For any number of reasons, a shopping center may miss its mark. The development company may have executed the wrong idea in the right location. Maybe the company had a good idea but failed to spend what was necessary to pull it off. Perhaps the demographics of the trading area changed during the time it took to develop and build the center.

Whatever the reason, the unfortunate center misses performance goals, drags down the developer's profits, causes general depression among the company's principals, and creates a desire to get out.

Other developers cruise the market looking for crusty dogs like this. They have cultivated a talent for spotting under-performing centers with potential and fixing them. The idea is to buy, reposition, ignite a rebound, and then sell for an attractive profit.

These developers are the real gamblers in the shopping center development game. They often make their plays with the help of a mezzanine loan, a specialized financial tool that slashes the amount of equity the owner must put into a deal.

Merchant developers who build shopping centers with the intention of selling and taking profits as soon as the project is completed also gamble with mezzanine loans.

Because a mezzanine loan bridges the gap between senior debt and equity, some people refer to such an instrument as a bridge loan. But the two terms mean entirely different things.

"A bridge loan is a short-term loan used during the period of time a borrower needs to arrange permanent financing," explains Dan Bryson, senior director with Holliday Fenoglio Fowler in Dallas. "A mezzanine loan is high leverage and high risk. It fills the gap between equity, the most expensive money in a deal, and senior debt, the least expensive money."

Value creation is key Whether a project involves renovation and repositioning or building and selling, mezzanine finance may appear expensive. By the time a mezzanine loan is paid off, it can cost a tad more than the interest rate on an expensive credit card, depending on the terms of the loan.

Then again, for a deal with a big upside, a mezzanine loan looks cheap.

Suppose a developer buys an under-performing center for $30 million and structures the deal with 80% in senior debt ($24 million), 15% in mezzanine money ($4.5 million), and 5% in equity ($1.5 million).

If the developer manages to reposition the property successfully and sell for $40 million, the $10 million upside would make it worthwhile to pay, say, 20% in interest and fees on a mezzanine loan.

But if the repositioning strategy produces only a slight increase in value, and the center sells for only $32 million, the cost of the mezzanine loan would seem huge.

"To justify paying a mezzanine rate, there needs to be a significant amount of value creation," says Don Campbell, managing director of Finova Realty Capital, a San Francisco-based lender active in the mezzanine market.

There's another wrinkle related to mezzanine loans: What happens if the borrower defaults? Since the 1989-90 recession, senior debt requirements have prohibited owners from taking out second liens against property connected to a deal.

As a result, a mezzanine lender has no claims against the property in a deal. Recourse lies in a claim on the ownership interest on the borrowing company.

"Senior debt lenders that allow mezzanine loans do so because the mezzanine is secured by the ownership interest," says Bryson. "In the event of a default, the mezzanine lender ends up owning the partnership or development entity."

In other words, a mezzanine loan looks like equity. Funds go from the lender to the development company, which then makes an equity investment in the development.

Profit participation or exit fee? Two basic structures characterize mezzanine loans today, although individual deals produce variations on these themes.

In both structures, the mezzanine loan accrues interest just like any other loan. And both structures require additional payments - but they are calculated by different formulas.

In one case, the mezzanine lender receives a pay rate or interest rate and also participates in the IRR, or internal rate of return. For the sake of discussion, say the interest rate stands at 10%. The structure of this loan also defines some form of participation for the mezzanine lender. "These participations can be structured as a preferred interest rate or an IRR lookback," Bryson says. Either way, the developer pays a percentage of the project's cash flow until the participation requirement of the mezzanine lender is satisfied.

Under the second kind of mezzanine loan structure, the developer pays the interest over the term of the loan. When the loan comes to term, the developer repays the principal plus an exit fee established at the beginning of the term.

In selecting one structure or the other, a developer must make a judgment about the level of success a project may achieve.

"If your development is going to be a home run, the exit fee structure will generally get more leverage," Bryson says. "Exit fees are a set cost payable before profit distributions. Profit participations could ultimately cost more if the development takes longer to sell and if those profit participations are tied to IRR hurdles."

On the other hand, a project that fails to live up to its full potential may find set exit fees burdensome.

