Diminishing proceeds

Additionally, rating agencies and bond buyers of subordinated debt are increasingly frowning upon fixed-rate, interest-only loans. They're pushing lenders to amortize loans, which would force borrowers to pay principal plus interest, says Gary Mozer, a managing director with George Smith Partners, a Los Angeles real estate investment-banking firm that arranges loans.

That's reducing the amount of proceeds borrowers can secure, which will also impair a borrower's ability to justify paying high property prices, especially leveraged buyers of high-priced, stabilized properties.

Up until a few months ago, buyers of those properties relied on cheap capital to eek out a cash-on-cash return of around 6%, adds Mozer, whose firm arranged $4.2 billion of financings in 2006.

But the combination of amortization, rising interest rates and widespread anticipation of slowing, or even stalling, asset appreciation has clouded exit strategies for such buildings. Lenders, rating agencies and bond buyers worry that a sale or refinance may not cover the debt if a property fails to perform.

Mozer should know. In May, he and other George Smith members all but escaped the capital market clampdown when they arranged some $37 million in financing for Santa Monica, Calif.-based Doerken Properties Inc. The funding financed Doerken Properties' purchase of the 141,310 sq. ft. Commonwealth Shopping Center from New Hyde Park, N.Y.-based Kimco Realty Corp., a retail REIT. The grocery-anchored project, near Sacramento, is 97.5% occupied.

Doerken Properties received a fixed-rate, interest-only loan for five years that represented 95% of the project's cost. The debt comprised a $33.2 million senior loan at an interest rate of roughly 6% and a $3.9 million mezz loan at a rate of 10%. The lender, Greenwich Capital, also received a preferred return and a 35% pari passu profit participation as part of the mezz terms.

Despite the turmoil hitting the capital markets at the time, Greenwich had already started marketing a loan pool for securitization that included the Commonwealth center financing, says Allen Lynch, president of Doerken Properties. Lynch doesn't expect to receive the same terms going forward and acknowledges that Greenwich required a larger profit participation than originally planned.

Lynch credits the company's longstanding relationship with Greenwich's Los Angeles office for the successful closing. “Our timing was fortuitous,” adds Lynch. “It would have been a lot more difficult had we not been part of that pool.”

Joe Gose is a Kansas City-based writer.

Borrowers can't always get what they want

The commercial real estate mortgage market's big push to re-introduce underwriting discipline among senior lenders has jolted the investment world, giving subordinated debt lenders more leverage to deny aggressive borrowers.

Until recently, borrowers routinely won favorable terms such as fixed-rate loans with interest-only terms for five or 10 years, even for risky deals. But today the new risk-reward equation benefits providers of riskier financing.

“More disciplined underwriting at the senior debt level has made our job easier,” says Jim Mazzarelli, managing director with Chicago-based Transwestern Investment Co., a provider of equity and mezz debt.

In today's market, mezz providers are generally generating returns ranging from just below 10% to the mid-teens, depending on risk, the project type, borrower and other conditions.

Several providers have raised or continue to raise more funds to finance subordinated positions, too. Transwestern Investment, for example, which oversees a $300 million mezz fund, has started another round of mezz capital raising.

Today's senior lenders are putting more of a premium on mezz providers who have proven real estate operating capabilities. That's because mezz and other subordinated debt providers typically secure their loans with an interest in the property's ownership group. Thus, a mezz lender steps into the owner's shoes in case of a default.

Case in point: Last year bridge and mezz loan provider Mountain Funding of Charlotte, N.C., took over four failed condo conversions in Florida from Boca Raton-based Bay Communities Real Estate. Mountain Funding had provided $178 million for the projects.

From a borrower's perspective, certainty of execution has become a concern, says Mazzarelli, who operates out of Transwestern's Atlanta office. That stems from senior lenders pulling back from loan commitments after sponsors had paid non-refundable deposits for acquisitions. Borrowers then scrambled to find mezz or other subordinated financing to make up the funding shortage.

Earlier this year, a senior lender required a Chicago office building buyer to increase its equity stake to $38 million from $33 million, Mazzarelli says. In the end, Transwestern financed the deal, but not all buyers left hanging will be so lucky. “The demand for mezz has gone up,” Mazzarelli says, “but whether you can underwrite it is a different story.”
— Joe Gose