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Mesmerized by Mezzanine

Mezzanine lending for commercial real estate is exploding. Origination volume of mezz loans, second mortgages and preferred equity deals skyrocketed 296% in 2005 to $12.84 billion, up from $3.24 billion the previous year. That's according to the Mortgage Bankers Association, which didn't even track the sector until 2004.

Capital providers are flocking to this market. Of 79 lenders surveyed by the MBA, 31 completed second mortgages, mezz loans or preferred equity placements in 2005. Yet some pioneering firms in the mezz arena are giving second thought to this financing vehicle as the market becomes overheated. Charlotte, N.C.-based Mountain Funding LLC now passes over many deals, citing too many risks for too little return.

“In the 1990s, there wasn't a lot of competition, and we were charging a lot more than is being charged now,” says Arthur Nevid, Mountain Funding's managing director of acquisitions and lending. “Now, it's a huge business that's getting bigger every day. More often than not, when we're asked to bid on a mezzanine loan, we just don't think the return is worth the risk. The institutions keep cutting the returns to win the business.”

Experts say that these new entrants are attracted by annual returns that trump those available from senior mortgages, even if the returns aren't as lofty as they once were. Mezzanine returns averaged 20% or more five years ago, when only a handful of providers offered mezz debt. Now, however, stiff competition has lowered investors' returns on a typical deal to between 8% and 15%.

Underwriting is also suffering. The debt-coverage ratio (DCR) for the combined senior and mezz debt on a stabilized office property five years ago was about 1.1, says Steve Bram, a senior partner at Los Angeles-based real estate finance provider George Smith Partners. Today, debt-coverage ratios average 1.05, and 1.03 isn't unusual. “In mezzanine loans for value-added deals, lenders will go way below break-even in their underwriting, if they're confident that the property value and cash flow will increase,” says Bram.

Today's more lax underwriting standards reflect intense competition to place loans, explains Ari Altman, vice president of capital markets at Columbus, Ohio-based Huntington Capital Markets. “There are a lot of players today, and when that herd mentality occurs, somebody eventually gets run over.”

Risky business

Mezz loans are backed by an interest in a property's operating company, rather than by the asset itself. That puts providers of this financial vehicle in a more precarious position than mortgage lenders, which is why the interest rate on a mezz loan will be higher than a typical mortgage rate.

What's more, the mezz level is always subordinate to at least one mortgage and takes the first hit when the borrower runs into trouble. If the borrower defaults on the mortgage and the senior lender forecloses, the value of the mezz lender's investment can drop to zero.

To avoid that outcome, mezz lenders usually reserve the right to intercede in the event of a default and attempt to cure the mortgage before a foreclosure. This right is spelled out in an inter-creditor agreement. Also called a subordination document, this contract with the mortgage lender enables the mezz provider to foreclose on its loan and take over as the borrower on the senior loan, if necessary.

Thanks to historically low interest rates available in recent years, mezz lenders with a defaulted loan might recover their investment by taking over and refinancing the senior loan, but rising interest rates will make that more difficult in the future. “As far as an exit, we see that our options are limited,” says Altman of Huntington Capital. “The potential for mezzanine lenders to get hurt is right now as interest rates and cap rates increase.”

The proliferation of mezz loans may make the commercial real estate market as a whole more vulnerable to dips in the economy, observes Tad Philipp, managing director of the CMBS group at Moody's Investors Service. “One of the concerns we have is that the mezzanine market is enabling the leveraging-up of the industry,” he says. “More and more borrowers with mezz loans ultimately means that it will take less of a downturn to cause stress in the lending sector.”

With returns growing less attractive for lenders, will they close the purse strings on mezz debt, just as the market has developed a taste for it? If not, then how are lenders adjusting their business models to mitigate risk, and what role will mezz debt play in the commercial real estate market going forward?

Mezz lenders, a breed apart

Capital providers at the mezzanine level aren't frightened off easily. Those who are most successful embrace risk and depend on their market savvy to overcome unforeseen challenges. Mountain Funding, for example, has responded to increased competition by seeking investments “with some degree of hair on them,” Nevid says. The company has found less competition in land development and construction, which may be too speculative for some institutional investors.