Lender can determine the structure Lenders also exert control over the type of mezzanine financing used in a deal. The higher the percentage of equity supplied by the mezzanine lender, the more likely the lender will require participation.

At Heller Financial Inc., a Chicago-based lender specializing in mezzanine finance, the most common structure is a current pay rate plus a percentage participation.

Heller provides mezzanine funding up to 90% of the equity contribution. In a $100 million deal with 80% funded by senior debt, Heller might provide $18 million of equity, requiring the developer to put in $2 million.

"As a total percentage of the project, the developer would put in 2%," explains Kim Liautaud, senior investment officer with Heller. "Under our program, a developer can complete a project with very little cash. But the structure would involve participation."

Heller also structures deals based on exit fees, but in these cases it would provide a lower percentage of equity, say 50% to 70%.

While Heller funds deals using either mechanism, other mezzanine lenders specialize in one or the other.

The roots of mezzanine financing Mezzanine finance has been around since the early 1980s, when a number of Wall Street firms introduced the idea as a way of funding the gap between senior debt and equity on deals funded by CMBS issued by the firm.

"There were instances where the CMBS loan wouldn't provide enough money for the borrower," says Campbell of Finova. "A borrower might have needed $8 million, but CMBS underwriting might have restricted financing to $7 million. So there was a $1 million shortfall. For a while, Wall Street firms provided mezzanine financing to cover the difference."

These loans would be on a stabilized property that had little upside potential, Campbell explains. They carried a low interest rate but were amortized over a short period, perhaps three years.

"Instead of using proceeds from the sale of the property to pay off the loan, it was paid off through property cash flow, and that sucked all the cash flow out of a deal," he says. "This approach turned out to be too hard on the borrower, and mezzanine lending morphed into what it is today - three- to five-year deals with a big upside potential."

Developers justify the use of mezzanine financing by comparing the cost of monies used to fund a deal. Senior debt or permanent financing, of course, costs the least. Equity costs the most, because the developer loses the ability to use that money for other purposes. Mezzanine money, despite its interest rate and participation or exit fees, still costs less than equity.

Depending on the value produced by the deal at sale, a mezzanine loan will look more or less expensive.

New twist 'promoted' In recent years, Atlanta-based GE Capital Real Estate has been moving away from mezzanine lending and toward a modified form of shoulder-to-shoulder equity investment that may provide more benefits for certain projects than mezzanine money.

GE Capital might, for example, provide 80% of the equity investment in a project through a modified joint venture structure. In this arrangement, the sale that closes out the deal returns GE's equity portion plus a small percentage return.

On the upside of the deal - the net value of the sale above the original cost of the deal - the GE Capital concept allocates 50% to the developer under an arrangement called promoted interest. So, if the net value of the upside totals $10 million, the developer and GE would both receive $5 million.

The "promote," as it is called, applies only to the upside. If the deal loses money for one reason or another, GE suffers the loss with the developer in proportion to the original investment of each.

For a developer, this structure represents a conservative alternative to mezzanine finance that GE Capital believes has more appeal in today's market. "If you aren't as confident that you will make money, you can hedge with this approach," says Frank Marro, program manager for Joint Ventures/Leveraged Equity with GE Capital.

"In the early 1990s, real estate was appreciating at high levels and mezzanine financing was popular," he recalls. "Developers would have deals that might triple their money, making a 20% cost on mezzanine money look cheap.

"Today, tripling your money is not realistic," he says, "and equity or promote structures look more attractive to some developers - depending, of course, on the deal."

In the end, though, a developer that buys to reposition and sell or builds to sell must tackle the question of a deal's upside potential - and then select a form of financing tailored to that potential.

* Allied Capital www.alliedcapital.com

* CIBC World Markets www.cibcwm.com

* Dana Commercial Credit www.dcc.com

* Finova Realty Capital www.frcapital.com

* First Union Capital Markets www.firstunion.com

* Fleet Financial Group www.fleet.com

* GE Capital Real Estate www.gecapitalrealestate.com

* Heller Financial www.hellerfin.com

* Holliday Fenoglio Fowler www.amresco.com

* Summit Bank www.summitbank.com