Second trust deed lenders are getting obliterated in this recession. Whether it be a residential loan or a commercial loan, the second trust deed holder (known as a mezzanine lender) is likely to be completely wiped out, or if fortunate, may receive four to 10 cents on the dollar for their outstanding principal. As sad of a circumstance for some, namely the borrower in default and the lender who has been defaulted on, some astute individuals, firms, and institutions are finding a silver lining in this situation and profiting and generating substantial returns for themselves and/or their investors.
In a previous article I mentioned that there is nearly $5 trillion of investment capital in various investment funds that hold a minimum of $10 billion in assets under management each. These funds are looking for avenues to invest their capital. Stocks are falling, bonds are paying a paltry 2% (at best), and gold is no longer the standard. Direct purchases of real estate have matured into bidding wars, so now one of the options for decent returns is to go backward in the food chain. Accordingly, investors are buying 2nd TDs in hopes of making money off of “mezz.”
Let’s be clear, buying trust deeds is nothing new. Investors (both large and small) have purchased them for decades as a way to get control of a property through the “back door.” However, with the advent of the value implosion of the current recession, it’s not uncommon for properties to be underwater by 150%-300%. In cases of properties located the states of in Arizona, Nevada, and Florida, having 200% Loan-to-Value (LTV) against a property’s first TD was not a shock to the system. As such, any 2nd TD holder behind a loan such as these was severely impaired with no hope of repayment for years to come. Accordingly, buying either piece of the underlying debt was similar to throwing money into a black hole.
Now, the market has changed. Investors of all stripes have learned their lessons, licked their wounds and are ready to re-enter the mortgage market. The bigger investment funds are making large forays into mezz. They have completed their market research, assessed the risks and are willing to place their bets on the rebound of various markets across the nation. For instance, Blackstone Group recently bought $2 billion worth of mezz, which is underlying a multi-billion portfolio of 95 industrial properties at 40 cents on the dollar. Their play on the transaction is that the property will be turned over by the current owners who have a $2.45 billion debt payment due prior to the end of June. Blackstone hopes that it will increase the occupancy of the portfolio to 95% from 85%. Perhaps they can pull it off, if the economy doesn’t dip into a secondary recession.
Fortunately, this isn’t a game for the large players alone. Now, mom-and-pop investment groups are pooling their dollars together and are buying to mezz as well. It is extremely evident that short sales are wiping out Home Equity Lines of Credit (HELOC) and Home Equity Loans (HELOAN) left and right. Some of these loans are on properties that are long-term buys. During the short sale process, many 2nd TD holders are subjected to receiving only 3 cents on the dollar; accordingly, they could be receptive to getting more money for their debt, which is currently on the books. The challenge at the smaller scale is the same at a larger level; that is, having appropriate market knowledge to determine if the risk is worth it. Any purchaser of existing mezzanine financing must be willing to deal with the first trust deed holder and determine if they will be able to service its debt. This is not for the casual investor; however, it can be a wise investment for the individual or group with specialized market knowledge, a comfortable understanding of the legal ramifications involved and an expertise in the property type.
Clearly, investing in mezzanine financing is a dangerous proposition. It requires skill, legal understanding, and market savvy; otherwise, you can lose everything. Done right, it allows investors, large and small, to get some control over a property without an overly large investment. Investors need to believe in their prospects for the future concerning their targets; otherwise, it becomes a foolhardy use of capital. Economic prospects for the future can dwindle, first lien holders can prove themselves difficult to negotiate with, and restructuring plans can go awry. Therefore, mezz financing isn’t a game for the faint at heart. However, make no mistake, for the wise and astute, buying second TDs can be highly profitable if one has the expertise and knows what they are doing. In the end, making money off mezz may sound sexy, but it’s not made for the neophyte.
Preston Howard is a mortgage broker and Principal of Rose City Realty, Inc. in Pasadena, CA. Specializing in various facets of real estate finance, he can be reached at firstname.lastname@example.org.