The massive popularity of retail real estate and the resulting shrinking cap rates has helped give new life to an old structure: mezzanine financing. Though it's been around for a long time, investors use of mezzanine debt and equity has risen in the past two years. The main reason for the growth is that mezzanine financing provides both lenders and borrowers with a way to increase otherwise shrinking yields.

Buyers are tapping the mezzanine market to help juice the returns on their equity. Meanwhile, other investors are eager to get in on placing mezzanine capital because it promises a higher return than by investing directly in real estate. What used to be viewed as a risky structure that required a great deal of savvy is now becoming a haven for yield-starved institutional investors. Even lenders that thrived on operating in the safe, guaranteed senior loan business are ramping up their mezzanine businesses.

“People are finding creative ways to get capital out the door, be it in the form of first liens or high-leverage mezzanine pieces,” says Tucker Knight, a director with Holliday Fenoglio Fowler. “You have a wide array of companies doing it. Even conduit lenders are coming out with mezzanine pieces these days.”

The market has become one where traditional lenders, small finance shops, insurance companies and institutional investors are all vying for a piece of the mezzanine finance business. A few years ago, lenders were seeing returns north of 20 percent on their product. That is what caught many people's eyes and has sent them hurtling into the mezzanine finance arena. But the flood of new players — combined with the fact that there have been few defaults — has helped reduce pricing, which now is more in the 9 percent to 12 percent range.

Still, it's a win-win situation for both borrowers and lenders, each of whom are getting better returns than they would get simply buying and selling real estate. And most expect the picture to remain the same in 2006.

The mezzanine market is highly fragmented. “I don't think there is one player that you'd point to and say, ‘They're the biggest,’” says Eric Tupler, senior director with LJ Melody Co.

Because of this, it's impossible to track the total volume of mezzanine deals. Anecdotally, however, the numbers are impressive. Holiday Fenoglio, for example, says its mezzanine and preferred equity originations more than tripled in 2005: By mid-December, the firm had completed 77 deals totaling $486.8 million, vs. 22 deals and $132.9 million in 2004.

Overall, the use of mezzanine financing is growing. According to Susan Merrick, managing director of commercial mortgage-backed securities for Fitch Ratings, an average of 30 percent of the loans in Fitch-rated CMBS issues contain a mezzanine tranche. In June 2001, the average was 8.4 percent.

“It's a small piece of the big picture, but I think it will continue to grow,” Knight says.

With mezzanine financing suffering few defaults, the risk profile is dropping (and so is the pricing being offered to borrowers). As a result, for the first time, fund managers are raising capital for pure-play mezzanine financing funds. Returns on mezzanine used to be in the high teens or low twenties, but today have dropped to the 9 percent to 12 percent range.

“I'd say overall, returns are 300 basis points below where they were two years ago,” says Daniel Goelz, Capri executive vice president of investments.

Still, institutional investors like the idea of getting locked-in returns, which beat what you can get investing straight on real estate.

“There's a whole slew of funds doing financing now,” says David Sonnenblick of Sonnenblick Eichner Co. “If you have a quality asset and you go searching for it, you can do deals down below 10 percent.”

The funds provide an outlet for investors, who historically might not have played in the debt side, to provide a sliver of financing and get a better return than direct investment. Without an equity partnership stake they can't share in any upside the owner may squeeze from a property. But they also don't have to put any work in managing a center or shoulder any risk.

New sources for mezzanine debt and equity are popping up every day. Some REITs, such as Kimco Realty Corp., are getting into the business, placing mezzanine debt or equity in joint ventures as an aside to their core operations. Money managers have also introduced new funds that deal only in doling out mezzanine financing. And traditional lenders are devoting more time and capital to the business.

In early November, Capri Capital Advisors LLC closed the second in a series of commingled mezzanine debt funds. It raised $287.5 million from 15 institutional investors. While Capri traditionally has focused on multi-family properties, the new fund will lend to all four property types, including retail. Already, the fund has placed $70 million of that capital and expects to be fully invested in 18 to 24 months.

“We're looking for complexity,” Goelz says. “We feel we can understand things and come up with solutions to get deals done. We like mixed-use in the right transactions.”

But with so many new players competing in the market, some fear that this is a recipe for bad deals getting made. Moreover, if retail slows, mezzanine lenders would be set up for a letdown.

“The sponsor is incredibly important,” says Rex Paine, partner at Torreon Capital. “On a lot of these, because it's new money, folks have not been in this business before. They've been in real estate or in lending, but they have not been factoring the risk in this kind of debt business.”

Debt or equity?

One of the tricky things about mezzanine financing is that the broad term covers both debt and equity. But not all providers of mezzanine capital offer both products. More conservative lenders say that mezzanine debt can only be up to the 85 percent mark in the loan-to-value ratio. Above that, they say, and you're really in an equity position — no matter what you're calling your product. You can structure that to be more passive, like debt, in that you don't become a full-fledged joint venture partner in the equity. You shoulder slightly less risk, but also forego any upside the owner may achieve through repositioning the asset. And other lenders, if they are going to play that high, insist on a joint venture equity arrangement.

