Byline: Joe Gose

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%.

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