Wall Street continues to convulse from the sub-prime fallout — more than $90 billion in value had been wiped off banks' books by mid-January. One group of financiers, however, is finding new opportunities in the roiling market: mezzanine lenders.

These lenders provide financing in the form of preferred equity, bridge loans and mezzanine loans that closes the gap between a borrower's equity contribution and senior debt. In recent years, mezzanine players have gotten squeezed by senior lenders' increasing aggressiveness in moving higher up the capital stack — providing 85 percent or more of a deal's value. Borrowers, in fact, could go one-stop shopping, getting all their financing in one shot, leaving specialty mezzanine lenders out to dry.

All that's now changed.

“Now most lenders won't give anything but the senior piece,” says Jeff Knowles, managing director in Holliday Fenoglio Fowler's Houston office. “You're going to have to go to a third party if you want a mezzanine loan today.”

Conservatism has set in and senior lenders are back to only going up to 65 percent to 75 percent in the capital stack, giving mezzanine lenders more breathing room to provide mezzanine debt or preferred equity. Further, the opportunity is being created in large part due to the slowdown in the conduit market.

“We haven't been active over the past couple of years because other lenders were offering mezz money at such cheap spreads,” says Lynn McKee, senior relationship manager in GE Real Estate's North America lending division. “We were not competitive, but the current environment has given us an opportunity and the risk-to-return ratio for mezzanine lending looks attractive once again.”

Up until six months ago, through the commercial mortgage-backed securities (CMBS) market borrowers were able to get cheap mezzanine debt, which made it difficult for many traditional mezzanine players to put money out. That spigot is now shut.

Put this all together and traditional mezzanine players do have an opportunity today even despite a drop in the total amount of borrowing that is occurring in the market. Overall, expectations are that investment sales volume and developments will be down considerably in 2008 (see story on p. 18), and that will cut the need for borrowing. Still, there is massive demand for mezzanine debt, according to Tom Shapiro, president and chief investment officer of GoldenTree InSite Partners, a New York City — based private equity sponsor that did $150 million of mezzanine debt and preferred equity deals in 2007. In the end, experts say that the percentage of the capital structure represented by mezzanine will be higher, but the total dollar volume of mezzanine deals will be lower than last year.

However, there is a price for this new prosperity. As of last summer, mezzanine yields were as low as 9 percent, a return that many experts say didn't reflect the amount of risk. However, risk has been re-priced and mezzanine lenders are now being rewarded. That means that borrowers have seen spreads on mezzanine money widen as much as 600 basis points, Shapiro estimates, adding that GoldenTree InSite Partners is offering mezzanine loans at 300 to 500 basis points higher than it was 12 months ago.

The bottom line?

“If you're a borrower looking for mezzanine debt, you have to realize that it's going to be much more expensive and the maximum leverage will be lower so you have to have a greater equity cushion,” says Dean Benjamin, principal of Ascent Real Estate Advisors, a New York City — based investment manager that is currently raising a $200 million mezzanine fund.

On the borrower's side of the equation, Chicago-based shopping center developer Prime Group Inc. is seeking out mezzanine money for its newest construction projects, according to president Larry Vogler. “We want to use mezzanine on our new projects because we don't want to put all of our equity into any one deal. We'd prefer to use it for several deals.”

Biting the bullet

While mezzanine lenders do see opportunity in 2008, the real action may not kick into gear until later this year. That's because across the nation, sellers have yet to adjust their pricing for commercial real estate assets to accommodate the current debt markets. As one industry expert says, “you can drive a truck through the bid-ask gap,” and that gap is creating a sluggish investment market.

But, some acquisition deals are still closing, while new development projects are still seeking financing and loans still need to be recapitalized or refinanced.

“We've gone from a place where there was almost no mezzanine getting done because it wasn't worth the headache,” says Ryan Krauch, a principal at Mesa West Capital, a Los Angeles — based investment firm that both originates mezzanine loans and buys mezzanine debt from other originators. “Now it's necessary.”

For example, Dan Gorczycki, managing director of Savills Granite, is currently in the market helping a buyer find financing for a portfolio of B-minus-quality regional malls and the quotes for senior debt aren't high enough. “We have had to go to different lenders to quote mezzanine loans too,” he says.

Terra Capital Partners is one investment firm that is actively quoting mezzanine deals. Recently, the New York City — based firm launched several new mezzanine products, says president Bruce Batkin. He estimates the firm could invest as much as $500 million in mezzanine deals in 2008, up from its typical average of $200 million a year.

