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Robert Karnes on mezzanine real estate debt

Aug 24, 2016

Mezzanine real estate debt, the layer of financing subordinate to a first mortgage but senior to common equity, may offer some unique benefits in today’s low-yield environment. It can provide a substantial pickup in yield compared to a variety of more liquid asset classes, and it also has a defensive quality, as the cash flows are tied to a real asset.

For investors seeking both income and a degree of downside protection, mezzanine debt may have a role to play in a diversified portfolio. Robert Karnes, BlackRock’s Global Head of Real Estate Debt, provides a look at current trends and opportunities in the asset class.

Q. What’s the current opportunity set? What trends are you seeing?

A. I think one of the biggest trends affecting the space today is the global supply-demand dynamic. The picture is especially favorable in the U.S., where there is close to $2 trillion in commercial real estate debt scheduled to mature in the next few years.  A good portion of this debt came to the market in the pre-crisis years, which was obviously a very different environment.

Maturing U.S. commercial real estate debt

Commercial real estate debt maturities from 2000-2020.jpg

Source: Trepp, LLC, June 2016; based on Federal Reserve Flow of Funds Data.

Back then, commercial banks were big providers of capital in the space. But now, due to both regulatory and capital constraints, banks have pulled back. They’re lending less money to a smaller group of clients. So as the debt overhang of the pre-crisis years rolls off, borrowers need to look for alternative sources of capital, creating some compelling opportunities for institutional investors.

Commercial banks used to be comfortable lending 75% or more of the value against a particular piece of real estate, and many building owners were willing to write equity checks to cover the remaining 25% of the value.

Now, we’re seeing banks capping their lending at 60% of a property’s value, but owners still don’t want to contribute more than 20-25% in equity. So that dynamic is opening things up for mezzanine investors to fill out that portion of the capital structure between the senior bank debt and the owners’ equity.

There is also a similar dynamic playing out in the commercial mortgage backed securities (CMBS) market, which has historically provided a significant amount of supply in the U.S. Private label CMBS issuance peaked in 2007 at around $230 billion, dropped to slightly under $100 billion last year, and this year we think the figure will be closer to $50-60 billion.1 So again, there is a real opportunity for institutional investors to step in here.

Given the sizeable demand for capital across both mezzanine debt and CMBS, we think it’s possible to assemble an attractive, diversified portfolio, and we believe there are opportunities in almost all regions of the U.S. and in all property types.

Q. How do you expect this asset class will perform as the cycle turns?

A. The answer to that depends partially, of course, on how and when the cycle turns. If markets experience another downturn like they did in 2008 and 2009, then investors in all types of sub-investment-grade debt are likely to suffer some losses. However, since we haven’t seen the same kind of excesses that we did in the years before the financial crisis, we don’t anticipate we’ll see the same intensity of dislocation if the market experiences a downturn.

Also, mezzanine investors do have the advantage of holding debt that is backed by a tangible asset, and they are insulated by the equity capital that is invested in the property. For example, if equity makes up one-fourth of the capital structure of a deal that you’ve invested in, then that asset would need to lose 25% of its value before the value of your investment can start to erode.

Finally, I think it’s also helpful to consider how property owners may react to a downturn in the market. Let’s say an owner starts to lose some tenants and isn’t collecting as much monthly rent. Would the owner stop paying debt service and walk away from the equity that has been invested in the property, or would that owner continue to support the property and pay the debtholders?

Q. What is required for success in this asset class?

A. I think that number one is experience in the space. If you haven't been through major real estate cycles, I think you're at a big disadvantage. There’s no substitute for the lessons that you learn and the knowledge you acquire from being an active participant in the market throughout different cycles. For example, understanding and recognizing the differences between an overbuilding cycle and an over-leveraged cycle can really only come from having lived through both.

Beyond experience, I think there are some advantages to being part of a large platform. Access to deal flow is one of the foundations of a successful mezzanine business, and having a large, diverse platform can certainly help when it comes to sourcing deals.

Once you do get a look at deals, a broad platform can aid with analyzing the opportunity set. Even if you’re only interested in the mezzanine portion, having a team with experience in the equity portion of the capital structure, as well as in more senior debt, can give you a more balanced and holistic view of the risks a particular deal.

Robert Karnes
Managing Director, Global Head of Real Estate Debt
Robert Karnes, Managing Director, is Global Head of Real Estate Debt at BlackRock and a member of the Real Estate Global Executive Committee.
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