Real Estate Finance Outlook 2023 - Mezzmeric

2023 looks to be a mix of low margins for very low gearing or expensive money at modest gearing. Base rate increasing by 14x in 1 year hasn’t helped.

As senior debt lenders continue to reduce their LTVs the gap between debt and equity will widen. In January revised capital cost assumptions and new regulatory pressures will result in prime lenders having to offer gearing in the 35% to 50% LTV range. Prime interest margins remain attractive in the 1.75% to 2.50% range with the recent problem now being either the floating, or fixed, cost of capital. 3- and 5-year caps can be good value but perhaps not if thinking about holding an asset in the medium to long term as the 10-year gilt rate is 3.60% and variable Bank of England Base Rate is at 3.50%. Lenders offering margins in the 3.50% to 5.00% range are likely to be in the <65% ltv space if the deal can hold up to pessimistic assumptions.

Both commercial and residential investment portfolios are under pressure from different directions, low yields for residential portfolios leaves less capacity for servicing and higher capital costs (due to regulatory requirements) for commercial assets suppress leverage capacity. Logically softer yielding assets are more difficult as lenders re-price, reduce LTVs and take an even more defensive approach to covenants. Gross to net cost assumptions and occupancy levels are also being more pessimistically sensitised. This is before any formal valuations are undertaken which may present further surprises due to reduced transactional activity and therefore comparables. 2023 might be frustrating as they there should be some interesting opportunities up for grabs.

The logical ways to plug capital gaps in the middle of the structure is either equity or junior debt. Mezzanine and preferred equity will both be in demand in 2023 and 2024 to help replace reluctant senior debt funders on both refinances and purchases. If adopted alongside an existing prime debt facility then a mezzanine top up should cost 8-12% pa, be up to a minimum of 60% LTV and present 10% of the LTV but it will be essential. The main drivers look to be to help protect low pricing, avoid a breach of covenant, possibly leave a fix intact or to avoid being exposed to the refinancing market.

A mezzanine facility will make sense up to a cost of c13% pa on top of BOEBR at 3.50% and a margin of 2.50% as the weighted average cost of capital (WACC) will still be sub 5%. Retail banks are currently speaking to existing borrowers to urge them to adopt a base rate of 5%, plus their existing margin, to open discussions on how a re-financing, or re-pricing, would look. The usual 3-year loan term taken out in January 2020 (Base rate 0.75%) will be maturing now with a realistic historic margin of 2.20%, so a sub 3% all in cost of capital. If the retail bank’s new approach is adopted, then the same loan needs to stack up and service at 2.5x of its historic cost. Mark Carneys last MPC vote was March 2020 which now feels like a lifetime ago.

In the early stages of 2023 mezzanine capital costs might be a little higher than later in the year as more funders tune in to the prospect of double digit returns for senior debt like risk. Established fixed income funds, hedge funds and family offices are already actively seeking mezzanine deals. Other lenders and funds who were previously focused on senior debt only are now raising capital for mezzanine lending.

If your debt lender is offering you a lower LTV than you would like then we can help.