Rapidly expanding retailers need new sites — as many, as fast and as well-located as they can get them. With the financial agility thatoptions offer, retail real estate developers are better able to meet tenants' needs. By using mezzanine finance to reduce the amount of equity needed for each project, developers can produce more centers, more efficiently, and in the highest-quality locations.
Recently, the increased usage of mezzanine finance has become a fact of life. Today, owners and developers are accessing more sophisticated financing solutions to optimize the value of every transaction. Additionally, the availability of mezzanine debt is part of the larger influx of capital into real estate during the recent economic downturn, dollars that might previously have gone into higher-risk investments.
A few years ago, mezzanine debt was used primarily by larger developers, for projects of significant size and cost. However, recent years have brought an industry-wide, national evolution to more sophisticated financial structuring for all types and sizes of transactions. This is thanks in part to low interest rates. Mezzanine debt does not necessarily create a high cost-of-capital scenario for the borrower, when interest rates are low.
When structured to complement the permanent loan, using mezzanine debt can actually lower the overall cost of capital. A mezzanine loan might carry a high cost when compared to a permanent loan, but compared to paying industry-standard returns to a group of private investors, it can become the more financially attractive option.
Pipelines are pumping for active retail developers, and using mezzanine debt has become an increasingly popular tool to keep thevolume flowing. Many smaller retail developments — particularly strip malls and grocery-anchored neighborhood centers — are driven by population growth, and by local developers that can identify opportunities quickly. However, these typically smaller developers cannot launch a large number of new shopping centers concurrently unless they have access to capital beyond private investors.
Access to mezzanine financial options allows developers to move faster, and get projects out of the ground in time to meet the tight time frames that highly competitive retailers require, when they are under the gun to open a certain number of new locations by a given date. For example, if a developer can raise enough capital to launch one to two grocery-anchored retail centers on its own, mezzanine equity could allow that number to become five or six.
The availability of mezzanine finance has created advantages for developers and retailers. For the retailer, more developers competing for the next location means a stronger negotiating position and increased site selection options. For developers, larger deals and/or a higher quantity of deals means more returns from more opportunities. Economies of scale are created for both the developer and the retailers, while supporting the developer's corporate growth. Beyond pure growth and profit, using a mezzanine loan to contribute equity reduces the number of financial stakeholders in a development as compared to a more traditional assembly of individual investors.
As a result, the borrower keeps 100 percent ownership — reaping a higher percentage of the profits when the property is sold, and keeping decision-making power streamlined. In a retail property with a high quantity of small leases, not having to gain approvals from a large pool of investors for each lease negotiation can contribute not just to the developer's bottom line, but to its ability to meet the aggressive lease-signing timelines of the retailers.
The redevelopment of regional malls as power centers or lifestyle centers offers a particularly appropriate opportunity for the use of mezzanine finance for retail development. These projects typically have sizable capital requirements, which means that seeking a mezzanine loan will make sense for the developer. The higher capital requirement results from a comparatively high market risk for the leasing of the new property. Borrowers for these regional redevelopment projects tend to be well-capitalized, privately held regional developers, who simply can put their equity to better use than keeping it tied up in a single project.
Conversely, grocery-anchored retail developments usually are bolstered by the use of mezzanine finance only when a developer is seeking capital to increase the quantity of smaller developments in its pipeline — as opposed to financing a single large-scale project. The lower leasing risk in these projects leads to lower equity capital requirements (less leasing risk, higher senior loan proceeds), and thus less use of mezzanine financing.
For capital providers such as KeyBank that lend in the markets in which they live and work, the community impact of the projects for which the bank provides financing is a critical consideration. In urban areas in need of redevelopment, the availability of mezzanine debt can make a difference in a project's realization or failure. Everybody wins when loans close more rapidly: stores open, rent checks start coming in and most importantly the unsafe empty lots and buildings that weigh down the character of a neighborhood are replaced by vibrant shopping destinations.
As more developers use mezzanine options to finance more transaction sizes and types, retailers will begin to see their needs for newer, better, and faster-delivered locations increasingly well-served by retail developers of all shapes and sizes, from small towns to major markets.
NORMAN V. NICHOLS
Senior vice president in KeyBank Real Estate Capital's Private Equity Group. He is based in Albany, N.Y.