It's critical for a mezz lender to be able to step in and save a failing property in order to protect an investment. For that reason, and unlike purely financial institutions, mezz lenders need deep pockets and expertise in commercial real estate operations, according to Brian Lancaster, head of structured products research at Wachovia.

“If the loan was on an office property in Boston and some major tenant walked out [causing a default], for example, the mezzanine lender has to step in and find a new tenant and would have to understand the Boston office market,” Lancaster says.

Lenders such as Mountain Funding take an active role in the projects they finance to keep both mezzanine and senior loans performing. Sometimes that involves making additional loans to a developer, or providing expertise to overcome occasional hardships without foreclosing on the mezzanine piece.

“Of course, if we made a $50,000 interest payment to a senior lender out of our pocket, that would be added to our loan,” says Nevid of Mountain Funding. “That also puts our loan into default, so we may be entitled to default interest.”

Other lenders, such as Austin-based Torreón Capital LP, stay at arm's length to avoid interfering with the borrower's activities. When and if things go awry, rather than attempt to take over the property directly, the company typically finds a new operator or developer to buy out the borrower's equity in the project and take over, says Charlie Singletary, a partner at Torreón Capital. “We've been in a situation where we could finish the project, but I don't think we would want to,” he says.

Risk mitigation

New protections for lenders are cropping up. Some national title insurance companies, including Santa Ana, Calif.-based First American Corp., now offer insurance for mezz debt and other subordinate levels. The insurance assures the lender of a specific subordination level, which guards against someone turning up with another lien and claiming seniority.

Insurance with a mezz endorsement is becoming common on large deals, especially in major markets such as New York, says James D. Prendergast, senior vice president at First American. In addition to protecting the lender, the insurance can make it easier to sell the loan to an investor, or roll it into a securitized deal such as a collateralized debt obligation (CDO). “The whole transaction can move more smoothly because [the buyer] doesn't have to start from scratch to do all his own due diligence,” Prendergast says.

Mezz lenders can lower their chances of a loss by carefully screening borrowers, or sticking with trusted firms. Torreón Capital works as a financial partner with the same developers, deal after deal. The understanding built through that collaboration helps both parties carry out their jobs more efficiently. “They can go out and make deals rather than spending their time finding money,” Singletary says.

A strong relationship with the mezz lender is equally important for the borrower, says Altman of Huntington Capital. Remember that the mezz lender's principal recourse when the borrower encounters difficulties is to take over operations. “It's very rare that a project goes 100% the way you want it to,” he says. “If you don't know those folks fairly well, there could be a tendency to pull the trigger.”

The latest innovations

This year, lenders have begun to offer “blended loans” that incorporate senior mortgages, mezzanine and other levels of subordinate debt as package deals. The loans lure clients with the prospect of a one-stop-shop experience, a single interest rate and a higher loan-to-value ratio than would be possible on a senior mortgage. The lender works out the details of a senior loan and subordinate debt to achieve that final offer to the borrower.

The collateralized debt obligation (CDO) is another breakthrough that is fueling mezzanine lending, according to Lancaster, the Wachovia researcher.

Improvements made to the CDO format in 2004 have enabled lenders to repackage and sell mezzanine and other short-term debt as securities, freeing up capital to make new loans in the same way that commercial mortgage-backed securities have revolutionized financing for senior loans. Previously, mezzanine lenders either sold their mezzanine loans or held them on the balance sheet.

“It's incumbent on traditional market participants to understand the opportunities of commercial real estate CDOs,” Lancaster says. “Competing effectively is turning more and more on how these businesses are financed, and commercial real estate CDOs are a more efficient way to do that.”

Borrowers' needs to change

The short-term effect of rising interest rates is higher demand for mezz loans, explains Bram at George Smith Partners. As loan-to-value ratios decrease on senior loans, borrowers will require more mezz debt to achieve the same leverage. Eventually, however, higher interest rates raise cap rates and lower sale prices. “Then borrowers won't need as much capital to buy properties, and their requirements for mezz won't be quite as great.”

But don't expect to see mezz lending disappear, says Jamie Woodwell, senior director of commercial/multifamily research at the Mortgage Bankers Association. “Being able to offer borrowers more options is always a good thing,” he says. “Mezzanine is an additional way that borrowers can approach their mortgages, so it's probably going to have a continuing role regardless of the interest rate environment.”

