Mezzanine numbers jump, but ...

When it comes to originating real estate debt in the COVID-19 crisis, it's not like the last crisis, real estate managers say.

Unlike in the global financial crisis, real estate owners during the pandemic still have access to some loans, which is helping to prop up asset prices. However, since property valuations are staying at pre-pandemic levels, lenders of riskier mezzanine debt pulled back from originating loans from the start of March to June 30.

While mezzanine worldwide assets of the managers that responded to Pensions & Investments' annual survey grew by 15.4% to $22.9 billion and mezzanine assets managed for U.S. tax-exempt institutional clients rose by 14.8% to $10.5 billion in the 12 months ended June 30, the bulk of the investment activity occurred pre-COVID-19, industry sources said.

PGIM Real Estate Inc. issued no new loans from early March through June 30, even though it was very active in the space before COVID-19, said Eric Adler, London-based CEO.

PGIM Real Estate is ranked third on the list of mezzanine managers for U.S. tax-exempt institutional investors, with AUM up 19.7% to $784 million.

Mr. Adler said that until valuations drop, "there is not a lot of space for mezzanine lending."

PGIM Real Estate did not stop originating mezzanine loans because of lack of deal flow, Mr. Adler added.

"People want loans but they say their property is worth as much as it was in January," he said. "We say 'no,' values have to come down. They are waiting and we are waiting. Distress is the catalyst for borrowers and sellers to do something."

Once valuations come down, there will be a huge opportunity for mezzanine, Mr. Adler said.

However, right now there is too much liquidity for that to happen, he added.

Nuveen LLC tops the list of mezzanine managers for U.S. tax-exempt clients with assets up 18.2% to $6.4 billion, followed by Brookfield Asset Management, with assets down 5.9% to $848 million.

Nuveen also slowed the pace of mezzanine lending due to the pandemic, said Carly Tripp, Charlotte, N.C.-based CIO of the Americas at Nuveen Real Estate.

"We're making mezzanine loans on a more selective basis and at lower volumes than we did last year," Ms. Tripp said. "We've had a strong mezzanine program over the last several years."

Valuation uncertainty caused by the pandemic is prompting mezzanine lenders — whose loans are riskier — to lend only at lower loan-to-value ratios and higher rates, she said.

Lenders are in no hurry to start the foreclosure process or restructure loans, which is expensive. According to Real Capital Analytics Inc. data, banks are responsible for a larger portion of U.S. commercial mortgages than any other type of lender, including commercial mortgage-backed securities and investor-driven lenders, a term RCA uses for non-bank lenders such as debt funds and mortgage real estate investment trusts. Indeed, in the second quarter of 2020, banks gained market share of U.S. commercial lending as CMBS and investor-driven lenders pulled back. Since commercial real estate transactions have also declined, most of these loans are refinancings, Jim Costello, New York-based senior vice president of Real Capital Analytics, said in a RCA insights post on Sept. 16.

While there is a decrease in the riskier loans originated by CMBS and investor-driven lenders, bank and government agency lending in the second quarter have helped to prop up asset prices, Mr. Costello said.

That is a contrast to the global financial crisis when real estate lending by all parties declined dramatically, leading to a "vicious downward spiral" with falling prices, making lenders hesitant to issue new mortgages and even owners of properties with good cash flows willing to sell at lower prices, Mr. Costello said.

Declines are likely to be coming in the months ahead, he said.

PGIM Real Estate executives have just recently started to consider mezzanine loans again, Mr. Adler said. Senior loans are a different matter.

"There is a lot of debt dispersion," Nuveen's Ms. Tripp said. Senior financings are still attractive "if you are a diversified investor who also owns bonds," she said. "The spread between mortgages and investment-grade bonds is wider than pre-COVID."

Even then, lenders are less willing to originate even senior loans in certain sectors and locations or where the mortgage is for a larger portion of the value of the property.

Industrial and multifamily mortgages are easier to access and cheaper than office properties. It is difficult to obtain financing for retail, Ms. Tripp said.

In the COVID-19 era, the type of loans managers are issuing have changed, said Meg McClellan, head of private credit in J.P. Morgan Asset Management's global alternatives group. One recent deal was to provide a loan to refurbish an apartment building. Prior to the pandemic, the borrowers were going to use the CMBS markets, but the CMBS market pulled back from lending due to the pandemic, she said.

So, JPMAM is providing a transitional loan for a few years to tide the borrower over and allow it to continuing refurbishing the building.

"There's really a need for interim financing," Ms. McClellan said.

At the same time, there is investor demand to invest in real estate debt, she said.

"Pension funds are looking for income generation that can supplement the very, very low yields in the fixed income market," Ms. McClellan said.

And as for its current portfolio of loans, in certain circumstances the firm is working with lenders rather than starting the foreclosure process, she said. "As a fiduciary, our goal is to maximize the outcome for our investors" Ms. McClellan said.

The primary question is whether the borrower has a short-term or long-term problem. Many issues are short term and it makes more sense to work out an alternative to the borrower defaulting on the loan, she said.

"It makes sense to work with the borrower and be very, very transparent with investors," Ms. McClellan added.