Mezzanine finance revealing another weak spot in the U.S. economy.
After the Global Financial Crisis (GFC), U.S. regulators imposed stricter regulations on larger banks. Limiting their riskier lending for commercial real estate and development. Their more conservative lending practices meant property owners turned to smaller banks or sought second loans from non-bank lenders to bridge their financing gaps, often on top of existing bank mortgages.
Lenders, in turn, favoured mezzanine loans because they yielded higher returns, often exceeding 10 per cent, even when long-term government bond interest rates were close to zero.
In a frightening example of déjà vu, companies such as Blackstone, KKR, and Starwood Capital stabilised on the trend, collectively lending billions in mezzanine loans. South Korean asset managers joined the fray, becoming major players in mezzanine lending against properties in cities like New York and Los Angeles. Meanwhile, it was reported some finance companies leveraged the EB-5 cash-for-visa program, converting funds from thousands of aspiring immigrants into mezzanine loans for developers.
Unsurprisingly, the tidal wave of debt led to inflated real estate prices in the run-up to 2022.
Unlike traditional mortgages, mezzanine loans have higher interest rates and offer a streamlined path to foreclosure, making them a preferred option for lenders in times of uncertainty. Mezzanine loans are secured by the limited-liability company owning the building rather than the real estate itself., which allows lenders to assume control of the property relatively quickly. And, as they aren’t technically mortgages, they don’t appear in property records.
Today the U.S., like Australia, has materially more office space than it needs. Building owners who financed their properties are being bitten by both higher interest rates and vacant offices as workers continue to spend time working from home.
According to some estimates, more than 17 per cent of the U.S. office supply, on average, is vacant, with a further four or five per cent available for sublease from primary tenants who don’t require the space. Of course, if I put my head in an oven and my feet in a freezer, my ‘average’ temperature will be just fine, but I won’t be. The averages mask a wide disparity in vacancies. San Francisco, for example, is estimated to have a quarter of its office space vacant.
Perhaps unsurprisingly, and in a troubling development for both the U.S. commercial real estate market and its banking sector, foreclosures on higher-risk loans are on the rise, all while falls in commercial property values are spreading.
Morgan Stanley noted in its third quarter release deteriorating conditions in the commercial real estate sector required it to provision U.S.$134 million for credit losses on top of the U.S.$161 million it set aside in the second quarter. Meanwhile, in October, Goldman Sachs revealed it had halved its exposure to office commercial real estate (CRE) this year.
Because mezzanine loans are opaque, escaping the scrutiny of property records and data companies, the total amount in the market is uncertain. But lenders have issued an unprecedented number of foreclosure notices, with the surge illuminating the escalating challenges presented by higher interest rates and rising vacancies.
According to The Wall Street Journal, there have been 62 foreclosure notices on mezzanine loans and other high-risk loans from January to October this year. This figure represents more than double the total for all of 2022, marking what could potentially be the highest annual total in history. The distressing increase in mezzanine loan foreclosures provides a more immediate gauge of the real estate sector’s distress than traditional mortgage foreclosure rates.
As real estate prices decline and defaults mount, it’s becoming evident that U.S. regulators’ post-2008 efforts to avoid a repeat of the GFC and stabilise the financial system have created new challenges, with borrowers unable to service their loans and lenders reclaiming properties.
As the foreclosures mount, the ripples will spread. Your author does not suggest the issue will trigger wider instability, but it will be fascinating to see whether the disruption remains contained to CRE or breaches the banks of that sector.
Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.
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