Stephen Quazzo, Co-Founder & CEO of Pearlmark, joined us for an interview. We discussed the firm’s lending strategy and how it’s deploying capital in this environment.
Daily Beat: Can you please share your background?
Stephen Quazzo: I got started in real estate investment banking at Goldman Sachs. My first three years were spent in the New York office, and I then worked out of their Chicago office for two years.
Sam Zell was one of our largest clients and I went to work for him. I spent five years there and in 1996 left to co-found Pearlmark’s precursor, an entity called Transwestern Investment Company.
We built up a terrific team and have sponsored a number of both equity and debt funds. This most recent fund is Pearlmark Mezz V.
Daily Beat: What’s the strategy?
Stephen Quazzo: It’s a continuation of a high yield lending strategy that we started in 2001.
The current environment is extremely conducive for it. We’re seeing our doors get kind of knocked down with people looking for this type of gap financing.
Whereas in the past, many of the opportunities would be construction loans and other deals that were harder to finance, our team is now seeing a steady dose of refinancings, acquisitions, in addition to development opportunities.
Daily Beat: Do you still focus on the equity side, or are you solely focused on debt?
Stephen Quazzo: I would say that we’re about 50-50. We’ve been active on the equity side over the years, and are in the process of launching an equity fund.
The common thread for us is that we’re a mid-cap player, and generally invest or lend against assets that are $100 million or less. We’re not taking huge positions in assets like the Chrysler Building or 425 Park. Generally, the deals have a value-add orientation, as opposed to core.
Daily Beat: Which markets have been your focus over the past decade?
Stephen Quazzo: For the last eight to 10 years, we’ve primarily invested in the Sunbelt, with a heavy emphasis on apartments.
Daily Beat: How does a typical Pearlmark debt investment look like? In other words, how do you go about only providing the mezzanine (mezz) piece? Are you supplying the whole loan and then selling off tranches of debt?
Stephen Quazzo: We tend to be collaborative and generally team up with traditional senior lenders for situations that need gap financing.
The beauty of having been in this business since 2001 is that we have 150 intercreditor agreements that we can just pull off the shelf with almost every lender from Bank of America, Ozarks, Madison Realty Capital, Prime, and many others. Historically, our strategy does not involve originating whole loans and then selling off pieces.
Daily Beat: Why do you choose this approach?
Stephen Quazzo: It’s more collaborative. We don’t want to compete with the senior lenders – we want to compliment them. The strategy works well because we’re on the short list of firms they authorize for the mezz piece.
We’re not trying to fill a massive bucket. This isn’t a $3 billion fund. Generally our fund sizes have ranged between $200 to $400 million.
Daily Beat: Do you leverage the book at all?
Stephen Quazzo: No. We did in the old days, but we don’t anymore after the 2007–2008 financial crisis.
With that being said, we do have co-invest capital to place alongside our fund. So while our typical mezz loan size is the $10 to $20 million slug, we’ll do larger mezz loans because we have co-invest capital.
In some cases, we’ll also bring in co-invest capital to diversify our construction risk. We have a 35% limit in our fund on construction, so we’ll bring in partners because these days you’re getting pretty juicy returns on those deals.
Historically on the mezz side, you were limited to getting 1.3x multiples, but now you’re fully getting 1.5x multiples on your money.
Daily Beat: What percentage of your loans are floating-rate?
Stephen Quazzo: It’s a mix and generally we’ll be the same as the senior lender. Floating rate comprises roughly two thirds of our portfolio.
As you can imagine, a lot of borrowers these days want to lock in rates, particularly on stabilized assets.
Daily Beat: Can you please step us through the differences between deals you look at today compared to before the downturn?
Stephen Quazzo: We’re basically taking less risk for higher returns. In simplistic terms, our attachment point today in the senior loan is generally around 60% versus 65% before. We’re only going up to 70 to 75% today, whereas before we were going up in the 80% range.
The return is higher for the less risky position.
Daily Beat: How do the fixed-rate loans you originated 18 months ago look like in this environment?
Stephen Quazzo: The good news is that most of our loans in the current fund were put into
after May of last year.
The few that were put in place prior to that were primarily floating rate. There was one fixed rate loan, but the value of the asset appreciated in that case in part because of the value of the low fixed rate senior debt. It’s a good question and that’s why almost two-thirds of our book is floating-rate.
Daily Beat: To flip the question to when you sit on the equity side, what does your capital stack in this environment look like?
Stephen Quazzo: Generally we’re levering around 60% today. The equity returns are attractive enough at those leverage levels that you don’t really need to push it. Debt costs are obviously high today, so you want to minimize the negative leverage because by definition value-add investing means that you’re certainly not getting accretive leverage out of the box.
The lower you go in terms of leverage, the less negative kind of arbitrage you have. In this market, a lot of the investors are doing all equity deals, with plans to move the NOI, prove the asset, and then hope the debt markets are better when they have a stabilized asset a year from now.
Daily Beat: And that explains what we’re seeing in today’s market.
