The insatiable investor demand for real estate over the last couple of years has touched off a mezzanine debt bonanza. Traditional lenders, opportunity funds, real estate investment trusts (REITs) and high-net-worth individuals have launched hundreds of new mezz lending programs since 2001 and are deluging the mezz market with billions of dollars seeking deals.

Private borrowers are the big winners: By “stacking” mezz debt atop first mortgages, they're reducing the amount of equity they need to pour into properties. In turn, that enables borrowers to spread out their equity and acquire more properties. Using mezz also gives property owners more control over their real estate — less equity translates into fewer business partners, if any at all, with whom to share profits.

Although they avoid loading up on debt, or “leverage,” REITs are occasionally using mezz to accommodate joint-venture partners or to fulfill short-term goals, such as paying for tenant improvements and broker commissions during lease-up periods.

“The mezz lending environment is extremely competitive and borrowers are the beneficiary of that,” says Bruce Schonbraun, managing partner of Schonbraun Safris McCann Bekritsky & Co., a national real estate consulting and accounting firm in Roseland, N.J. “Certainly it makes sense for any property buyer to consider mezz as a part of his capital structure.”

Value-Add Mezz

Davidson Hotel Co. in Memphis, Tenn., has used mezz for a decade to buy and add value to hotels, which it typically holds for three to seven years. In December, Davidson Hotel completed an extensive $7 million renovation of the Renaissance Chicago North Shore Hotel's 386 rooms, lobby and 22,000 sq. ft. of meeting space.

The company, which purchased the struggling former Sheraton in the fall of 2001, financed the acquisition and rehab with the help of $6.5 million in mezz furnished by RockBridge Capital of Columbus, Ohio.

John Belden, executive vice president of business development for Davidson Hotel, says Renaissance Chicago's revenues increased 20% last year over 2002. He expects an even higher jump in revenues this year as the hotel's reputation continues to rebound, as does the economy. “Mezz allows our principal to spread his equity into as many deals as possible, which allows for strong growth within the company,” Belden says.

RockBridge, whose mezz business grew 132% to $44 million in 2003 from $19 million in 2002, is targeting a return of between 20% and 25% for its four-year mezz loan on the Renaissance Chicago. RockBridge is charging 12% interest, is sharing in operating cash flows, and will share in sales or refinance proceeds.

“Mezz borrowers might pay a higher return in the short term,” says James Merkel, a managing director with RockBridge, “but if you're a successful owner and operator and are adding value to your deals, over the long term you won't have to share your cash flow with an equity partner.”

Mezz in a Nutshell

Rising real estate values and first-mortgage lenders who are applying strict loan-to-value (LTV) underwriting standards have propelled the burgeoning mezz market. Traditionally, senior lenders made loans for 80% or more of a property's value, and borrowers generally turned to equity providers to fill the remaining gap.

But today, primary lenders are limiting first mortgages to between 50% and 75% LTV. Rather than use equity, however, borrowers can fill a lot of that gap with less costly mezz that typically has terms of three to five years. By combining mezz and senior loans — the interest rate on 10-year, fixed-rate debt was approximately 5.7% in mid-February — borrowers usually pay a “blended rate” on all their debt, ranging between 6% and 10%.

How much cheaper is mezz than equity? Equity providers generally charge interest upwards of 20%. While transactions differ, mezz debt that increases the LTV ratio from 65% to 75% generally carries an interest rate in the mid-to-high single digits. Mezz gets pricier as borrowers move to higher LTV ratios. A mezz loan that increases LTV to 90% from 80% may bear interest in the high teens. Plus, the higher the LTV ratio, the more likely the loan agreements will include “kickers,” which enable lenders to share in a building's cash flows, sales proceeds or both, for example.

Mezz lenders most commonly secure their loans by using the borrower's equity interest in the building as collateral. Thus, if a borrower defaults, the mezz provider becomes the property's owner and operator. To mezz lenders, that risk and reward scenario is more appealing than providing equity. While equity suppliers demand higher returns for their investments, if a borrower goes into default, equity partners have little hope of recouping their investment.

“There's a perception that mezz is a prime-return, lower-risk investment than equity, so people are flocking to provide it,” says Jay Rollins, senior vice president for Newman Financial Services in Denver. “So there's really a greed factor that has been driving the market.” Newman Financial, which provides debt primarily for multifamily deals, completed $75 million in mezz loans in 2003, up slightly over 2002.

