Equity is becoming a rare animal in commercial real estate, even as property prices remain at historical highs. Pressured by senior lenders who are making bigger loans, mezzanine lenders are increasingly replacing equity providers in the so-called “capital stack.”

But mezz providers are hardly reaping a windfall. A deluge of mezz capital competing for deals has forced mezz lenders to assume more risk for lower returns. About two years ago, senior lenders generally provided loans ranging from 60% to 75% of a project's value, depending on type and location. Mezz lenders topped that senior loan with another tranche of debt, which typically ratcheted up leverage to 85%, leaving the remaining 15% to equity financing.

Driven by the need to put money to work in a market awash with capital, senior lenders are more frequently making loans ranging from 80% to 85% loan-to-value, forcing mezz lenders to move up the leverage curve, and reducing the amount of equity in deals.

But that move into a riskier range has not provided a bigger payoff. Indeed, mezzanine lending has seen profitability slip. Three years ago, a mezzanine financing that took the loan-to-value into the 90% to 95% range usually generated an internal rate of return of around 23%.

Now IRRs, which are effective interest rates expressed on a compounded basis, have dropped to around 17%, according to David Hendrickson, senior vice president of capital markets and real estate investment banking for Chicago-based Jones Lang LaSalle.

The bottom line is that borrowers are replacing equity with mezz that's hundreds of basis points cheaper than equity. Equity providers typically charge some 22% annually for financing. “The lines are blurring between mezzanine debt and equity,” says Hendrickson, who has been arranging highly leveraged mezz loans for borrowers for the last five years. “Mezzanine is definitely more prevalent today than it was even three years ago.”

As competitive as mezz is, the debt instrument hasn't completely wiped equity off the board. In fact, most mezz lenders want borrowers to put about 10% equity in deals, says Jan David Reese, executive vice president of Cypress Creek Capital, a real estate investment bank in Fort Lauderdale, Fla.

In some cases, lenders cut that equity requirement to 5% as they become familiar with borrowers. “Most sophisticated lenders still want borrowers to have skin in the game,” he says. “But there's a lot of money chasing real estate that's not necessarily sophisticated.”

Exuberant capital

Part of the change stems from the explosion of mezzanine activity. As real estate has attracted a flood of capital amid rapid property appreciation, mezzanine has matured from a fallback position for dealmakers that bridges the gap between equity and debt to a routine component in commercial transactions.

That's particularly true as investors have searched for high yields in a climate offering few attractive alternatives. Susan Merrick, managing director of commercial mortgage-backed securities (CMBS) for Fitch Ratings, the New York-based credit rating concern, says that an average of 30% of the loans in Fitch-rated CMBS issuance contain a mezz tranche today. In June 2001, the average was 8.4%.

Clearly, there is plenty of money ready for mezzanine deals. Merrick estimates that institutions, after allocating more funds to finance real estate about 18 months ago, are in the process of adding $30 billion in new money to the property financing markets. Foreign investors, meanwhile, are pouring an additional $5 billion to $10 billion into real estate. A chunk of that combined $35 billion to $40 billion is ending up in mezz funds. “Mezz is so freely available, you can effectively borrow your equity,” she says.

But fat leverage leaves borrowers scant wiggle room to meet their debt obligations if projects fail to perform for whatever reason — poor management, a faltering economy or an interest rate spike when it's time to refinance.

Lenders today, however, are more willing to bet that real estate values will continue to rise, which ultimately should give borrowers greater ability to repay debt going forward. But if the higher values fail to materialize, some borrowers won't be able to repay those loans.

So, are lenders becoming too optimistic? Not yet, suggests Charles Krawitz, national director of small balance lending for the real estate capital markets group of Chicago-based LaSalle Bank. “We've seen exuberance in our economy before. It's the American way,” he says. “I suspect we've gotten a little bit in front of our skis, but not horribly so.”

Trouble on the horizon?

Some financing veterans are wary of what they see as an increasingly unsustainable situation. Gary Tenzer, co-founder and executive vice president of George Smith Partners, a commercial mortgage brokerage specializing in acquisition, mezz and construction loans, says that cracks in the market could appear sooner, rather than later.

“There's a lot of aggressive lending going on, and when interest rates move up there will be a lot of highly leveraged deals that aren't going to make it,” he predicts. “Fundamentally, the economy still has pockets of weakness, and I think we'll see some defaults this year.”

