Financing: Rating Mezzanine Loans

By Stuart Eisenberg

In the past decade, mezzanine lending has grown from a somewhat arcane form of junior financing to a primary role both in non-securitized lending and particularly in commercial real estate (CRE) collateralized debt obligations (CDOs). Their important role is emphasized in a new report by Moody's Investors Service titled "Moody's Approach to Rating Commercial Real Estate Mezzanine Loans."

Pre-mezzanine real estate financing consisted primarily of a first mortgage equal to 65 to 75 percent of the property's value and if additional financing was required, by a junior mortgage for an additional 15 or 20 percent. Junior mortgages are not favored by primary lenders because a junior mortgagee is likely to raise legal obstacles to the senior lender's remedies in the event of default. This led to the use of the mezzanine loan that has no claim on the underlying property itself but is secured by a pledge by the borrowers of their equity. For example, if the property is owned by a partnership, the partners can pledge their interests as security for the mezzanine loan. Thus, the mezzanine lender would have no claim against the real estate itself in the event of a default.

Growth of Mezzanine

CRE mezzanine debt placed in CRE CDOs increased from just under $26 million in 2004 to over $3 billion in 2006. Says Moody's, mezzanine loans now have their own capital market outlook and Moody's rates them in their own right, not viewing them only as an impediment to higher ratings on the senior debt (although they remain so to some degree).

While a mezzanine loan can be long or short term, amortizing or standing and with a floating or fixed rate, most are relatively short term, interest-onlyfloating rate transactions. A small but growing number, however, are fixed rate debt that matches the term of the senior loan. Most are at the bottom of the debt stack and receive below- investment-grade shadow ratings.

In this respect, mezzanine is akin to B-notes. However, the mezzanine holder lacks any pledge of ownership interest in the property, as noted above. Moody's expects that all of the beneficial ownership interests in the property-owning entity will be pledged as collateral for the mezzanine loan so that any foreclosure of the loan will result in a transfer of all the equity interests, leaving behind no minority interest. Complete control of the property owner is crucial since a pledge of partial ownership interests opens the door to many imponderable legal, structural and credit risks and claims.

Balloon Maturity

Most real estate loans have balloon maturities (i.e., when the loan matures it has not yet been fully repaid). Moody's prefers both loans to mature at the same time. The balloon date of the senior loan is a natural "break point" when borrowers will be making an all-out effort to "restack" the debt. The major financing sources now prefer "one stop shopping" and "the convenience of refreshing all buckets at once becomes a credit positive." Moody's believes that the inter-creditor agreement (between senior lender and mezzanine lender) probably produces a more favorable result for the mezzanine lender when both loans are originated at the same time.

Inter-creditor Agreements

The success or failure of a mezzanine loan may depend upon the terms of the inter-creditor agreement with the mortgage lender, since the mezzanine ultimately has only the right to step into the shoes of the borrower in the event of problems. Typical provisions include the following:

• The senior lender must give notice to the mezzanine lender of any default under the senior loan together with the opportunity to cure following expiration of the senior borrower's cure period.
• Amendments to the senior loan documents require the mezzanine lender's consent.
• The mezzanine lender has the right to assign its interest without the senior lender's consent.
• The senior lender will take no action if the borrower defaults under the mezzanine loan (i.e., no cross-default provision in the senior loan documents).
• The senior lender's consent is not needed to enforce the mezzanine lender's rights under the equity pledge.

Mezzanine Loan Limitations

The mezzanine lender must recognize that a lien does not touch the real estate itself nor does it relate back to the date of the loan. It merely gives the lender the right to step into the borrower's current (and likely troubled) position as it exists at the time of the mezzanine loan foreclosure. By contrast, the real estate mortgage remains the most powerful lender-friendly instrument.

The mezzanine lender's position after foreclosure, says Moody's, “is subject to whatever a borrower in its wisdom or foolishness—or disregard of promises—may have done to the real estate asset.” The borrower might even sell the underlying real estate asset from under the mezzanine lender and misapply the proceeds or give a deed in lieu of foreclosure to the senior lender.

One way for the mezzanine lender to protect its interest is to obtain UCC insurance from one of the major title insurance companies. Such insurance insures the lender’s security interest for enforceability, priority, perfection and attachment of the equity collateral. It also insures against fraud and forgery. Also available to the mezzanine lender is a form of title insurance called "mezzanine financing endorse ment."

Stuart Eisenberg is a Partner with the Real Estate and Hospitality Services practice in BDO Seidman’s New York office. He can be reached at (212) 885-8431.

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