“Mezzanine is a very over-used word,” says Rick Gallitto, executive director with Tremont Realty Capital, which does about $1 billion a year as a direct lender and intermediary to the real estate industry. “The cost is skewed depending on what you're talking about. Long-term mezzanine money is provided on stabilized or near-stabilized assets. There's only a handful of players that can go out as long as 10 years to dovetail with conduit or long-term fixed rate mortgages.”

That's the safe area, where conservative players such as Capri prefer to stay. They also won't go past an 85 percent loan-to-value ratio unless they are working on a stabilized property in a top market with a Grade A owner.

Gallitto further contends that going above 90 percent really puts you in an equity position, no matter how you structure the deal.

“You're really take a pledge of partnership,” he says, but without the advantages. “The borrower may think they're going to hit a home run, but they'd rather give you a fixed return rather than participation in the upside.”

Holding the line

For borrowers, the wealth of debt in the market allows their equity to go further. In some cases, owners are putting down as little as 5 percent of their own money. Higher leverage mean higher returns on that equity. The readily available financing — and cheap pricing — makes debt an attractive option, especially with assets appreciating in value so quickly.

“Investors are climbing the leverage curve as much as possible on the senior piece,” says Mike Myatt, executive managing director for Pacific Security Capital. “Especially with cap rates where they are, the lower cost of capital helps protect their margins.”

In essence, owners through a blend of senior and subordinate debt are able to stretch their equity further than they could otherwise, Myatt says. For some, it means not having to tap into any external sources of equity. Owners don't need to do as many joint ventures and can control 100 percent of the properties they are acquiring.

In fact, it is even changing holding patterns. Rather than constructing projects and then flipping them when they become stabilized, merchant builders can now get returns on their money through building and holding.

For example, a few years ago, a builder could construct a strip center for $11 million, which would then be worth $12.5 million when stabilized, according to Knight. Now with cap-rate compression, the same $11 million investment would be worth $14 million to $15 million when sold. But rather than sell, builders can borrow against that stabilized value. A 10-year package of senior debt and mezzanine financing could come up to 85 percent of the value of the property — or $12.75 million.

“Now you're getting money over and above what you put in while keeping the asset and locking in low interest rates for 10 years,” Knight says. “A lot of developers that had been merchant builders are now holding because of this. I've seen people get loans at 150 percent of the cost they paid to build a center.”

This newfound popularity for mezzanine financing is also altering the playing field.

Mezzanine financing is no longer seen as risky as it once was. It used to be available for shorter terms and at higher interest rates and borrowers were always required to begin paying off the principal immediately. Now mezzanine financing is commonly extended for 7 to 10 years. And for the first time, some lenders are offering interest-only periods on mezzanine debt.

In the past, mezzanine financing was seen as a tool for extreme circumstances. Firms only tapped into it when they needed considerable funds for mergers or large acquisitions. It represented a risk for lenders in that borrowers were really trying to stretch their equity to make a big purchase. Because it is subordinate to senior debt, mezzanine providers also are shouldering more risk and therefore interest could be as high as 20 percent. And in most cases, the capital was provided on a short-term basis — three to five years. Mezzanine financing is also more of a hybrid in that it is debt capital, but lenders usually have rights to convert to an ownership or equity interest if the loan is not paid back in time and in full.

With senior lenders willing to cover more of a borrower's costs, mezzanine lenders have been forced to go higher up in the capital stack — sometimes up to the 95 percent loan-to-value level — without being able to raise pricing on the debt to reflect the added risk.

“One would think with moving higher in the capital stack, spreads would correlate and be driven higher,” says Eric Baum, who is responsible for the lending operations for the proprietary lending group with GMAC Commercial Mortgage Co. “In reality, spreads have tightened from a couple of years ago. Essentially you're taking more risk for less reward. But you have to take that on a daily basis if you want to get deals done.”

Part of that is due to senior lenders willing to go higher as well. In 2002 it was typical to see senior debt cover 65 percent of a property's value, so mezzanine financing would cover from 65 percent to 75 percent or 80 percent and be priced in the low- to mid-teens. Today, senior lenders are going to 75 percent or even 80 percent, pushing the mezzanine piece to 85 or 90 percent.

GMAC has tried to maintain structures in its mezzanine business as a way to guard against the added risk. They insist on reserves for tenant improvements and leasing commissions on properties that will have rollover of some major anchor tenants. Some conduit shops have waived those reserves. Moreover, GMAC sells the loans it originates both through syndications and securitizations.

Other safeguards come through underwriting. GE Real Estate, for example, when underwriting deals, projects a rise in cap rates when calculating a property's value and used that stressed value as the basis for how much capital it will put forth on the property.

“If it is a center that is in a secondary market that might not be the ‘best of the best’ and it needs some TLC and leasing attention, then we'll expect some cap rate increase on the sale,” says Paul Simmons, managing director at GE Real Estate.