Ratcheting Up Leverage

Once a tool to simply fill a small gap between senior-note financing and equity, mezz now has turned into an omnipresent crowbar to ratchet up debt to well above 90% of property value — a level rarely matched, in the last 15 years. Indeed, last fall Macklowe Properties financed its record-setting $1.4 billion purchase of the 50-story, 1.9 million sq. ft. GM Building in New York using 98% debt.

If interest and cap rates rise before rents, many borrowers may not be able to meet their debt obligations. That means mezz lenders could wind up owning and operating a large amount of real estate over the next few years.

“We could have a deterioration in value after a huge run-up in value, and the highly leveraged people are going to be underwater,” warns Gary Mozer, CEO of George Smith Partners, a mortgage broker in Los Angeles.

Still, not all mezz users are pumping up leverage. A group tied to the Sycuan Indian tribe that operates a casino in El Cajon, Calif., last fall acquired the U.S. Grant Hotel in downtown San Diego.

New York-based Ramsfield Hospitality Finance, which formed in June to make mezz loans to hotels, provided Sycuan a $9 million mezz loan that increased the debt level to 70% from 55%. Sycuan Investors intends to renovate and reposition the hotel with a Starwood Luxury Collection flag.

Ramsfield Hospitality's return is based solely on the interest charged for the mezz — the firm doesn't have kickers — though officials declined to reveal the interest rate. “Our program doesn't try to take profits out of the owner's pocket,” says Jim Mandel, president of Ramsfield Hospitality.

The diverse ways in which lenders dole out mezz mirrors the growth of the broader trend toward securitization. Indeed, a growing number of mezz lenders are competing for debt placements throughout a deal's capital structure: Debt providers with certain risk tolerances are joining with appropriate borrowers and leverage levels.

Thus, while Ramsfield Hospitality typically cuts off hotel mezz when total debt reaches 80% of property value, Cleveland-based KeyBank may make mezz loans for apartments that increase total debt to more than 90% of property value, says Dan Walsh, managing director of Cleveland-based KeyBank Real Estate Private Capital.

“It's a confirmation that the mezz market has become more sophisticated,” he asserts. “That hasn't been the case in the last eight to 10 years.”

REITs Find a New Market

Targeting and financing different levels of leverage in a property's capital structure isn't the only characteristic that sets mezz lenders apart. Indeed, some mezz providers are more comfortable than others with the notion of owning and operating real estate in the event that a borrower defaults.

Many REITs are making mezz loans, or in some cases buying existing mezz loans from traditional lenders. In addition to positioning themselves to potentially take over ownership of properties, REITs that supply mezz debt are generating returns on their cash in a market with few acquisition opportunities.

In December, Cranford, N.J.-based Mack-Cali Realty made a $16.3 million mezz loan on the 480,000 sq. ft. One River Center office complex in Middletown, N.J. The complex was 48% vacant at the time of the loan, and owner One River Center Associates issued the mezz to pay costs associated with lease-up. Mack-Cali's kicker? The REIT can convert the loan to a 62.5% ownership interest at any time during the three-year term.

As part of the agreement, Mack-Cali took over leasing and management of the complex. Mitchell Hersh, CEO of Mack-Cali, estimates the loan would provide an 11% total return at term. However, Hersh expects to convert to ownership if the leasing strategy proves successful, and he's optimistic that it will. In mid-February there were enough leases in the works to boost occupancy to 75%.

The One River Center deal marks Mack-Cali's second mezz loan over the last few years, and Hersh says he'll be on the lookout for similar mezz opportunities.

“If interest rates rise and certain asset classes continue to suffer, in all likelihood there will be a higher level of equity required to support existing loans,” he says. “And that may provide companies like ours with an opportunity to step into mezz positions that could very well turn into ownership positions.”

A Creative Solution

In some cases, REITs are even becoming mezz borrowers. In 2002, New York-based Trizec Properties used $40 million in mezz debt as part of a $120 million loan package when it bought out Whitehall Street Real Estate Fund's 75% interest in the 915,000 sq. ft. Ernst & Young Plaza office building and a 330,000 sq. ft. attached mall in Los Angeles.

Trizec, which had owned 25% of the building, bought out Whitehall as office leases were coming up for renewal and the level of future cash flows was uncertain. Trizec opted to use mezz as it worked to renew leases and keep occupancy at 90%. Having successfully stabilized the property, Trizec was recently able to replace both the senior and mezz debt via a 10-year, fixed-rate loan from Eurohypo, a German mortgage bank.

“As a publicly traded REIT, we don't use mezz that often because on average our debt levels are below the leverage range where you typically see mezz,” says Jeffrey Echt, senior vice president and treasurer for Trizec. “But in certain circumstances, we've found it effective and efficient capital to access.”

Joe Gose is a Kansas City-based writer.