In brief:

• A set of positive dynamics, including higher interest rates, tighter liquidity in the market and fewer lenders, have created a more favorable outlook than we’ve seen in a long time for core mezzanine debt lending.

• Recession may diminish transaction activity, cause rent growth to slow and/or properties’ cash flows to decline, but we expect coupon payments to remain steady or even rise.

• Less competition in the markets and a higher cost of capital potentially should allow us to bring greater scrutiny to our underwriting and negotiate better pricing for loans to institutional-quality borrowers.

• Rising interest rates should allow mezz lending to achieve higher returns at better credit metrics than before—potentially exceeding those of real estate equity, generally considered a riskier asset class.

• While property values are likely to decline, we don’t expect a severe or prolonged downturn; amid what will probably be a period of economic tumult, core mezzanine debt may moderate portfolio volatility.

At first glance, it’s a sobering time in the markets, and the coming year will likely present an unstable environment for commercial real estate (CRE). However, taking a deeper look, the core mezzanine debt¹ outlook is positive—more so than it has been in a long time.

Consider: What if a property’s value fell moderately, but it didn’t much matter to your real estate investment because you had confidence in the underwriting and could anticipate repayment in full at maturity? What if rent growth slowed or cash flows declined, but you continued to receive a steady coupon payment—or even potentially a higher one, lifted by rising interest rates? That’s the scenario, broadly speaking, for core mezzanine debtholders today.

No one knows for sure if the economy will have a soft or a hard landing, how high inflation and rate hikes may go or how long this uncertainty may last. Capitalization rates, a risk measure in real estate², are rising; economic growth is slowing; the cost of capital is continuing to increase; and transaction activity is declining. However, amid the likely tumult, there’s an opportunity for core mezzanine debt to serve as a volatility moderator.

During economic downturns and under strained financial conditions, market liquidity tightens. Currently, lenders of various types have started to pull back: banks, commercial mortgage-backed securities (CMBS) issuers, insurance companies and debt funds. As a result, we have opportunities to lend at more conservative loan-to-value ratios (LTVs) than in the past, which requires borrowers to put in more equity, and also to bring greater scrutiny to our underwriting. Well-capitalized and experienced lenders can do well during times of economic stress.

Amid uncertainties, with cautious underwriting and a focus on generally higher quality, stabilized assets, we see the chance to take advantage of compelling opportunities, even if real estate values fall. And when values likely do decline, we don’t expect the downturn to be severe or very prolonged. We have planned for the worst and are investing at our best.

Potential to moderate volatility amid turbulent markets

Investors seeking a hedge against rising rates, declining values and inflation may find that mezz lending provides a high quality downside hedge that moderates volatility. Core mezz, particularly, does not tend to see large daily or quarterly moves. Mezz lending is also insulated from fluctuations in property values, as it is senior to equity—an additional cushion in the event that real estate values decline.

In times of market turbulence, mezz debt can be more stable than other real estate securities, such as commercial mortgage loans and public market fixed income overall. That’s because mezz debt is less sensitive to the interest rate environment and macro factors (Exhibit 1)³. At the same time, mezz debt’s spread over Treasuries is much wider than mortgage loans’, which allows it to be less sensitive to short-term spread movements.

Mezzanine debt spreads over Treasuries command a healthy premium vs. senior real estate loan spreads
Exhibit 1: Senior and mezzanine loan spreads and 5-year Treasury bonds (bps), 2002–22

Source: J.P. Morgan Asset Management Proprietary Lender Survey; data as of July 2022. Spreads are on five-year debt deals.

Broadly speaking, most market participants don’t expect a significant deterioration in properties’ net operating cash flows, a crucial issue since that is what pays debt service. Even if a recession caused a property’s cash flows to decline modestly, we’d still expect them to receive coupon payments (in a debt strategy investors receive returns primarily in the form of income). Most core mezz loans are underwritten with a debt service coverage ratio greater than 1.00x (1-to-1 ratio of operating income to debt service obligations), providing a cushion if cash flows fall. Floating rate mezz loans can also offer an attractive inflation-hedged, variable rate income return.

Nothing is fully insulated from a recession or volatility; we expect mezz debt to help moderate, not erase, declines and depreciation in investment portfolios. Debt investors should have a hold-to-maturity perspective. By lending to the right borrowers on the appropriate terms and holding the debt to maturity, we forecast being repaid in full (par) when loans mature, even if the building’s value declines (and our LTV metric rises) during the life of the loan.

In a lenders' market, tighter underwriting and lower leverage

Lending standards currently are extremely stringent, nearly as much as during the global financial crisis and the worst of the COVID-19 pandemic, according to the Federal Reserve’s Senior Loan Officer Opinion Survey (Exhibit 2). We expect this “lenders’ market” will continue in 2023 as competition for loans continues to wane and the market braces for an impending recession.

Banks are tightening commercial real estate lending standards like the economy is already in a recession
Exhibit 2: Net share of banks tightening CRE loan standards

Source: Federal Reserve; data as of December 31, 2022.

The tightening in liquidity has impacted prevailing credit metrics. Mezzanine and other CRE lenders are demanding higher debt yields, while at the same time lending at lower LTVs (which requires that borrowers put in more equity). Using higher credit metrics allows the lender to take on less risk, a highly beneficial situation, given the prospect of a decline in some U.S. property values.

We expect these tighter underwriting standards and more restrictive covenants—more conservative practices overall—to help core mezz cement its reputation as a flight-to-quality investment, backed by a tangible asset and with a history of good fundamentals. The lending conditions we anticipate not only favor making high quality loans but also, with less competition in the markets, create the potential to negotiate better pricing.

And with rates rising, we expect to achieve higher returns at better credit metrics than before. Returns on core mezzanine debt may even exceed those of equity, normally considered a riskier asset class. All these points make 2023 an appealing time to enter this space.

Focus continues on high quality assets

In the year ahead, we will proceed with caution, with a focus on quality. We prefer competitive multifamily and industrial assets in markets with strong employment and wage growth, and good public transportation. We expect to avoid oversupplied secondary and tertiary markets, and fledgling industries. While the story of the future of office continues to evolve, we are gravitating toward differentiated assets with high credit tenants and long-weighted average lease terms.

In retail, we like grocery and other necessities, and malls that proved their ability to perform even during the worst of COVID-19. We expect to lend to strong institutional firms committed for the long run. We will look for sponsors with excellent balance sheets that we expect to continue funding properties through an economic downturn, and those that have operated properties through the challenges of multiple business cycles.

We know that challenges lie ahead, and we are prepared. One of our best tools is our underwriting. The return opportunities we expect for investors this year may come only once in an economic cycle. While we view mezz debt as a very worthwhile opportunity all the time, 2023 appears to be an unusually good entry point.

¹ Real estate mezzanine financing is a type of lending that is below senior lenders when it comes to being paid back in the event of a default, and higher than equity holders. Often providing higher returns than other types of corporate debt, mezz lending’s coupon payments are contractual obligations.
² The capitalization (cap) rate, a common measure of commercial real estate investing risk-return, is a property’s net operating income (NOI) as a fraction of the property’s current market value.
³ Greg MacKinnon, “The Capital Stack: How Do Different Parts Stack Up as Investments?” PREA Quarterly, Pension Real Estate Association, Spring 2022.

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