3/21/2024

Magical mezzanine

Viewpoint

As Islamic real estate investors lament the death, at least for now, of the levered equity investment, mezzanine offers a comforting alternative. High benchmark interest rates make adding leverage to the vast majority of equity investments non-accretive, but also underpin the attractive returns of mezzanine participation.

There has been plenty of chat for more than a year that private credit provides an attractive investment option, but having just returned from the Middle East, the reality seems to be that the use of mezzanine has not extended very far beyond providing a solution to reduce senior finance on existing investments.

With real estate values down and interest rates up, it comes as no surprise that senior finance covenants are being breached, with mezzanine providing a helpful structure to reward those coming in to resolve the problem. But its demand in real estate extends beyond existing landlords recapitalizing their investments, to both developers and investors making new acquisitions.

Banks are overexposed to real estate, and are coming under increasing pressure from regulators, including changes to capital adequacy rules. Meanwhile, developers and new investors alike are not minded to fill all the gaps from lower loans to value senior with equity, or better; the economics of transactions do not support this — which is where mezzanine comes in.

Offering a largely fixed return and capable of being structured to provide a current return, even on development transactions, it fulfils the wishes of most Middle Eastern investors for a current yield. The double-digit yields are attractive enough to prise monies out of bank deposits, even exceeding the returns on equity investments of old, while providing the security of having first-loss equity ahead of it.

I won’t pretend that development transactions are risk-free, but with comprehensive developer and development due diligence, fixed price construction contracts and a suitable collateral package, this can be managed. And by definition, value is being added through the construction process, further improving the mezzanine’s position in the capital stack upon an exit.

Hopefully, we will see headlines of closed mezzanine deals in Islamic Finance news very soon.

Written by Philip Churchill, first published in Islamic Finance news Volume 21, Issue 12 dated 20th March 2024.