Non-recourse and mezzanine finance: from feast to fast

  • 30 Jun 2008
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The non-recourse loan market in Japan has enjoyed high growth since the late 1990s, but has slowed sharply since mid-2007. Meanwhile, the mezzanine finance market, which established itself in 2004, has all but disappeared. But all is not bad news — Japan’s property market fundamentals remain intact and new deals and refinancings are still being executed, albeit at lower leverage and higher cost.

The change in the Japanese real estate financing market in the past 12 months has been dramatic.

Not only have non-recourse lenders cut back on lending sharply since mid-2007 and shaved loan to value ratios, but there has also been a sharp reduction of risk appetite for mezzanine debt. In the commercial mortgage backed securities (CMBS) market, issuance in 2007 surged as conduit sponsors sold many very big deals, some with more than 100 underlying assets. Today, volumes are thin and diversity is out of favour.

Whereas non-recourse funding for Class A office buildings in central Tokyo about 18 months ago cost 200bp-225bp over Libor all-in, with leverage up comfortably at 75%-80%, and sometimes up to 85%, today the all-in cost is at least 100bp higher, while maximum leverage has fallen to between 60% and 70%.

"Borrowers are now lucky to obtain loan to value ratios [LTVs] of 75% and that is only possible if the underlying asset is absolutely prime Tokyo office space," reports Hiroyuki Takada, managing director, Asia Pacific real estate finance and securitisation at Credit Suisse in Tokyo.

Douglas Smith is head of commercial real estate for Japan at Deutsche Bank in Tokyo. "We reckon that LTVs today are about 10% less [than mid-2007] and the spread on the whole loan is roughly 1% higher," he says. "Those sponsors that are suffering most have weak relationships or lower grade, perhaps provincial assets, or both."


Lower advance rates challenge IRRs

Leveraged borrowers that had until late 2007 dominated Japan’s property acquisition and CMBS markets are now more concerned about the LTVs, or ‘advance rates’, than about the actual cost of funds, because the higher the equity portion of funding required, the lower the sponsor’s internal rate of return (IRR), all else being equal.

But high LTVs are a thing of the past, even for the most prime Tokyo office assets. And lenders appear reluctant to put money up now for many property assets, and for more regional exposures across Japan, that they happily used to fund. When lenders do agree to finance those assets, it is usually at modest LTVs and higher cost.

The good news is that the Japanese property finance market did not become bloated with excess, even during the recent good times. "While there is widespread caution," Smith says, "the market continues to function and the Japanese commercial real estate market remains solid, with a positive outlook."

Toshikazu Miyagawa, head of real estate investment banking at Merrill Lynch Japan Securities, recalls the beginnings of the non-recourse market around 1997, when due diligence and evaluation methodology imported to Japan from the US.

"Before that," he explains, "the property financing market here was plain vanilla, but cashflow appraisals and a switch to non-recourse, cashflow lending techniques radically reshaped both the underlying asset market and the financing market. Both markets moved in tandem through to mid-2007, with the greatest liquidity, highest asset prices and tightest funding costs from 2006 to early 2007."

But he also notes that even during the most bullish phase of the property and property financing markets, the Japanese commercial banks and selective balance sheet lenders always erred on the side of caution. That caution, which has become instinctive since the Japanese property bubble burst, has simply been reinforced by recent developments.


Lenders set a stricter tone

Miyagawa reports that lenders are nowadays strictly using their own assessment values, instead of basing their lending on the original acquisition or evaluated prices, and permitting maximum LTVs of 60% to 70%. "That," he says, "means that when an existing loan matures, unless the value of the asset has risen, the borrower might find it tough [to refinance], and sometimes may need to top up the collateral with a guarantee or to partially repay."

Since mid-2007 there has also been a sudden and almost complete drying up of the mezzanine market. The only buyers now are specialised real estate financing operations, whereas before the global investment banks were major players.

Mezzanine property finance arrived in Japan around 2004 when physical asset prices were rising sharply and cap rates falling. Mezzanine helped buyers plug their theoretical IRR shortfalls, by boosting leverage potential. This was a windfall for the most leveraged buyers, especially the conduit funds then dominating the market.


New deals shine in the darkness

While mezzanine funding has all but disappeared and bank and other lenders have narrowed their field of vision, deals can still get done. Deutsche in the spring of this year completed the ¥90bn funding for a sale and leaseback of the Shinsei Bank head office. The non-recourse financing was provided to a tokutei mokuteki kaisha backed by a trust beneficiary certificate on the building. The TMK, which acquired the 20 storey Class A building in one of Tokyo’s prime office districts, is a special purpose company, established and owned by a real estate fund managed by Morgan Stanley.

"It was a fantastic transaction," says Smith. "All of the prime characteristics of a top quality deal were inherent in it. The building is relatively new, it is in a top class location, the architectural standards and building quality are outstanding, and the tenant is a highly rated credit with government ownership as well. Finally, many of the investors can look out of their windows and see the asset that they are financing."

Deutsche quickly sold the ¥20bn of most subordinated, unrated paper outside the planned CMBS. When the deal does emerge, it should set the new pricing benchmarks for deals linked to prime Class A Tokyo buildings.


Quality will out.....

There is also today still a world of opportunity, as the office and commercial buildings of Tokyo and other big cities represent such a large portion of the Japanese commercial property market.

"The bulk of the activity in the near term will focus on Tokyo, which enjoys strong growth dynamics, and on a handful of the other top cities," Smith observes. "But the commercial real estate market here is so vast and the bulk of the value is in the highest grade buildings in the best locations, so the problem [in financing] the smaller or more regional properties is somewhat insignificant."