Matt Hudgins is an Austin-based writer.

All equity finance is not created equal

No, they're not interchangeable terms. Mezzanine debt and preferred equity are distinctly different financial vehicles and occupy different positions in the capital stack — although many commercial real estate professionals don't seem to know the difference.

Preferred equity is a direct interest in the entity that owns a commercial property; mezzanine debt is a loan, secured by an interest in that company. The holder of preferred equity securities — often referred to as mezzanine equity — may have little or no control over the property owner and occupies a junior position to any other debt, including a mezzanine loan.

The payoff for preferred equity is a high annual return, generally north of 20%. That's unusual, in that most other equity investments generate returns through capital appreciation, according to Brian Lancaster, head of structured products research at Wachovia. “It's going to feel more like a bond,” he says.

Sometimes borrowers will issue preferred equity when more affordable mezzanine debt isn't an option, Lancaster says. Typically, if a property owner seeking secondary funding has covenants with the senior mortgage lender that prevent the use of mezzanine debt, then the borrower will use preferred equity.

The high risk and equally high returns of preferred equity suit companies like Austin-based Torreón Capital just fine. While the commercial real estate equity provider makes some mezzanine loans, it usually works out a preferred equity position instead, according to Charlie Singletary, a partner in the firm. In fact, Torreón refers to its equity business as a joint-venture program.

A mezzanine lender receives a return that is either fixed or tied to a benchmark interest rate, but preferred equity deals can produce returns that increase with the success of a project. On most of its deals, Torreón receives a full 50% of the operating company's profit after expenses and debt service.

Some preferred equity stakeholders take an active role in property operations, Singletary says, but Torreón prefers to work with experienced real estate developers that handle those operations independently. With Torreón providing capital, those partners can then focus their energies on the real estate, Singletary says.

“We give the developer all the independence we can to do their job, which is to get the project built, get it stabilized and create value.”
Matt Hudgins

A closer look at the mechanics of mezz debt

How much leverage can a mezzanine loan add to a deal? If the senior mortgage equals 75% of a property's value, mezzanine debt can boost that loan-to-value to 85% or even 95%, reducing the amount of equity required to close a deal.

The range for mezzanine loans is large, from $2 million to $150 million, says Chris Kelly, managing director of real estate at CapitalSource Finance LLC. Institutions at the larger end of that range include Bank of America, Wachovia, Lehman Brothers and some of the larger hedge funds. At the lower end are credit companies and real estate investment trusts, including CapitalSource based in Chevy Chase, Md.

Some owners use mezzanine debt to liquidate excess value created by escalating asset prices. The average price paid for core office properties nationwide increased from $165 per sq. ft. in the first quarter of 2003 to $209 per sq. ft. in the first quarter this year, according to Real Capital Analytics. For some properties, that trend has left a wide gap between the amount of the first mortgage and total asset values.

For owners unable to refinance a senior debt and prohibited from taking out a second mortgage by restrictive covenants, such as those on loans rolled into commercial mortgage-backed securities (CMBS), mezzanine deals offer a way to cash out some of that increased value.

Borrowers also use mezzanine debt as bridge loans, as a replacement for equity, and even for long-term financing, according to Steve Bram, a senior partner at Los Angeles-based George Smith Partners. The maximum loan amount depends on how much additional debt service a property's cash flow can support beyond the senior loan.

For example, a borrower seeking to buy a $100 million office building in a core market today might qualify for a $79 million senior loan with a 6.25% interest rate, Bram says. (That interest rate is based on a 5.15% 10-year Treasury yield, plus a 110 basis point spread). Assuming a 7% capitalization rate, or annual net operating income of $7 million from the property, the resulting debt-coverage ratio is about 1.2.

A mezz lender can offer a loan to lower the property's combined debt-coverage ratio for both senior and mezzanine debt to a target of, say, 1.05. In this example, the resulting mezzanine loan would be $7.94 million at a 10.5% interest rate. “So, we're going from a $79 million loan to $86 million in combined leverage,” Bram says. “That allows the borrower to just put in 13% equity, as opposed to 21%.”
Matt Hudgins

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