The combination of historically low interest rates and tighter underwriting standards on senior loans has made mezzanine debt highly attractive to borrowers. But with lenders tripping over each other to woo customers, returns are shrinking.

Owners and investors are now able to obtain mezzanine loans with interest rates as low as 8% to 9%, which is comparable to rates on senior loans in the early 1990s. Meanwhile, returns on loans are being squeezed as the growing ranks of lenders offer the best deals possible to attract borrowers.

“It used to be that lenders were able to achieve 15% to 20% [average] returns on mezzanine loans, but the crowded arena has compressed yields down to 12% to 15%,” says Richard Katzenstein, managing director at MONY Realty Capital Inc., a mezzanine loan provider and subsidiary of The MONY Group, based in New York.

The overall size of the mezzanine market — the dollar amount of outstanding loans — is estimated to be between $65 and $135 billion, according to Doug Vikser, a managing director at Parsippany, N.J.-based Prudential Financial. Although the firm can't provide the exact figures on how much the market has grown in recent years, Vikser says it's clear that more borrowers are turning to mezzanine financing because traditional mortgage lenders are tightening their underwriting standards.

Loan volumes at New York-based Capital Trust, the country's largest mezzanine lender, indicate that mezzanine lending is indeed on the rise. Edward Shugrue, CFO at Capital Trust, says mezzanine loan originations at the firm have risen from about $400 million per year in 1997 to approximately $700 million in 2002. “Mezzanine financing has become an acceptable part of the capital structure, which in our case explains the 70% increase in our average yearly volume,” Shugrue says.

Good Times for Mezzanine Lenders

Despite the downward pressure on returns, a surge in volume still makes mezzanine financing an attractive business. Borrowers looking for financing beyond what senior lenders will provide increasingly are turning to mezzanine financing, which fills the gap between a senior loan provided by a lender and the amount of equity the borrower is able to contribute to a project.

Mezzanine loans typically carry terms of two to five years. Other mezzanine financing options include junior debt that is secured by a partnership interest, and a preferred equity structure in which the lender makes a capital contribution to the borrower in exchange for an equity share in the property.

When seeking additional money for projects an investor typically has two options: team up with a partner or take out a loan. However, an investor who joins forces with a partner sacrifices a piece of the profits if the property increases in value. By assuming debt through mezzanine financing, the investor keeps a greater percentage of ownership and the opportunity to gain more profits in the future.

Because borrowers are making relatively low interest payments on long-term loans, they tend to be well positioned in terms of cash flow to pursue mezzanine financing, says Don Moses, director of structured finance in the San Francisco office of Chevy Chase, Md.-based Capital Source Finance.

“It has been a terrific opportunity for us,” says Moses. “We've really seen higher-quality deals than we expect to see because deals that should be financed, in our view, by a traditional bank or insurance company are being turned down.” That's because the tighter underwriting standards at senior lending houses is making it more difficult for borrowers to receive the amount of financing they need for projects and other initiatives.

For example, Capital Source recently jumped at the chance to provide a $12.6 million loan to the owner of a 500,000 sq. ft. distribution center outside of Indianapolis. Moses says he was surprised that the owner, which he declined to name because Capital Source was in the process of closing the deal, could not obtain financing from a senior lender. Capital Source considered the owner an ideal loan candidate because the property is an essential parts-distribution hub for the Ford Motor Co., which occupies 80% of the building.

The firm provided an $11.1 million senior loan and a $1.5 million mezzanine loan, which were rolled into one loan package, and the owner chipped in $2.2 million in equity. The two-year loan will refinance the original acquisition loan and pay for a build-out of the section of the warehouse that is currently unoccupied. Capital Source will earn a 10% yield, which Moses considers a solid return because the loan package includes both senior and mezzanine components.

Borrowers Line Up for Loans

Borrowers often turn to mezzanine loans when a first mortgage doesn't provide the level of financing needed to pay for a project. The Pyramid Cos., a Syracuse-based mall developer, did just that to provide a piece of the funding for its planned $2.2 billion Destiny USA mall and entertainment project, which will be built on the site of the firm's 1.5 million sq. ft. Carousel Center in Syracuse. (See related story on page 10).

In 2000, the company was unable to refinance its existing securitized loan, which was encumbered by a call-protection clause, so it took out a $68 million mezzanine loan with Capital Trust to pay for assorted site and planning costs, as well as tenant expansions at the Carousel Center. When the original securitized loan expired in late 2002, Pyramid took out a new senior loan with Credit Suisse First Boston and consolidated the mezzanine loan into that package.

“We felt the loan was extremely safe. Pyramid has a huge portfolio,” Shugrue says. “It fit all the hallmarks of what we like to do.”

A typical deal for Capital Trust is a mezzanine loan ranging from $25 million to $100 million. With an $845 million equity fund at its disposal, the firm is extremely well capitalized to fund large mezzanine deals.