Still, defaults over the last couple of years have virtually vanished. But if commercial real estate, the economy, or both, experience a real downturn, mezz lenders could wind up operating assets to get their returns. While senior lenders secure their loans with the actual properties, mezz lenders most often secure their loans with a partnership interest in the building's ownership and can simply take control of a property, if borrowers default.

Condo converters' big appetite

The highest mezz leverage is taking shape in the condo-conversion market and — surprise — the hottest action is in South Florida, where the conversion fad has only cooled slightly. Converters are seeing profit margins of 10% to 15% before debt service, according to Seth Frohlich, a managing director for Miami-based Hudson Capital. The figure was 20% a year ago, he says.

Still, with that kind of money to be made, mezzanine finance deals are easy to come by. Converters are regularly receiving loans that represent more than 90% of a project's cost. Their goal is to add value and sell the units. Once all the condos are sold, the loan-to-value might range between 70% and 80%.

In May, Holliday Fenoglio Fowler's Miami office secured $127 million in acquisition financing and $25.5 million in mezz debt for Miami-based Hudson Capital, which acquired an 848-unit apartment complex in Miramar, Fla. Hudson Capital is converting the building into condos, and the debt represents upwards of 95% of the cost of the project.

Almost three years ago, lenders provided Hudson Capital with only 92% loan-to-value for an earlier condo conversion, says Seth Frohlich, chief development officer of Hudson Capital. He has few doubts that Hudson Capital could get financing for up to 99% of a project's cost today, due to the company's conversion experience and the state of the capital markets.

“There has been so much money coming into the mezz market that 95% leverage for a condo conversion is standard,” he says. “But there are some mezz players that are willing to go up higher than that.” As a result, Frohlich adds, Hudson Capital is paying an interest rate in the high teens for mezz today, or about 400 basis points less than it was paying about three years ago.

New York-based Colonnade Properties, which owns a portfolio of commercial properties, hotels, apartments and land valued at $2 billion, provided Hudson Capital's mezz financing. According to Joseph Sambuco, Colonnade's CEO, the company recently began committing more resources to the mezz arena after dabbling as a mezz lender for several years.

But Colonnade is targeting the upper end of the capital stack because making mezz loans in the 75% to 88% loan-to-value range is no longer lucrative enough. In that range, mezz competition has driven down the IRR some 200 to 400 basis points over the last three years, Sambuco says. In fact, Hendrickson of Jones Lang LaSalle adds that mezz lenders are accepting an IRR as low as 8% for mezz at 75% loan-to-value, and as low as 12% at 88% loan-to-value.

The spread of mezz

Mezz is hardly exclusive to condo conversions. Indeed, the gap financing is growing in all property types. In January, Charlotte, N.C.-based Mountain Funding acquired a 75% interest of a $19.4 million mezz loan made to Bromont Investments and Dolgen Ventures to acquire 25 shopping centers from Glimcher Realty Trust. An unidentified Wall Street lender provided Bromont and Dolgen with the bifurcated senior and mezzanine loan totaling nearly $120 million. The loan-to-value was 90%.

Mountain Funding provides high-leverage senior and mezzanine debt for value-add projects, special situations and other developments. Arthur Nevid, managing director of investment and lending with the firm, downplays growing concerns over increasing leverage levels. Nevid points out that lenders are only providing the highest loan-to-values for what are considered to be gold-plated projects. “Certainly for the most desirable projects in the best locations, there is no limit to the amount of leverage one can attain,” Nevid says.

Nevid adds that capital providers, who make loans at the 95% loan-to-value level within the capital stack, often participate in a project's equity returns, particularly when lending to developers with little experience. Still, he's aware that a sharp interest rate move could cause liquidity to dry up quickly. “This will end, but who knows when?” he asks. “We tend to keep our horizons short and try to do deals where we believe we can get our money out in a one- to two-year period.”

Still expanding

While some industry execs are worried about excesses in the mezz market, there is no shortage of new players — or ambition on the part of existing providers. These players include traditional real estate institutions, as well as mezz providers with little real estate experience. Some conduit lenders have established mezz programs to offer one-stop shopping to borrowers. Fitch Ratings' Merrick expects to see more sources emerge.