Paying more for less

Mezzanine money is not only more complicated, it's also farther down the capital stack and far more expensive — in other words, borrowers today are paying more money for less debt. Previously, mezzanine lenders were filling a gap between 75 percent and 90 percent of the capital stack. But with senior debt only reaching 65 percent to 75 percent LTV, mezzanine debt rarely reaches more than 85 percent.

“The capital structure looks different today than it did in the past,” points out Frank Sullivan, senior regional director at Wrightwood Capital, a Chicago-based investment firm that has raised several funds to invest in mezzanine debt. Currently, it is raising a mezzanine fund of $250 million to $300 million.

In the past, Wrightwood Capital has filled the 75 percent to 95 percent position in the capital stack with mezzanine debt and preferred equity. That's not the case today, where it only goes up to 90 percent or so. “Given the changes that have taken place in the capital markets, we've been able to get lower in the capital structure and preserve our yield,” Sullivan says.

In fact, Wrightwood Capital's mezzanine investments are yielding returns of 14 percent to 16 percent for debt and even more for preferred equity, Sullivan says. Other mezzanine players have also seen their yields increase now that many providers of cheap mezzanine money are out of the market.

Higher prices for senior and mezzanine debt means that borrowers are getting little or no return on equity, Knowles points out. “My buyers are telling me that the only solution is to pay less for the property,” he says. “One of the major concerns for mezzanine lenders is declining valuation.”

That means that mezzanine lenders are being very conservative in their underwriting. “On one hand, mezzanine lenders could cash in on the current environment, but on the other hand, they're more conservative, so deals have to look better,” says Ed Craine, CEO of Smith Craine Finance, a mortgage brokerage based in San Francisco.

David Heiden, a partner with New York City — based W Finance Mortgage Fund, says mezzanine lenders who provide construction loans are a little more hesitant. “There will come a time when these deals just aren't as attractive,” he says.

W Finance expects to do about $25 million in mezzanine debt in 2008, most of it for construction projects. However, the firm is being “extra careful with underwriting,” Heiden says, adding that “people are really trying to cherry-pick which deals they're getting involved with.”

GoldenTree InSite Partners, for example, has seen requests for mezzanine money increase, but is being “very conservative” with its lending, Shapiro says. “People are nervous because you could look really bad if you put out a bunch of money right now,” he explains. “But there's a lot of opportunity … and you can get very juicy returns.”

Yield Seekers

New players enter the mezzanine market.

With many mezzanine lenders (especially investment banks) exiting the market because they don't have any capacity to make any loans, a number of private equity players and hedge fund managers are entering the mezzanine market — either by raising new funds or by reallocating existing funds to invest in mezzanine debt or preferred equity.

“If you are looking for mezzanine money right now, you have far fewer options than you did last year, but that's only because the new funds aren't up and running yet,” says Frank Sullivan, senior regional director at Chicago-based Wrightwood Capital. “You'll have many more options as the year progresses.”

Tom Didio, a senior managing director with Holliday Fenoglio Fowler, says that most of the new mezzanine players are gravitating toward larger deals. “In the past two weeks, we have had people coming to market with funds and the minimum mezzanine piece is $20 million,” he notes. “Finding a mezzanine piece under $5 million is much harder, and there's a much smaller group of lenders.”

That's one reason why New York City-based Ascent Real Estate Advisors is focusing on the small and middle market — mezzanine deals between $5 million and $20 million. “We feel there's a real opportunity in that portion of the market,” says principal Dean Benjamin, adding that the market has been underserved for years.

Benjamin adds that many real estate funds that were focused on equity investing and joint ventures are now turning their attention toward mezzanine debt and preferred equity. “They've decided to move up the capital structure to improve their credit situation while maintaining yields,” he explains, adding that Apollo Real Estate Advisors is a perfect example of a fund that has raised more money for debt investing than equity. Just recently, the firm provided senior and mezzanine debt to Taconic Investment Partners LLC and Square Mile Capital LLC for a condo project in Manhattan.

Los Angeles-based Mesa West Capital, for example, is entering the market with more than $400 million available for mezzanine deals — either originating loans or buying existing mezzanine paper. “The appeal is that the risk is being priced back into the mezzanine piece,” says principal Ryan Krauch.

“The old equity providers are now preferred equity providers, and the old preferred equity providers are now the mezzanine lenders,” jokes Mark Fawer, a partner with Dreier LLP and chairman of the firm's real estate department.

GE Real Estate, for example, recently launched a preferred equity program for North America and has noted a fourfold increase in inquiries. “Retail borrowers really like preferred equity because of the CMBS restrictions on mezzanine debt,” says Jamie Stolpestad, managing director in the North America Equity division. “And for us, preferred equity is a more defensive structure where we are in priority relative to the sponsor and equity.”