Commercial Mortgage Insight

Mezzanine Financing More Popular Among Lenders And Borrowers

Seen as in between a mortgage and an equity investment, the subordinate debt increases leverage and helps lenders win deals.

BY MICHAEL J. KLING

Lenders are increasingly offering mezzanine financing, subordinate debt most commonly structured as interest in the borrowing entity.

Lenders cite several reasons for the increase in popularity in mezzanine financing.

Borrowers like it because it increases their leverage. Even if developers and purchasers have the funds to increase their equity, they would usually prefer to keep their money. That allows them to take on the greater number of development projects common in many markets.

Borrowers find mezzanine financing more cost-effective and less intrusive than equity investors, who want an active role in project management and yields upward of 30%. Instead of budding into construction management, mezzanine lenders rely on the senior loan lenders to monitor the construction process and merely check the project's financial reports.

Lenders, flushed with capital and hungry for deals now that refinancings have dropped, must offer the structure in order to win business. Underwriting standards for securitizable loans have tightened, forcing down loan-to-value limits and prompting originators to turn to the structure to fill the gap.

Rising rents, low vacancies and increasing property values in many markets protect lenders against the downside risk and give them the confidence to take the extra risk the structure poses.

Lenders also appreciate the higher yields of the product that range from the mid-teens into the high 20s - yields that approach those of equity investors. But when those rates are combined with lower rates of the larger senior portions, the blended rates are "not atrocious," points out Doug Esteves, director of real estate finance for Bridge Financial, a non-conforming lender based in Phoenix.

Because of its advantages, mezzanine financing is replacing equity investors, according to Esteves.

A short-term lender, Bridge Financial generally finances construction or renovation projects, selling the loans after stabilization or completion. It has a preferred rate of return - also known as a pay rate or "pref" rate - of 10%, he says, explaining that the borrower pays that minimum rate plus a percentage of profits.

How deals are structured

Mezzanine lenders may finance about 10% to 20% of the loan amount, reducing the borrower's equity contribution and boosting total loan-to-value or loan-to-cost. As security, they take interest in the borrowing partnership or company.

The subordinate debt can also be a second mortgage. However, although subordinate lenders would love a second lien, senior lenders generally don't want a second mortgage, which could delay and complicate a foreclosure.

Some lenders, billing themselves as one-stop shops, finance both the senior loan and the "mez piece." Other companies finance just the subordinate debt, working with a third party senior lender. And other companies finance both structures through different divisions, but not for the same property.

Transactions may also be structured as participation deals. The lender finances both pieces but sells the mezzanine debt. The borrower sees the financing as one deal and pays one fee and one rate, although the mezzanine lender gains a higher yield.

The structure is inherently risky. Most of the deals involve new developments that entail construction and lease-up risk, and the lenders lack security in the real property, Esteves says. However, industry experts are optimistic the trend won't produce an S&L-like crisis.

"There are some very sophisticated lenders out there in mezzanine financing," Esteves notes.

If the project fails, the subordinate lender can ideally take over the project, step into the borrower's shoes and cure the loan. But the particulars of taking over defaulted loans depends on the inter-creditor agreement between lenders. "The real issue is what's negotiated with the first piece lender in the inter-creditor agreement," Esteves says, noting that lenders complete different agreements.

The inter-creditor must give the subordinate lender the right to step into the borrower's shoes and cure the loan if needed. "If you don't have that, you don't have a deal," says Jim Mazzarelli, regional director in the Atlanta office of MONY Life Insurance Company, headquartered in Irvine, Calif. "In general, we're finding that senior lenders are willing to recognize the mezzanine lender."

In addition, the agreement must forbid the senior lender from modifying material terms without the mezzanine lender's consent, adds Mazzarelli, who oversees the company's mezzanine program.

Although lenders take interest in the borrowing entity, the financing legally remains debt, Mazzarelli says. Unlike equity investors, lenders have power over leases and capital budgets but are not involved in "governance of assets" or daily property decisions.

"A lot of work goes into mezzanine debt," he comments. The structure entails less of a cushion, less of a tolerance for variance between projected outcome and actual income.

Involving separate senior and mezzanine lenders does involve more work. However, loans are typically underwritten at the same time, so don't take longer, he notes. And the company may sometimes use the senior lender's third party reports. Mezzanine lenders, he adds, are increasingly working with the same senior lenders, which smooths the process.

Profitable for both

Daniel Edrei, director for Meecorp Capital Markets of Fort Lee, N.J., agrees that the financing structure is more in demand.

"It can be more profitable for both the borrower and the lender, but if it's not done properly, it can be very chaotic," he says.

Edrei points out that the structure:

allows the borrower to highly leverage the property,
frees up cash flow to complete renovations, or
makes the purchase possible in the first place.

Financing for hotels has especially become so restrictive, many borrowers are unable to obtain the funds they want without using mezzanine financing, Edrei observes. Although mezzanine financing is expensive for borrowers, the blended rate may be only about 1% higher than the senior loan.

Meecorp can finance construction, but generally requires strong existing cash flow, he notes. "Everything's got to look pretty."

Although the deal has to "make sense," the company is not locked into any formula. Flexibility is the name of the game. For instance, the company can create a mezzanine credit line that provides the borrower additional funds as it meets lease-up goals. "It's similar to an earn out, but it can take a lot more into consideration," he explains.