Even Fannie Mae is getting into the business. Earlier this year, the multifamily lender began offering mezz under its Delegated Underwriting and Servicing (DUS) program in a product known as “DUS Plus.” The initiative provides mezz in combination with senior debt underwritten by DUS lenders. New York-based RCG Longview, a real estate opportunity fund, is buying the mezz loans.

Cleveland-based KeyBank Real Estate Capital is in the process of closing a mezz fund with The Hartford Financial Services Group, and the two firms are targeting stabilized properties, according to E.J. Burke, executive vice president for commercial mortgage lending at KeyBank.

For seven years, KeyBank's main mezz program within the bank's private equity group focused on acquisitions and new development, generally providing $5 million to $15 million with a three-year maximum term, Burke says.

Late last year, KeyBank entered into a high-profile deal. It loaned $90.1 million to Prospect Capital Group, a private real estate investment firm, which acquired the 8-month-old Ten Aragon mixed-use development in Coral Gables, Fla.

The 511,700 sq. ft. retail, office and residential project includes 184 apartments that Prospect Capital intends to convert into condos.

Financing of the transaction was divided into three pieces, including a mezzanine credit facility that represented 98.5% loan-to-cost, according to Bob Carmichael, senior vice president for KeyBank Real Estate Capital.

In June, New York-based Hudson Realty Capital (no affiliation with Hudson Capital) launched its third high-yield real estate fund, aiming to raise $100 million and then leverage that equity to finance $400 million in real estate. Known as Fund III, the pool will focus on providing bridge loans, mezz, preferred equity and other high-yield financing.

Hudson Realty was formed in 2002 by executives of SWH Funding Corp. and Newbridge Realty Capital to finance transactions of less than $25 million. The firm's first two funds have financed some $350 million worth of deals, including three condo conversions in South Florida that received $20 million in mezz.

Capital shift

Mezzanine funding has long been used as a way to capitalize all sorts of mid-size companies that could not sell debt directly. Now, companies that have provided that kind of financing are moving into real estate, too. Conning Capital Partners, a $530 million private equity fund based in Hartford, Conn., that invests in financial services and healthcare companies, led an investment group that plowed $25 million into Mezz Cap early this year.

Based in Short Hills, N.J., Mezz Cap is a 4-year-old firm that has partnered with 14 institutional lenders and provides mezz lending to developers and owners who borrow senior debt from partner companies. Mezz Cap also extended its credit lines with Merrill Lynch to $325 million, up from $125 million.

The funding and expanded credit lines will help support Mezz Cap's new ABC product, which offers borrowers loans comprising senior debt (A); mezz debt (B); and junior mezz (C) tranches. Up until it launched the ABC product this year, Mezz Cap provided between $250,000 and $3 million in mezz for up to 85% loan-to-value atop the senior debt of the institutional lender.

Under the ABC product, Mezz Cap is continuing to offer its mezz up to 85% under its B note, but it also has added the C note to provide between $500,000 and $5 million in additional junior mezz for up to 90% loan-to-value. Mezz Cap, which is funding the junior mezz itself, is charging between 12.95% and 14%, and will hold the loans on its balance sheet. The firm is securing the junior mezz with a partnership interest in the assets.

“Basically, we've taken the company to the next level,” says Martin Lanigan, CEO of Mezz Cap, which is opening an office in Toronto this summer. “We realized we had a pretty good one-trick pony about a year-and-a-half ago, and the solution for us was to broaden our array of products and heighten the relationship with our lending partners.”

Keeping watch for the turn

How long will the mezz craze last? Experts repeat a familiar refrain: High interest in mezz will last as long as interest rates stay low, the economy remains stable, no other asset classes rise in appeal and no single event — such as a terrorist strike — shakes the markets. For now, experts expect providers to continue to expand business and fresh capital to keep pouring into the market.

If markets do turn south, mezz lenders will quickly have to rethink their strategies. An interest rate spike that touches off a string of defaults, for example, would put properties in the hands of mezz lenders. Potentially those lenders could be forced to accept less of a return than they'd anticipated, or even a loss.

“At that point,” according to Jones Lang LaSalle's Hendrickson, “mezz lenders will evaluate whether the returns they're getting are worth the event.” If so, look for mezz to hang around.

Joe Gose is a Kansas City-based writer.