C-PACE: The Friendly Mezzanine Alternative

“Mezzanine Lender Initiates Foreclosure on Hotel Owner.” I came across this headline in a local article just the other day. The hotel is located here in downtown Denver, however, this is not a local phenomenon. This is a national and increasingly systemic problem because of the rapid change in the credit markets. As the saying goes, when it rains, it pours, and right now, it’s starting to rain pretty hard, and there are sharks swimming in these puddles.  

With the current instability the credit markets are facing both here in Denver and across the country, we’re seeing more lenders refusing mezzanine financing options. A little over a year ago, we were at the height of the “good times” – construction lenders were liberally underwriting deals and developers were successfully securing additional leverage by utilizing mezzanine financing in the capital stack. Most of these loans were structured as floating rate loans, which are now presenting a myriad problems. With rates nearly double what they were this time last year, the recent capitalization rate expansion and the incredibly conservative loan underwriting practices that are becoming the norm, developers are defaulting in droves.

Who wins in all this? It’s not the developers, sponsors, or primary loan holders – it’s the mezzanine lenders, who are widely, if not fondly referred to as “loan to own” shops. I don’t necessarily subscribe to that broad stroke characterization; most mezzanine lenders don’t want to be in a default position. Most, however, are much more prepared for default and stand to benefit the most when things go south. They have the benefit of time and legal resources to secure their success at the foreclosure table, and typically move to bury the banks in a long legal battle that ultimately forces the banks (who do not have the time or resources to carry this weight) to concede by selling them their position in the asset for mere pennies on the dollar.

So, what is the alternative?

In the world of lending, there are two types of lenders: The ones who have been in this situation with a mezzanine lender and the ones who haven’t. The lenders who have experienced the unpleasantness of these situations tend to be much more amendable to C-PACE financing. They see it as the “friendly” alternative in foreclosures.

What makes C-PACE the more attractive option to lenders? First, for construction projects, C-PACE capitalizes all the interest necessary to carry the deal through to the anticipated stabilization date, which means a default wouldn’t happen until the after the project is completed. It’s important to remember that C-PACE is fixed for decades at closing, so its rate does not float.

Second, if the payment comes up and is missed when regular property taxes come due, we, as the C-PACE lender, immediately notify the lender and municipality that the sponsor missed their C-PACE payment and is now in default. However, we have no rights to accelerate the loan (ever!) or take a legal position at the foreclosure table. We must ultimately lean on the municipality to move through the motions of their specific tax foreclosure process. This process can take years, and prior to an actual tax foreclosure (which is nearly unheard of for commercial assets), the lien would be put up for tax lien sale. At that point, an investor would likely show up and purchase the lien rights and cure the payment and anything in arrears.

It’s important to note that before it reaches this stage in the foreclosure process, the bank has the right to make the annual payment on behalf of the asset in foreclosure. This means C-PACE lenders hold off for a year while the bank settles the foreclosure on their terms. Compared to the alternative, C-PACE sounds a lot more pleasant, doesn’t it? Now, a savvy banker might argue that “we can’t clear you out at foreclosure.” That might be true, but in the alternative scenario, I’d argue that you are also not clearing out the mezzanine lender. After you assess your losses and legal costs (not to mention the time and frustration), the annual C-PACE payment and ability to transfer the debt along to the new owner more than makes sense.

Obviously, everything has a grey area, but our position is that the banks might want to take a closer look at which type of mezzanine lending they would prefer to be protected by when the storm comes their way.