Mezzanine Has No Role to Play in Banks Repairing Loan-to-Values
Banks Should Consider Discounted Pay-Offs Instead of Subordinated Debt
Banks are asking borrowers to reduce their loans in situations where the value of the property has fallen. Many borrowers are looking at mezzanine lenders to inject cash on their behalf. I don’t believe there is a meaningful role for mezzanine lenders in these situations. Instead, banks should consider a Discounted Pay-Off.
Consider a €60 million bank loan on a building where the value has declined from €100 million to €65 million. The initially conservative loan-to-value shoots up to 92%. The bank wants to bring this down again to around 60% and asks the borrower to make a €20 million prepayment in return for a three-year extension of the €40million remaining balance. The borrower has not got the equity and turns to a mezzanine provider.
Some mezzanine lenders may be tempted. It is still not easy to deploy 15%-plus money in credit. The bank could show a bit more leniency with the intercreditor agreements than typical, offer a lower margin and/or increase the LTV slightly. A deal on paper may be within reach.
This may have worked in previous cycles, but not this one. The credit risk appears elevated.
For the mezzanine loan to repay successfully, you need a recovering cycle with rising property values. This is challenging to underwrite. The current downturn has been triggered by higher interest rates, which seem here to stay. Similarly, banks could be expected to offer higher loan-to-values as the cycle recovers due to increased competition. This time, however, Basel IV rules coming into effect until 2027 imply continued balance sheet shortening. European banks remain highly levered (20 times) compared with their American peers (10 times). Mezzanine lenders will also be reluctant to roll up their interest and wait for the exit. Banks and borrowers expect mezzanine to price at 10 to 12%, but mezzanine lenders will only do that for some rock-solid deals. Why would you write a mezzanine loan at 10% when you can charge that for a less risky, whole loan? Finally, borrowers want prepayment flexibility, but early prepayment will be expensive as mezzanine lenders have minimum absolute return targets.
Going back to the earlier example, the bank may decide to push for a consensual property sale in the absence of fresh capital to pay it down. Following the value drop, the borrower has only got €5 million of equity left. The bank stands to recover 100% and the borrower only 12.5% if it co-operates. This doesn’t seem attractive for the borrower, particularly if you assume the property sells for, say, €50 million after an enforcement, which would result in a 17% loss on the original loan amount for the bank.
Many borrowers won’t co-operate given the unique macro-trigger behind this cycle. This provides an excuse to play hardball. As the next best option, the bank should offer the borrower the option to buy back the loan at a DPO price of €50 million. This reduces recovery uncertainty, reputational risks and legal costs. Banks have not got the manpower to deal with enforcement. Properties have become more operational during the past decade. European countries have high real estate transfer taxes, which are avoidable by doing DPOs.
The cost of fresh capital for DPOs will also be competitive, especially if stress is limited to the capital structure and not the property. New documentation can be agreed with the borrower. There may be a premium over whole loan pricing but still below the typical capital for non-consensual loan sales.
Clearly, pretend-and-extend may be in the interest of bank and borrower. Regulators have wanted to make this exponentially more expensive for banks, including for performing credit at higher LTV’s. Early signs suggest the regulator has more work to do, for instance German banks have started delaying re-valuations. However, I expect regulators to tighten the screws.
In the UK there is the first example of an existing lender who had refused a DPO offer but is now facing lower enforcement proceeds. DPOs are a self-fulfilling prophecy, the more borrowers believe in them the more likely they are to come true. Strap in!
This article was featured in CoStar
