Foreclosures are on the rise in a complex and risky segment of commercial real estate finance, signalling an escalation in the property market's turmoil. A Wall Street Journal analysis reveals a record number of foreclosure notices issued this year for high-risk property loans, particularly mezzanine loans, which resemble second mortgages.

  • Mezzanine loans, known for their high interest rates and expedited foreclosure processes compared to traditional mortgages, have seen a notable surge in foreclosure notices.
  • The analysis identifies 62 such loans, along with other high-risk loans, through October of this year—more than double the count for the entire previous year.
  • This increase, attributed to higher interest rates and growing vacancies affecting the property sector, provides a more immediate indicator of distress in commercial real estate compared to mortgage foreclosure rates.

While commercial mortgage foreclosures remain relatively low, mezzanine loan foreclosures are gaining prominence due to their swift and straightforward nature. Unlike traditional mortgages, mezzanine loans do not appear in property records, making it challenging to determine their dollar value in announced foreclosures.

Mezzanine Loans

The popularity of mezzanine loans surged in the decade following the 2008-09 financial crisis as regulatory pressures on major banks led to more conservative lending practices. Smaller banks, debt funds, and nonbank lenders, including Blackstone, KKR, and Starwood Capital, became prominent mezzanine lenders, contributing to the inflation of the commercial real estate market.

  • However, with real estate prices now declining, many of these loans are defaulting, highlighting new challenges in property finance resulting from post-2008 regulatory efforts.
  • Before the onset of rising interest rates last year, mezzanine loans typically carried interest rates ranging from 10% to 12% or even higher, as noted by Alex Draganiuk, who oversees the commercial-loan sales desk at Mission Capital brokerage.

Right now, these same loans frequently come with rates surpassing 15%, posing significant challenges for refinancing upon expiration and contributing to an uptick in defaults and foreclosures.

Layers Of Debt

Mezzanine loans played a pivotal role in financing major transactions in the years leading up to 2008. To make things worse, they often involved intricate layering, as recounted by Kenneth Chin, a partner at Kramer Levin Naftalis & Frankel law firm, who described a deal with six levels of mezzanine debt.

  • This complexity sometimes resulted in the cumulative loan amounts exceeding the value of the underlying buildings.
  • For instance, the Stuyvesant Town and Peter Cooper Village apartment complex in Manhattan, seized by lenders after the market crash, had 11 layers of mezzanine debt, as detailed in the property's bond prospectus.
  • Numerous loans nationwide were wiped out when the market underwent a downturn.

In recent years, the practice of layering mezzanine loans has resurfaced. The 42-story 20 Times Square hotel and retail tower in Manhattan, once valued at $2.4 billion, exemplifies this trend with court records indicating four mezzanine loans.

Loans Won't Come Easily

As the markets turns, lenders are becoming more cautious and this approach is expected to worsen the scarcity of liquidity for property owners with limited exit options. As two-year interest rate caps mature, new caps are becoming significantly more expensive, posing additional challenges for borrowers.

  • The market's liquidity gridlock is further exacerbated by dropping property valuations, leading to smaller senior refinancing loans at significantly higher rates.
  • Property owners find it increasingly difficult to sell assets, either due to a lack of buyers or demands for low valuations, leaving them with minimal proceeds after settling loans.
  • Estimates suggest that nearly $2 trillion of commercial real estate debt is set to mature in the next two years, further increasing the demand for private liquidity.
  • The competition among lenders has dwindled, with fewer lenders submitting quotes, and the challenges faced by over-leveraged applicants are resulting in a lower loan approval rate.

Despite a surge in loan applications, private lenders may only approve a small fraction due to over-leveraging issues, leading to concerns about portfolio management expenses for some lenders. The current delinquency rate for commercial mortgage-backed securities is 4.7%, expected to rise to 10.5% in the coming years, although experts believe the risk of a systemic crisis is low.

Disclaimer

Please note that Benchmark does not produce investment advice in any form. Our articles are not research reports and are not intended to serve as the basis for any investment decision. All investments involve risk and the past performance of a security or financial product does not guarantee future returns. Investors have to conduct their own research before conducting any transaction. There is always the risk of losing parts or all of your money when you invest in securities or other financial products.

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