Mezzanine lenders are tripping over each other in their haste to accommodate hungry borrowers. Each week brings news of another commercial real estate fund amassing capital to make or acquire mezzanine loans, which are secured by the stock of the company that owns the property rather than by the real estate itself.

There is plenty of demand for such loans, too, as investors attempting to refinance or acquire properties struggle to increase their leverage beyond the 75% loan-to-value ratio typically available from senior mortgage providers today.

Yet experts say mezzanine lending is being squeezed out of the capital stack by conservative underwriting at the senior mortgage level. Seeking to reduce default risks, most first mortgage lenders have tightened restrictions on an asset's overall leverage and left little room for mezzanine loans. Some mortgage lenders go one step further, prohibiting secondary financing altogether by spelling out the restrictions in their loan documents.

For borrowers who can't close a transaction without the addition of mezzanine debt, the challenge is to find a senior lender willing to allow leverage beyond the first mortgage. “Our pipeline has swelled to nearly double what it would be in a normal environment,” says James Mazzarelli, managing director of Transwestern Realty Finance Partners, a Chicago-based mezzanine lender. “The challenge is, are those deals going to transact? If the senior debt doesn't come to bear, there will be no deal.”

That isn't to say mezzanine lending is dead — far from it. Transwestern Realty Finance Partners has already provided $150 million of mezzanine capital in eight transactions this year and has more deals pending. Successful mezzanine borrowers have learned to allay the senior lender's concerns by structuring deals with positive cash flow, and by using mezzanine and senior lenders who have worked together before or who accept each other's standard terms upfront.

Debt discomfort levels

Secondary finance options accounted for 7.6% of all commercial real estate lending in 2007, up from 7.2% in 2006, according to the Mortgage Bankers Association. Those loans include second mortgages, mezzanine loans and preferred equity.

Second mortgages are secured by the same asset as the senior loan and were already falling into disfavor among lenders before the credit crunch, according to Gary Mozer, principal and managing director of George Smith Partners, a Los Angeles-based financial intermediary. Lenders don't want to see two secured classes of creditors involved in the event of a borrower's bankruptcy.

Mortgage lenders' recent aversion to secondary financing stems from their reluctance to encumber the borrower with debt service that may increase the likelihood of default. Preferred equity, which is a direct investment in a real estate operating company, is particularly costly to borrowers because it commands annual interest rates of more than 20%. That compares with interest rates on mezzanine loans that average between 14% and 18%. Preferred equity lenders take a loss position right behind common equity, so the risks and rates are higher.

Those borrowing costs were less of a concern in the go-go days of 2006 and 2007, when competition to place loans drove conduit lenders to offer interest-only mortgages that reduced the borrower's debt service. That left excess cash flow that borrowers used to buy extra leverage, boosting overall loan-to-value ratios to as much as 95%.

“Those days are over,” says attorney Doug Buck, who heads the real estate practice in the Madison, Wis. office of Foley & Lardner. Buck's clients are finding it increasingly difficult to get senior lenders to allow the addition of a mezzanine loan in deals. “The advice I'm giving clients is that it's difficult, if not impossible, to bring in mezzanine lenders, and that you need to try to bring in the equity yourself.”

What changed? A marketwide repricing of assets, for one, has dashed hopes for significant price appreciation in 2008 and 2009. Lenders are again demanding amortization on senior mortgages to ensure those loans can be refinanced upon reaching maturity. That leaves less cash flow to pay debt service on additional financing, which is why senior lenders are increasingly reluctant to allow total leverage on a property to exceed 75%.

In order to land more deals, some mezzanine lenders have begun to offer an accrual feature that delays a portion of interest payments until the loan reaches maturity, usually in two to five years. That reduces the demand on current cash flow, which is enough in some instances to attain overall debt-service coverage required by the senior lender.

Yet with senior mortgages available at 75% leverage, there is little place for mezzanine in today's capital stack, according to Todd Maclin, CEO for commercial banking at JP Morgan Chase, a senior mortgage lender. “In many [pre-credit-crunch financed] projects facing maturity, the mezzanine debt sits beyond what many people consider to be a prudent debt structure,” Maclin says, encapsulating a senior lender's argument against secondary leverage. “There are properties out there that have more debt than can be refinanced. The solution is not mezzanine, but additional equity.”

A mezzanine lender also reserves the right to take over as the borrower on the first mortgage in the event of a default on the mezzanine loan, effectively seizing ownership of the asset. According to Buck, therein lies another sore spot for senior mortgage lenders, who may end up collecting loan payments from the mezzanine lender rather than the owner or developer to whom they extended the first loan.