Stephen Quazzo: Yes. In those cases, the buyer is extracting a pound of flesh from the seller. There’s a pretty wide bid-ask spread.
As we’ve seen in the past, it’s only when forced sales happen that the log jam starts to unblock because people finally recognize they are not going to get February 2022 pricing anymore.
Daily Beat: What are your ballpark rates on the debt side? Obviously every deal is different, but perhaps you can provide some ballpark numbers?
Stephen Quazzo: In today’s world, it’s double digit spreads on SOFR. Obviously, it depends if it’s a stabilized property, value-add deal, or ground-up construction.
Equity today is 20%, so our argument is that 11% to 12% of debt costs for that chunk of the capital stack from 60 to 75 when you blend it with a reasonable senior loan is fair.
We’re seeing some loans where our attachment point has been as low as 50% where we’ll cover from 50 to 70.
When you blend that from the borrower’s standpoint, it’s palatable because they don’t have to bring in outside equity and they can weather the storm and refinance us out in two to three years.
Daily Beat: Where do you anticipate seeing the most distress?
Stephen Quazzo: I think you’re going to see a lot of distress on the office and the retail side. Underlying cash flows are going down and capital expenses are going up in order to keep tenants.
There are probably five or six buildings on LaSalle Street in Chicago that are going back to the lender. The Board of Trade Building, 135 South LaSalle, 30 North LaSalle, 10 South LaSalle, and BMO’s old headquarters. The distress is happening.
At some point, investors will decide that the basis is low enough to dip their toes back in the water, but we’re not there yet and it’s going to take a while.
As someone in our firm said, it’s one thing to hit bottom, but you don’t know how long the bottom’s going to last, so there’s no point in rushing in.
You might be able to wait 12 months and you’ll still be at the bottom. It’s going to take a while for that to kind of ripple through the system and I think we’re looking at a tough couple years coming up in the real estate sector.
Daily Beat: Have you looked at lending on any office-to-residential conversions? They are just so expensive and probably only save 10% on the entire project cost if everything goes as planned. What are your thoughts?
Stephen Quazzo: Since rents in New York City are so expensive, people will basically live anywhere in Manhattan, but in Chicago, that’s not the case. People are not going to live on LaSelleStreet.
They have too many other options along the lake and in neighborhoods. New York is a 24-hour city, so there’s always a bodega nearby. I don’t see that happening in Chicago. We wouldn’t lend against those deals.
Daily Beat: Would you lend against an office building that’s benefiting from flight-to-quality trends?
Stephen Quazzo: Yes. Our team recently did our first office loan in four years. It was a suburban Seattle office property with excellent sponsorship and the right loan-to-value. It’s always important that we make good mezz loans because we are not interested in loan-to- own. We have to get repaid.
I sometimes joke with my team not to make the loans too good because we’ll get repaid too quickly. I don’t mind extending it for two or three years because we’re clipping away and that’s a great return for our investors, particularly if we have a sponsor who’s willing to pour money in the asset.
Daily Beat: Trepp noted in October that more than $18.8 billion worth of CMBS, CLO, Fannie Mae, and Freddie Mac loans covering 1,468 multi-family properties with DSCRs of 1.25x or less are set to come due in the next two years. Would you buy those loans? What type of flexibility do you have with loan structures?
Stephen Quazzo: The documentation in the 6 CMBS world is incredibly difficult and a lot of them preclude mezz. Where we’re likely to be part of the solution is to essentially be rescue capital or maybe even preferred equity. Depending on the situation, it could come out of our equity or mezz bucket.
That’s where I think we can be useful to a borrower who wants to get out from under the securitized debt and pay it off if their coverage is close enough. The problem with those 1.25 coverages is that the new rate is much higher, particularly when the NOI is declining.
Daily Beat: How do you decide if mezz or preferred (pref) equity is a better fit?
Stephen Quazzo: Mezz is our preference.
Many of our investors, particularly insurance companies, prefer mezz from a regulatory and reserve standpoint. Pref will likely be more expensive and would come out of our equity bucket.
Daily Beat: What would be the advantage of preferred equity? I know you get an ownership stake, but it seems like there’s a lot of semantics.
Stephen Quazzo: In some cases it’s semantics; however, there are a number of instances where pref equity is really equity.
In other words, I think there’s a lot of risk associated with that position, but the investor feels comfortable because if things don’t improve or go sideways, then essentially they’re buying an asset at a basis that they feel comfortable with and they have additional capital to protect it, de-lever it, and invest in it.
It is semantics in a situation where there’s a construction loan on an apartment project. We’re going to get a redemption either way. Instead of an intercreditor agreement, we’re going to get a recognition agreement.
Daily Beat: Happy hunting out there. I’m sure your originations folks are super busy.
Stephen Quazzo: Thanks. At this point we’re over 30%, 35% invested in this fund already. Given the pace of opportunities that we see, I think we’ll be fully invested by the end of the year.
*The interview has been edited and condensed for clarity.