Commercial Development News - Appraisal Development International

Tranche Warfare: Mezzanine Lenders Stepping Into Foreclosure Fray
Lenders Increasingly Opting to Protect Positions by Cutting Deals With First Mortgage Holders to Gain Control Over Distressed Property

By Randyl Drummer
CoStar Group
Published: Sep 2, 2009

Battles between junior and senior players in the commercial property mortgage capital stack are heating up as lenders try to avoid having their investments wiped out by the wave of troubled loans reaching maturities.

Mezzanine debt holders have been particularly active of late, exercising their option to push overleveraged owners -- including many who purchased property at inflated prices at the height of the market two or three years ago -- into foreclosure in order to gain control of the property.

At the same time, REITs, private-equity firms, asset managers and other investors, including many of the same players already holding mezzanine positions in distressed loans, are actively raising funds to buy senior positions in more mortgage debt. Several mortgage REITs have gone public in anticipation of an onslaught of distressed property investors and low-cost government financing available to investors willing to buy mortgage debt held by banks.

It's a mere fraction of the $3.5 trillion in outstanding U.S. commercial mortgages, but the $100 billion of outstanding B-notes and mezzanine positions has sometimes caused rifts between senior and junior lenders holding slices of the capital pie, which has grown larger and more complex since the relatively straight-forward loan structures of the last major recession in the early 1990s, according to Jones Lang LaSalle. The intervention by mezz lenders is a natural part of the market's disposition of troubled assets.

"Six months ago or so, mezzanine lenders weren't in a position to take an ownership position, and now they're closing out the debt equity operators' positions in the property as part of the foreclosure process," said Stephanie Lynch, vice president/real estate investment banking with Jones Lang LaSalle. "It's an acknowledgement that the equity is completely wiped out, and mezz lenders are working to solidify their ownership as part of a 'hold and hope' strategy and trying to hang on until they've recovered some of the value."

Lynch said debt structures were far less complex in the early 1990s, with fewer tranches, or tiers of segregated capital. Today, untangling the many and often-conflicting stakeholders' interests make asset disposition a longer and more drawn-out process. Parties frequently wind up in court.

"We expect to see a high degree of conflict between the competing interests of each creditor's position as these obligations are worked out," said Martin Kamm, managing director of Jones Lang LaSalle's Real Estate Investment Banking team, in a recent webinar presented by JLL and Hunton & Williams LLP.

Think of commercial real estate loan capital stacks as sophisticated pecking orders of junior and senior bondholders. At the top of the capital structure are first mortgages, usually held by senior lenders. Next come mezzanine loans, which are in effect second mortgages secured by the borrower's stock or equity. The owner's equity in the project comes third in the financial hierarchy.

Mezzanine loans are senior to the property owner's equity interests, but are subordinate to whole mortgage loans secured by first or second mortgage liens. In the event of a default, however, mezzanine lenders have the power to foreclose on the property, pay off the first mortgage and take ownership of the property. In addition, modern securitized commercial loans are bifurcated by risk, with B-rated mortgage notes subordinate to A-rated notes.

Acquisition of mezz debt followed by foreclosure has become a standard vulture play in recent months. Investors such as Fortress Investment Group, Blackrock Inc., Five Mile Capital Partners and Normandy Real Estate Partners typically swoop in and opportunistically acquire a senior piece of the mezzanine on a distressed property at a deep discount. The vulture then hires a special servicer when the borrower fails to make payments and takes the property into foreclosure. The investor then buys the asset for pennies on the dollar at auction.

Such foreclosures are occurring across the real estate spectrum, from office, hotel, retail, condominium and mixed-use properties to development land.

In the first big foreclosure, mezzanine lenders Normandy Real Estate Partners and Five Mile Capital Partners took over Boston's John Hancock Tower and an office tower in Los Angeles in March after gradually acquiring discounted tranches of the debt over the previous year.

Then in July, senior lenders restructured $1.3 billion in debt on a 33-property, 4.6 million-square-foot Southern California office portfolio to allow four mezzanine investors to convert $500 million of debt into equity. A joint venture of Houston-based Hines and the California Public Employees Retirement System (CalPERs) had previously converted a $100 million share of junior debt into equity when it took over the portfolio from Cabi Developers last December.

However, New York Life and three German lenders, holders of $700 million in senior notes, in July allowed BlackRock Realty Advisors, Gramercy Capital, KBS Realty Advisors and Square Mile Capital to convert $500 million in mezzanine debt into equity. Cabi, the U.S. arm of Mexico's largest developer, acquired the portfolio at the top of the market in mid 2007 for $1.5 billion from GE Real Estate's Arden Realty.

Mezzanine loan foreclosure activity surveyed by CoStar in recent weeks includes the following:

Fortress Investment Group bought Sheffield57, a condo project in New York City developed by Kent Swig, for $20 million in a mezzanine foreclosure auction last month. Credit Suisse First Boston filed a default on the $400 million first mortgage in April and Guggenheim Structured Real Estate Partners LLC followed suit on a $240 million mezz loan the following month.

SL Green Realty Corp. (NYSE: SLG) said last week that 100 Church St., a 21-story office in Lower Manhattan, is on the market and slated for an Oct. 15 auction. The New York REIT alleged that owner The Sapir Organization failed to make payments on an $85 million mezzanine loan provided by SL Green and Gramercy Capital. SL Green has taken over management and leasing of the building.

Wachovia Bank (now Wells Fargo) filed a foreclosure lawsuit Aug. 18 against BentleyForbes Holdings and BF Las Olas, developers of the Las Olas Center in Fort Lauderdale, FL, which consists of two Class A office towers totaling 415,000 square feet, 52,000 square feet of retail and parking space. BentleyForbes bought the property in 2007 for $230.9 million, a record South Florida price of nearly $500 per square foot. Wachovia, representing a group of lenders, provided a $166 million first mortgage and a $49.4 million mezz loan.

Mezzanine lenders in Terranea Resort, a $480 million oceanfront project in Rancho Palos Verdes, CA, filed a notice of default Aug. 11 on a $110 million loan to Terranea owner Long Point Development Partners. the Building Union Investment and Local Development Fund of America Trust, of Detroit

Detroit-based Building Union Investment and Local Development Fund of America Trust (Build) carried out a foreclosure sale of 104 acres in Cornelius, NC, where Cornelius Bromont LLC planned to build the $515 million Augustalee mixed-use project. Cornelius Bromont filed a lawsuit against Build last week seeking damages over the decision to foreclose on the project, which the Build funds described as being in a state of "technical default." Build said it acquired membership interests in four limited-liability companies that control the property and will work with the developer, the city and senior lender Fifth Third Bank on a plan to move Augustalee forward.

Citigroup seized the luxury 400-room St. Regis Monarch Beach Resort in Dana Point, CA, after owners Farallon Capital Management LLC and Makar Properties fell into default on a $70 million mezzanine loan. Citi scrapped a foreclosure auction after it became clear there would be no serious bidders.

In June, Bahrain-based Investcorp acquired a senior mortgage loan, a B-note for a senior mortgage and two mezzanine loans, all secured by U.S. commercial property assets, for a "discounted" $170.9 million. An office headquarters building in Washington, DC secured the senior mortgage loan. The two mezzanine loans, secured by office buildings in New York and Los Angeles, were acquired from a private investor. The B-note of a senior mortgage was secured by four self-storage facilities located in the boroughs of New York, and was purchased from a major commercial bank.