Miyagawa is similarly confident. "The market situation is still not certain, due to credit volatility and decreased activity. It can still be tough to get appropriate financing for residential properties, as well as for diversified property portfolios in regional cities across Japan. However, if a borrower wants to finance a true Class A Tokyo office building, that is relatively easy unless a high LTV is required."

And Jinkyu Hong, managing director of principal investment in Japan at Merrill Lynch, is also optimistic that the quality of the underlying assets and the strength of Japan’s banks will help the market regain some of its former momentum. "The market will not dry up," Hong says. "Japanese banks have been downsizing their balance sheets for several years but actually at the same time increasing their percentage exposure to real estate. They have a strong vested interest in continuing to ensure there is sufficient liquidity in the market, although this will clearly be on a selective basis."


Optimism holds sway

Market watchers note, however, that only strong investors enjoying good relationships with the lenders can continue to be active and successful, while weaker players will disappear from the market. Many also expect to see new debt and equity capital coming to Japan. In particular, more core capital, considering Japan’s relative lack of that compared with other developed countries.

"In the near future," says Hong, "we hope to see more capable domestic fund managers and investors appear that can raise domestic and foreign capital for Japanese investment opportunities."

His predictions might soon be realised. The Nikkei newspaper reported on May 29 that Japanese real estate fund operators were setting up funds of between ¥500bn and ¥1tr with money from Europe, the US and the Middle East, for investment mainly in Tokyo office buildings.

"Foreign investors have expressed strong interest in real estate funds in Japan, on the view that rents will remain high in central Tokyo because of an office building shortage," the author wrote, noting that among the sponsors were DaVinci Advisors, Secured Capital Japan and Creed Corp.

The spring and early summer of 2008 are a turning point for Japan’s commercial real estate market and the associated financing markets. Lenders and investors are focusing on quality and transparency. The more leveraged, opportunistic property buyers have been to some extent sidelined by lower LTVs and their inability to offer sellers funding assurances.

In the meantime, there is enough low-leverage, real money to plug the gaps and buy up properties at the new, modestly adjusted prices amid less intense competition from the IRR buyers. And it is not likely to be long before non-recourse lenders regain some appetite and CMBS buyers return in force.


Mezzanine finances key deals, then ebbs


Merrill Lynch from 2005 quickly won prominence in property mezzanine finance in Japan, helping finance some landmark deals. But the mezz market has now withered and Merrill’s focus is elsewhere.

Jinkyu Hong, managing director of principal investment in Japan at Merrill Lynch, is one of Japan’s few mezzanine finance experts. He moved from a real estate principal investment background with Morgan Stanley Real Estate Funds, to join Merrill in September 2005. Merrill had spotted an opportunity to act as principal investor and also take positions in the nascent mezzanine finance market, alongside non-recourse lenders.

"Before 2005 there was no real mezzanine-focused big player in the Japanese market," Hong recalls. "The void was until then filled by leasing companies taking what were largely passive, second-lien positions. We entered the market with a far wider perspective and a far more structured and sophisticated array of products, and also in the back of our mind with a six to nine month time horizon of being able to downsize the exposures from our balance sheet."

The firm enjoyed a spate of landmark transactions. In June 2006, Merrill cut its teeth in the mezzanine market by helping finance the buyer of the Shuwa Shiba Park Building, a Class A trophy asset in central Tokyo, then with an occupancy rate of 92.9%.

Hong reports that the entire mezzanine loan amount of $500m was structured and the firm’s global principal investments unit (GPI) successfully syndicated the trust beneficiary interest to foreign and Japanese banks in October 2007.

"We rapidly became the largest mezzanine investor in what was then a very new sector of the real estate finance market in Japan," says Hong.

After a roughly $900m deal for the Shinjuku Main Tower, Merrill was instrumental in the roughly ¥200bn funding package for Da Vinci Advisors to purchase Pacific Century Place in autumn 2006. It is a prime 31 storey Class A office building in Tokyo’s smart Marunouchi district and the deal was at the time the largest single-asset deal from Japan.

Merrill developed what Hong considers a unique, innovative structure including senior mezzanine financing of $350m and a junior mezzanine loan repayment guarantee of $230m. The capital structure thereby ended up as 54% senior debt, 18% senior mezzanine, 12% junior mezzanine and 16% equity.

Merrill trims its sails

However, Merrill began to trim its balance sheet exposures in mid-2007 by disposing of most mezzanine holdings through what Hong terms "unique exit methods like tailored forward contract sales to domestic and overseas investors". He says the strategy of structuring smart deals with investors gave the bank "a unique position far ahead of the market" and allowed Merrill to reduce its commitments greatly.

The decision to cut exposures was also prompted by the growing subprime problems in the US. "We had also formed a strategic view on a global perspective that the arbitrage in the CMBS market, which had been favourable for Japan compared with the US and other global markets, had changed to the point where it was likely that liquidity for CMBS in Japan would decrease substantially."

Hong says GPI sold almost all its large mezzanine positions between the third and fourth quarters of 2007 to domestic and foreign buyers in innovative schemes rather than simple sales or CMBS issues.

For example, despite an anticipated holding time of up to 36 months, GPI sold the whole Shuwa Shiba loan principal after holding it for only 15 months and retained the interest-only piece, generating an undisclosed annualised return for the ensuing 21 months.

But that is far from the end of the story. Hong says that as the market has turned, Merrill has reshaped its business model with new strategies to optimise debt and equity investment opportunities. "For the past few months in 2008, we have already completed around $600m hard asset and $300m opportunistic debt investments," he concludes.
  • 30 Jun 2008

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