A bit of deviation from HW's usual fare, but an interesting press statement late yesterday caught my eye -- the New York office of Holliday Fenoglio Fowler, L.P. said that it had arranged a $163.5 million acquisition and pre-development loan for a nearly 1.1 million-square-foot condominium interest in 375 Pearl Street in downtown Manhattan. Funding comes in the form of an adjustable-rate first mortgage and mezzanine financing through Apollo Real Estate Advisors, LP and M&T Bank. The commercial property, home to Verizon, will become a completely modernized and remodeled multi-tenant office space, with the telecommunications company leasing back three of the building's 32 stories. This is insanely interesting, but for a reason that might not be immediately obvious: the fact that mezzanine financing was used. In many ways, obtaining mezzanine financing is sort of like the commercial real estate equivalent of getting a second mortgage (although I need to note that there are very significant differences, such as what secures the loan, that I won't explore here). Those differences, however, have helped make mezzanine financing into Very Big Business™, since mezzanine debt is often treated as equity by the rating agencies. And -- much more importantly -- modern mezzanine lenders have taken to using the CDO market to leverage their returns. That would be the same CDO market now siezing up because of trouble in residential mortgages. Mezzanine debt is a popular feature in many a modern CMBS, but critics have oft-cited reckless mezzanine lending as a prime example of increased risk-taking in the commercial mortgage markets. That's what is so interesting here, even if the property in question is in a hot area like Manhattan. For one thing, I've been seeing some reports suggesting an emerging weakness in commercial real estate. For another, we don't know the particulars of this deal -- in particular, we don't know if the mezzanine holder plans to leverage the debt with a CDO or not. With that said, a report on mezzanine financing in commercial real estate from Dominion Bond Rating Service published in August of 2006 should be noted here:
The abundance and availability of capital is now at an all-time high. However, this has not always been the case and may not be in the future. In analyzing mortgage debt that includes mezzanine financing, DBRS addresses the likelihood of refinancing in a less favorable economic environment. It is surprising how few transactions have plausible plans to create value whereby cash flow increases sufficiently to refinance all mezzanine and mortgage debt at balloon.
With the Dow dropping more than 250 points today on recession concerns, now seemed to be a very good time remind readers that the "less favorable economic environment" that concerned DBRS in 2006 is likely now a reality. Which leads to the trillion-dollar question: has the commercial real estate industry adjusted?