current and, if the borrower defaulted, the investor in the debt would have the right to take over the property...

But that strategy isn't working in many cases because properties are no longer generating enough cash to cover the first mortgages, much less the mezz debt. For the mezz investors to take over the property, they would have to reach into their own pockets to pay debt service on the first mortgage...

Most recently, borrowers have begun to default on mezz loans, forcing the mezz investors to try to foreclose. But this isn't easy even in cases in which the mezzanine holders believe their position is worth something. Often the mezz debt is broken up into slices with different degrees of risk and claims on the property.

Also, for the mezz holders to take over the property, they often have to pay what is owed or refinance the first mortgage, a difficult feat in this credit-starved environment...

Click here for full story.

1 comment:

Dominique Grubisa said...

Unfortunately the flow-on effect from the loss of this often used source of financing will be a contraction in the construction industry and job losses which will resound in further contraction of consumer spending. It's a viscious circle with no end in sight.