Without a doubt, the landscape of competition for commercial real estate is stiff. And the entrance of aggressive foreign investors, along with an enormous amount of lingering liquidity, continues to drive returns lower. Institutions, such as REITS, pension funds, insurance companies and hedge funds must put larger sums of capital to work in this sector, and they are burning the midnight oil to determine how best to produce above average returns in this maturing sector.

A vehicle of choice for such lofty returns is the mezzanine loan space. Today, the idea of using mezz to gain a presence in highly visible assets and highly visible markets is also a strategy that few investors can ignore. Even traditional owners and operators who want to take their businesses to the next level have been drawn to this lending instrument.

Raising the bar for risk

Simply put, mezz loans represent credit extended to property owners that raise their debt leverage to dizzying heights. However, what epitomizes the inherent risk of mezz loans is that heavy competition is causing lenders to assume more risk by structuring loans with little or no security against the real estate asset itself. Instead, these loans are often tied to an interest in the borrower's real estate business, making a potential default event rather muddy.

For instance, an owner who takes out a loan of 65% of the value of a property may choose to engage a mezz lender/investor and secure additional financing that raises the total debt to 90% of the property's value. But if an existing loan agreement restricts additional debt from being written against the property, a mezz lender would almost always assume added risk to win the deal. The lender would do so by agreeing to hold an interest in the finances of the borrower instead.

Mezz loans can also be readily converted into equity in an asset, accumulating another form of interest. Thus the additional credit in the previous example may be an unsecured loan that is tied to a particular event in the real estate operation. This makes a mezz loan a commercial form of a home equity loan, anticipating that the property in question will increase in value, or be sold in short order for a healthy profit.

Related real estate business

Even though a mezz investor may not have a genuine lien against an asset, most are quite content to hold mezz loans as a real estate-related investment instrument. These loans have accounted for much of the growth in collateralized debt obligations (CDOs) over the recent past, as well as private investment funds. In its year-end 2006 CDO Performance Report, for instance, Fitch Ratings reported that the portion of mezz loans in deals it rates has been on a steady rise (see chart).

Wall Street views these loans as risky business because they are found mostly in more risky securities such as CDOs instead of their higher-rated CMBS cousins.

In fact, in the event of a default, the mezz holder may not even show up on the list of legal claims against an asset. In exchange for investment returns, which can top the mid- to high teens, however, investors are willing to buy mezz loans and invest in funds that aggressively pursue this space.

Nevertheless, the emerging trend among traditional real estate owners and operators to expand their investment mix through either buying a stake in mezz funds, or holding an interest in buildings through mezz loans, is quite remarkable. An example of this aggressive, but well-calculated play was seen in the launch of Denver-based JCR Capital in fall 2006. The company announced it would be seeking to originate $400 million by the fall of 2007, and according to its president, Jay Rollins, well over 50% of that volume was expected to be through mezz loans and preferred equity.

So, with well over $50 billion of institutional money still looking for a way to enter the real estate marketplace, according to University of Michigan Ross School of Business estimates, the mezzanine lending business is sure to be at the top of many real estate investors' hit list.

Investors today are prepared to ride the current up cycle through more risky products like mezz loans. But the question that more risk-adverse observers are asking is: What would be the shakeout in the mezz space once commercial real estate prices either level off or — I dare say — decline?

W. Joseph Caton is managing director of Oxford, Conn.-based Hartford One Group, a real estate finance consultant.