Mezzanine debt market expands as permanent lenders pull back, but this financing vehicle can be pricey.
By Jane Adler
As primary lenders claw back financing levels amid a variety of concerns about the senior living market and the wider economy, mezzanine debt is taking up some of the slack — a trend that could accelerate over the next 12 months.
Mezzanine funds, which fill the gap between senior debt and equity, are now readily available to owners, operators and developers of seniors housing and skilled nursing projects.
Borrowers are using mezzanine debt to refinance projects, reposition struggling acquisitions and undertake new development. Mezzanine debt is also being deployed prior to a permanent agency take-out loan in order to access equity.
The interest rate on mezzanine debt has crept up a bit, currently ranging from about 10 to 15 percent, according to sources. Borrowers are generally required to have industry experience, but lenders are finding more creative ways to structure mezzanine packages.
“It’s a borrower’s market,” says Anthony Alicea, managing director of bridge and mezzanine lending at New York City-based Greystone & Co. “There’s an abundance of capital.”
Mezzanine debt is the blurry part of the capital stack. It sits between senior debt and equity with features of both. Mezzanine debt is repaid like a loan, but it can also provide equity to the lender in the case of a default.
By comparison, mezzanine debt is cheaper than equity and it doesn’t dilute the owner’s position. The owner doesn’t share equity, or decision-making responsibilities, with multiple partners.
But mezzanine financing is more expensive than senior debt. It should also be noted that preferred equity is a growing alternative to mezzanine debt.
It’s hard to get a handle on the size of the mezzanine debt market for senior living. No one tracks the numbers, but interviews with lending sources indicate that demand for the product is growing.
For example, Locust Point Capital, an active mezzanine lender, reviewed or considered $900 million in debt financings in 2018 in the seniors housing and care sector, the vast majority comprised of mezzanine debt. Annualizing data from the first quarter of 2019, Locust is on track to review more than $1.3 billion for 2019 with an average transaction size of $5 million. Locust typically funds about 10 to 15 percent of the deals it reviews.
At Greystone, bridge financing for healthcare properties tripled from 2017 to 2018 to $1 billion. About 10 percent of its portfolio lending volume in 2018 consisted of healthcare mezzanine financing.
“Everyone wants leverage,” says Adam Offman, managing director of healthcare finance at New York City-based Dwight Capital. “Borrowers want to put as little money as possible into these deals.”
A number of factors at play
Since the big healthcare REITs no longer make up a big chunk of the seniors housing transaction volume, Offman explains, the latest crop of investors is not as well capitalized as the REITs and needs more debt to make acquisitions or to refinance. The most likely mezzanine borrowers today in the senior living space are regional operators and small to mid-size investors, he adds.
Other factors are boosting the mezzanine market. First mortgage lenders are becoming more cautious. They worry about the amount of new construction, added competition and low occupancies. Operating margins are also being squeezed as the cost of labor rises amid competition for frontline workers.
The seniors housing market remains soft, even though it has improved a bit lately.
Approximately 37,000 units were under construction at independent and assisted living properties at the end of 2018 in the top 31 markets, according to the National Center for Seniors Housing & Care (NIC) based in Annapolis, Maryland. This figure is down from the record high of about 44,000 units in the fourth quarter of 2017.
Construction as a share of inventory fell to 6 percent in the fourth quarter of 2018, down from a high of 7.3 percent in the fourth quarter of 2017.
The occupancy rate for seniors housing, which includes properties still in lease-up, inched up to 88 percent in the fourth quarter of 2018 from the seven-year low of 87.9 percent in the third quarter. The fourth-quarter rate was 70 basis points below its level of 88.7 percent in the fourth quarter of 2017.
Underwriting standards are becoming more conservative, reducing the amount of leverage available.
While borrowers often seek loans to cover up to 90 percent of the project cost, banks now only offer senior loans that cover about 50 to 60 percent of the cost.
“Over the past 12 to 24 months, we have seen senior mortgage lenders reduce their loan leverage approximately 5 to 10 percent on a loan-to-cost and loan-to-value basis,” says Eric Smith, CEO and managing partner at Locust Point Capital based in Red Bank, New Jersey.
At the same time, lenders are concerned about running afoul of regulations that limit the amount of real estate-related loans on their books. Although talk of a recession has cooled lately, many observers still worry about the macroeconomic outlook.
“Banks are reacting,” says Kathryn Burton Gray, senior managing director and head of healthcare and senior housing lending at Hunt Real Estate Capital, who is based in the firm’s Irvine, California office. “They’re being conservative.”
Some senior lenders won’t participate in deals with mezzanine debt. Alternatively, other senior lenders welcome mezzanine debt to solidify relationships with owners and operators, and to fill the pipeline of their permanent lending partners, specifically Fannie Mae and Freddie Mac.
Mezzanine loans range from about $500,000 to as much as about $25 million, sources say, though most loans are in the $1 million range.
HJ Sims structured a $27 million mezzanine loan for Next Healthcare Capital, a New York-based private equity firm, as part of the acquisition financing of 15 skilled nursing facilities. The properties are located in Pennsylvania, New Jersey, Connecticut, West Virginia and Massachusetts.
Welltower, a Toledo, Ohio-based REIT, sold the buildings to a joint venture between Next Healthcare and Genesis Healthcare (NYSE: GEN) for about $200 million. The primary lender was KeyBank. The deal closed January 31, 2019.
