Over the next few years, there is over $2 trillion of loans maturing. From this total, there could be anywhere from $500 billion to $1 trillion in terms of funds that can be refinanced, says Bruce Batkin, co-founder and CEO of Terra Capital Partner, a New York-based firm that provides mezzanine financing for commercial real estate properties.
“The climate today, particularly the regulatory climate, is such that alternative lenders like Terra are increasingly becoming an important part of the financial credit markets,” Batkin told this publication in an interview. “Now is a good time to be doing this type of financing because property values in most markets are still pretty beaten down. So we feel pretty comfortable in terms of the integrity of our collateral and our last dollar exposure to that collateral.”
But refinancing the senior portion of the equity capital stack of troubled debt on behalf of a borrower is not an easy task for an alternative lender like Terra Capital, as there are several hurdles that could hinder the completion of the transaction.
First, a mezzanine capital transaction cannot be completed without an intercreditor agreement, which sets forth the various lien positions and liabilities of each creditor and also establishes priorities in payments.
Generally, there are two lenders in most deals, the alternative lender and the senior mortgage. If an alternative lender has already worked with a lender before on a refinance transaction, an old intercreditor agreement can be used, therefore facilitating the closing.
But if the senior lender is someone new, an intercreditor agreement needs to then be negotiated, which Batkin says could be a difficult process.
Additionally, if a regional bank or local lender does not want an intercreditor agreement with a mezzanine lender, a deal has to be arranged via preferred equity, which has a whole different set of legal challenges. A preferred equity deal requires the alternative lender to become part of the LLC that owns the property. Therefore, the alternative lender then has to be put in a “preferred debt-like position,” Batkin says.
The financial aspect is another challenge that could stop the loan from closing. For example, if a retail property, industrial building, or apartment complex is only 60% leased while the rest of that submarket properties are all 85% to 90% leased, there may not be sufficient cash flow to service all the debt on the property.
“One of the challenges in these types of transactions is getting comfortable that the market and the borrower will enable this property to get better leased,” Batkin says. “It is important to evaluate what’s going on in the market. Does the borrower have a good management/leasing team? What are the capital requirements to get the building into good shape?”
Determining which borrowers should be offered refinance capital is a simple task for Batkin based from the vantage point of whether Terra Capital would feel comfortable owning that building. A second factor that Batkin says dictates whether the alternative lender provides funding for a borrower is if the asset could ultimately sell for the amount of the total debt on the property.
“Our business is negotiating, so nothing is easy,” Batkin says. “We are a fiduciary and have thousands of investors and we’re here to protect them. So if necessary, we’ll walk away from a deal if we can’t adequately protect their $25,000 to $25 million investment.”
Timing is also an important part of the financing business, as Batkin compared it to selling a stock by “waiting out the turmoil” and then “coming back and buying stocks when they are cheap.”
“The cycles are just more protracted than in the equity market,” Batkin added.
Batkin is projecting another five good years of “fertile investment opportunities” outside of major gateway cities such as New York, San Francisco, Washington, or parts of Boston where property values are still quite low relative to reproduction costs relative to where they were at the peak. Also, there is limited, if any, new construction going on within those markets, which is a very good indicator of when it’s time to leave a market.
“With the Basel III and Dodd-Frank regulations, it’s not easy for a regulated lender to lend more than a modest loan-to-value,” Batkin says. “I think the biggest challenge we are going to face is at some point, there will be too much money in the market again. Credit spreads will be driven down too far and the risk-reward ratio will not be favorable to us.”