Bridging the Gap

Only two years ago, owners typically were able to obtain a senior loan on about 65% to 75% of the total capital structure of a deal, but that range has fallen to between 50% and 60% because of rising risks in commercial real estate, says Donald Braun, the president of Hall Financial Group, a Frisco, Texas-based provider of mezzanine financing. Lenders are particularly wary of providing senior debt for hotels due to that sector's dismal performance over the past two years.

The increased demand for alternative financing is encouraging more lenders to include mezz debt as an option in their loan packages. “Every loan we do today has to have a provision to insert a mezzanine loan,” adds George Jahn, assistant real estate officer and head of mortgage lending at the Albany-based New York State Teachers' Retirement System.

Wall Street underwriters also are contributing to the spike in demand for mezzanine financing because they prefer to securitize only the investment-grade portions of commercial mortgage-backed securities (CMBS) transactions. In this credit-sensitive market, CMBS lenders tend to reduce the size of their loans, creating a greater need for mezzanine financing, notes Shugrue.

“For large loans, the most efficient financial source is Wall Street, but Wall Street tends to stop at the frontier of investment-grade portion [typically 60% loan to value]. The rest of that gap can be filled with mezzanine,” Shugrue says. “Mezzanine provides a level of flexible financing that complements Wall Street's senior loan.”

Borrower demand also has been behind the rise in purchase prices and the drop in capitalization rates. “The increase in the number of real estate owners bidding on new properties has driven cap rates down,” says Dan Walsh, a senior vice president at Cleveland-based KeyBank Real Estate Capital.

Walsh notes that cap rates on office properties have dropped by 1 to 2 percentage points in the past two years. Since a 1% drop in cap rates means a 15% increase in the value of a property, borrowers have more leverage to seek loans, including mezzanine financing, to fund capital improvements and other projects.

A Competitive Edge

Taking on more debt is no easy decision. But as owners of various property types struggle with rising vacancy rates and declining revenues, mezzanine financing can help provide the competitive advantage needed to boost a property's bottom line.

Daniel Edrei, director and principal of Meecorp, a Fort Lee, N.J.-based commercial lender, notes that mezzanine financing can be a way for property owners to squeeze more value out of a building.

Edrei recently arranged a $2 million mezzanine loan with a 17% fixed interest rate for the owner of an Alabama retail center. The three-year loan enabled the borrower to revamp the property and boost the occupancy rate from 82% to 98% within six months, he says. The loan carried a higher interest rate than is typical in today's market because the high vacancy rate made it less attractive to lenders. However, several years ago the same mezzanine loan would probably have carried an interest rate of 20% or higher.

The consensus among real estate professionals is that incorporating mezzanine financing into a funding strategy has become cheaper than obtaining more equity. The low interest rates available on senior debt provide owners an incentive to refinance as opposed to selling property since they can obtain such affordable fixed-rate loans, which makes room for excess cash flows to pay down mezzanine debt.

“If a developer is buying and holding the property long-term, lenders get repayment through the property cash flow and refinancing in the future,” says KeyBank's Walsh. “Lenders are looking for the refinancing proceeds to pay the mezzanine loan.”

Mezzanine financing also is attractive to investors who want to avoid tying up a lot of their own money in a deal. David McQuaid, president of Dallas-based Performance Properties, recently obtained $2.2 million in preferred equity mezzanine financing from Hall Financial to purchase the $10 million Crystal Springs apartment complex in San Antonio, Texas. The $6.9 million in existing debt on the project represented the bulk of the total purchase price. Rather than pony up $3 million in cash to finance the rest of the deal, the owner obtained $2.2 million in mezzanine debt and provided $850,000 in equity to finance the rest. “With the mezzanine piece, it made it a much more attractive deal,” he says.

Other borrowers are taking advantage of the flexibility of mezzanine financing. Steve Guy, CFO at Pittsburgh-based Oxford Development Co., considers mezzanine financing to be a good alternative to selling some of his property to obtain additional capital. He prefers to lock in the low rates available from mezzanine lenders than reduce his equity holdings through the use of a joint partnership, which he has a policy to avoid. “Mezzanine is less costly than raising equity,” he says.

For Joe Green, CFO of Winston Hotels, a Raleigh, N.C.-based REIT that develops and acquires hotel properties, mezzanine financing has helped him navigate the bumpy conditions since the market was hurt by the post-Sept. 11 travel crunch. For example, Green says he is currently in the process of lining up a mezzanine loan to finance the conversion of a historic building in Baltimore into a Hampton Inn Suites.

The flexibility of mezzanine financing only adds to its appeal among borrowers. “We expect there to be continued healthy demand for mezzanine financing this year,” says Vikser of Prudential Financial. “With the weakness in the markets, there's no reason to expect first-mortgage lenders to loosen their underwriting criteria.”

Kathleen Fitzpatrick is a New York-based writer.

RISKIER BUSINESS

This chart compares the probable default rate for an $8 million senior loan vs. a $1 million mezzanine loan on a single property in five markets. In Chicago, the default rate jumps from 2.2% for a senior loan to 17.5% for a mezz loan. That's because of deteriorating conditions in the Windy City, including declining rental rates and an active construction pipeline.