The mezzanine loan was structured to be repaid with the proceeds of a HUD financing or remain in place after HUD financing.
“Mezzanine loans can be a fit for a wide range of potential borrowers,” says Curtis King, senior vice president of HJ Sims, who is based in Austin, Texas. He points to another example of an operator with a portfolio of communities in lease-up that needed additional working capital to reach stabilization. Sims was able to provide the necessary funding.
Portfolio acquisitions in the mezzanine space mostly consist of skilled nursing properties. One-off transactions are more commonly single seniors housing properties of assisted or independent living.
Contemporary Healthcare Capital has placed about $50 million in mezzanine loans since Sept. 1, 2017, when the Tennessee-based company launched its Contemporary Healthcare Fund III.
In a typical transaction, Contemporary Healthcare recently provided a $2 million mezzanine loan to affiliates of The Portopiccolo Group, headquartered in Englewood Cliffs, New Jersey, for the acquisition of a skilled nursing facility.
The 130-bed licensed skilled nursing facility is located in Roanoke, Virginia and includes a 24-bed ventilator unit.
United Community Bank out of Blairsville, Georgia provided the accompanying senior loan in conjunction with a participation by Chattanooga-based Millennium Bank. The loan funded the acquisition and included approximately $1 million for future facility renovations and upgrades.
“Most borrowers are looking to push their leverage stack as much as they can,” says Steve McGee, director of operations and manager at Contemporary Healthcare Capital. His office is in Birmingham, Alabama.
Like other mezzanine lenders, Contemporary Healthcare offers debt for acquisitions and repositionings. It also provides bridge-to-HUD take-out loans. These loans help the owner access “trapped equity,” says McGee, by adding a mezzanine layer to the capital stack.
HUD typically only refinances existing debt, but doesn’t allow cash-out refinancing as a way for borrowers to tap equity they’ve built up. However, the rules in 2017 were relaxed in certain cases.
Red flags emerge
Mezzanine lenders are becoming more cautious about new construction, though they’ve seen no slowdown in demand from developers.
“We are more selective on construction debt,” says McGee, voicing concerns about the amount of new construction in the seniors sector, a worry echoed by senior lenders.
Offman at Dwight Capital says his firm is being more selective about new construction. “We are seeing a lot of demand for mezzanine debt for new construction of assisted living, independent living and memory care,” says Offman. He reviews at least one deal a week to fund a new seniors housing project. “It’s concerning,” he says.
Dwight Capital doesn’t avoid certain markets, but the firm methodically analyzes local demand and competitive properties.
The operator’s track record is very important too. Lenders want borrowers that know the industry and have a history of success.
Greystone vets borrowers to show they’ll qualify for a permanent agency loan, says Luann Gutierrez, managing director of the company’s healthcare portfolio lending group, which provides bridge and mezzanine financing for seniors housing and skilled nursing properties. Her office is in Dallas. “It’s not beneficial for me to get someone in the door if they are not going to qualify,” she says.
The borrower should have “boots-on-the-ground” experience in the local market. Also, the borrower needs liquid assets of 10 percent of the loan amount. “I want to know there’s a cushion there and the borrower is engaged,” adds Gutierrez.
An alignment of interests is crucial for new construction, says McGee at Contemporary Healthcare. He doesn’t like deals where a developer hires a third-party operator. “They need to have skin in the game,” he says.
Another red flag: borrowers seeking 95 percent leverage. That’s too much in today’s market, sources say.
An alternative to mezzanine debt is preferred equity. They both function much the same in the capital stack, allowing the owner/operator to bring less cash to the closing table.
Preferred equity investors are repaid the original amount of their investments either at a set date or when the property is sold and/or refinanced.
Preferred equity investors rank senior to investors who own common equity, but rank junior to the debt lenders.
Preferred equity has grown in popularity lately as some investors have looked to reduce their risk during what they feel may be a later point in the economic cycle. Returns for preferred equity are in the low-to-mid teens — similar to mezzanine debt.
From an owner/operator standpoint, mezzanine debt and preferred equity are viewed similarly, says Joel Mendes, senior vice president in JLL’s Senior Housing Capital Markets Group, Columbus, Ohio. “The senior lender is the one that sees the big distinction,” he notes.
Senior lenders favor preferred equity over mezzanine debt due to the collateral structure and control provisions that mezzanine lenders require, says Mendes.
Preferred equity investors do not typically have a lien on the membership interests of the real estate owning entity, for instance. Further, preferred equity structures frequently have a “full accrue” feature, which is important to both owners and senior lenders. Monthly interest payments are not required if property cash flows cannot support those payments, thereby lowering the likelihood of default, Mendes explains.
Where is mezzanine headed?
Lenders expect loan volume to increase going forward. If the economy slows, senior lenders will contract further and boost the need for mezzanine funds.
Weaker deals will not get done but others will, notes Smith at Locust Point.
“We see an opportunity with well-capitalized operators,” says Smith. New facilities that are taking longer to fill than expected may exhaust their reserves and be forced to liquidate underperforming assets or boost their reserves with a mezzanine loan. “It should be good for our business,” he says.
McGee at Contemporary Healthcare agrees.
He expects mezzanine volume to pick up during a market correction that will result in some failed properties, which will be sold at less than the original cost or replacement cost.
“That would be good for our business — as long as the failed properties are not in our portfolio.” n