Making it work

This summer, MGP Real Estate acquired Braddock Place, a 348,218 sq. ft. office complex in Old Town Alexandria, Va., for approximately $106.5 million. The privately held development, investment and management firm used a senior loan from GE Capital Corp. that covered roughly 78% of the purchase price and an $11 million mezzanine loan from Transwestern Realty Finance that brought the overall leverage on the deal to about 88%.

“For deals that support it, mezzanine capital reduces the amount of equity we need to bring to bear and it will correspondingly increase equity return,” says Charles Salcetti, president of MGP. “If you only have to put up half as much equity, then in effect you have more upside. There's more profit in the deal.”

Existing relationships with both lenders helped MGP secure funding, according to Salcetti. More importantly, the lenders agreed to finance the Braddock Place acquisition because the property generates a cash flow that is more than 1.2 times the cumulative debt service on both loans. Braddock Place is 96% leased, chiefly to government agencies and government contractors, without near-term exposure to leases rolling over.

A positive debt-service coverage ratio from existing cash flow is essential if a borrower hopes to gain a senior lender's blessing for the addition of a mezzanine loan, according to Eric Tupler, vice chairman of financial intermediary CBRE Capital Markets. “The first mortgage lenders don't want to risk that the borrower will have to come out of pocket to pay the debt service on the first mortgage or the mezzanine loan,” he says.

In May, CBRE Capital Markets arranged a $17.85 million mezzanine loan on top of an $80 million construction loan for Kane Realty Corp. to build St. Albans at North Hills, a mixed-use development of apartments and retail in Raleigh, N.C. The bulk of mezzanine loans being placed today are for new construction or strong value-add plays that will quickly appreciate in value, Tupler says. “That's where there's enough upside and value creation to get that mezzanine lender out of the deal at maturity,” he says.

To improve chances for bringing mezzanine into a deal, Mozer of George Smith Partners advises clients to choose a mezzanine lender first, obtain a copy of that lender's standard inter-creditor agreement, and then shop for a first lender willing to work with those terms. The inter-creditor agreement lays out the rights of both the first and second mortgage lenders.

Above all, investors should start lining up replacement financing six to nine months before their existing loans reach maturity, according to David Striph, senior managing director of Dallas-based Westmount Structured Finance. “When you run out of time, that's when you put yourself in the position of having people take advantage of you,” he says. “You don't want that bullet staring at you as your options start running out.”

Matt Hudgins is a writer based in Austin.

Mezz lenders range from benign to predatory

Before selecting a mezzanine provider, financial managers advise borrowers to evaluate the lender's expertise and business model as well as its loan terms. Here are some important points to consider:

  1. Is there a maturity issue?

    Fund managers receive a profit participation payment when an investment fund closes and all of its debt instruments are repaid or sold, says Gary Mozer, principal and managing director of Los Angeles-based George Smith Partners. If the fund is near its end date, there is no incentive on the manager's part to grant loan extensions that might delay closing the fund's books to trigger that payment. “You have to understand those inherent conflicts of interest,” Mozer says.

  2. Will the lender sell?

    Many lenders reserve the right to sell their mezzanine position. For the borrower, that means the mezzanine provider they select may not be the lender in place when, and if, financial difficulties occur down the road.

  3. What's the lender's strategy?

    Some mezzanine funds simply seek to make money from loan interest. CSV Capital LLC, for instance, is a joint venture newly formed by The Carlton Group and insurer Prudential that plans to invest $500 million in new and acquired mezzanine loans, preferred equity and other subordinated debt.

    CSV Capital seeks deals with a debt-service coverage ratio of at least 1.1 at the outset. Some mezzanine funds in the market, however, pursue a loan-to-own strategy and may take on distressed deals without positive cash flow because the mezzanine loan gives them an opportunity to ultimately acquire properties for cents on the dollar.

  4. Current or accrued interest?

    Some mezzanine lenders will let borrowers accrue interest until a loan matures, usually for a few additional percentage points on the interest rate. A full or partial accrual option can reduce monthly debt-service requirements.

  5. Is the mezz lender capable?

    Some mezzanine lenders lack the wherewithal to assist the borrower in times of crisis or take over an asset, something the senior lender should take into account, according to real estate attorney Jim Fox, a partner with Quarles & Brady in Chicago. “You don't just need money, you really need talent,” he says.

Closed-end funds in particular may be vulnerable to default on the senior mortgage if the borrower is unable to perform, Fox says, because those funds often invest without reserving capital for real estate expenses. “They've invested half a million dollars and there's nothing in the cupboard when Mother Hubbard goes over there.”
— Matt Hudgins