Typically, it provides up to half the remaining equity. Amounts can go down to $1 million if it's funding only the "mez piece," but it can go down to $200,000 or $300,000 if it's also funding the permanent loan.

The company looks less at the borrowing entity and more "at the merit of the property," including vacancies, market strength, cash flow and signed leases. It sells the permanent financing for securitization and keeps mezzanine as well as bridge loans in portfolio.

Long-term player

While some players are new to the structure, others have been offering it for years.

"It's not new for us. We've been doing these for seven years," says John W. Adams, chairman and CEO of Red Capital Advisors Inc. of Cincinnati, which offered the program previously under Bank One Corp.

The typical deal may entail a first mortgage of 80% LTV and a mezzanine piece of 10%, bringing total LTV to 90% with 10% borrower equity. The company has reached 70% LTV with mezzanine financing and has gone over 90%. For a long-term client, the lender may go the extra distance that it won't for a new customer.

In addition, determining if financing is recourse or non-recourse is highly negotiable. Typically, the first mortgage is non-recourse while the second is recourse.

"The typical deal is the one you never do. It's the creative side of the business," Adams says. "You have to be very deal-specific, and you have to be very borrower specific.

"It's not a cookie-cutter program. It's not a template program. It's tough to generalize. It depends on who the borrower is. It's very transaction specific.

"We've got the underwriting capability. We're integrated with our other products. This is really the complementary product."

Adams says he has not seen competitors jumping into the field. National players do not focus on mezzanine financing because of the relatively small size of mezzanine deals that may be $1 million or $2 million.

Billing itself as a one-stop shop, it typically provides both the first mortgage and mezzanine piece. Although it sometimes has arranged third-party first mortgage financing, that requires re-underwriting the transaction and duplicates effort, causing a possible loss of economics.

"Typically, we are more patient than the typical mezzanine lender," he says, noting that its term may be longer.

Occasionally working with brokers, it is selectively seeking correspondents, Adams says, noting that the company now has the staffing to review deals.

"It takes a good broker to be able to understand and appreciate the nuances of mezzanine financing," he points out.

New players

Capri Capital of Chicago, investing pension fund money, recently began financing mezzanine loans.

Working directly with borrowers in addition to sourcing deals through the mortgage banking community, it will finance amounts over $3 million, according to Lee Pollock, managing director, Capri Capital. Although its terms are usually from three to five years, they can go up to seven years. Pension funds, he notes, tend to grant longer terms than conduits - up to seven years as opposed to two or three years.

Like other lenders, it will finance the main property types in major metro areas. Deals are generally structured with 10% borrower equity, 60% to 80% senior debt and 10% to 20% mezzanine financing.

Although the company, a Fannie Mae lender, finances senior loans, its mezzanine fund will use third party senior debt.

Mezzanine financing, he notes, "creates a more complex deal structure. The senior lender wants to control how the mezzanine piece works."

CMBS lenders and rating agencies, he notes, don't mind the subordinate debt in limited doses, Pollock says. But if too many loans in a pool feature the subordinate structure, the pool will be sure to "get hammered" by the agencies.

Mezzanine lenders are large and sophisticated, he notes. "No one wants go back to days when shaky S&Ls did second mortgages," he notes.

Bank One Corp. has formed a wholly owned subsidiary, Banc One Real Estate Investment Corp., which will manage the new investment fund, OneRock Real Estate Mezzanine Fund LLC. Funded by Bank One and Shamrock Holdings of California Inc. of Burbank, Calif., the fund will invest up to $75 million over two years in the major property types.

Michael Morris, president of Banc One Real Estate Investment Corp., sees three types of mezzanine lenders:

banks,
non-bank institutions such as opportunity funds, and
credit companies, the "classic mezzanine lenders."

He defines three types of mezzanine financing:

a second mortgage,
a participation at the partnership level,
a first loss participation.

Its preference is for the first loss position, which borrowers see as simpler and "more sexy." In that structure, the bank makes a 90% LTV loan and services the loan. The fund buys the first loss position, guaranteeing the amount. That structure is simpler for the borrower who gets one note, one rate and one fee.

Although it will review packages from intermediaries, the bank's real estate division will source deals largely directly with borrowers.

The bank bills itself as a one-stop shop. Involving two lenders is more difficult and time- consuming, he says. Each lender must do its own due diligence and underwriting, probably with separate third party reports. And the lenders - in addition to the borrower - must also negotiate an inter-creditor agreement.

Sees inherent mismatch

There are plenty of requests as well as plenty of funding sources for mezzanine deals, observes Shekar Narasimhan, managing director of agency and funds management for PrudentIal Mortgage Capital Comp. of Newark, N.J.

The problem is that the structure is mismatched with borrowers' desires, says Narasimhan, who works in the company's Vienna, Va. office. Seeing it as a substitute for equity, borrowers initially want the product, but lose interest when they find that rates are higher than they are willing to pay and that they can lose their properties to mezzanine investors. For every 10 requests, the company may finance one deal.

"There's a significant amount of requests, but much of it doesn't translate into obtaining the financing," he observes.

Requests for small mezzanine deals abound, but lenders want the larger amounts. Because the work involved in the creating the structure, smaller deals are not economically worthwhile, Narasimhan explains, noting that the lender does mezzanine deals over $5 million, which translates into a total loan of over $50 million.

"There really are no two deals alike in this sector," he remarks. "This is catered financing. It's not an easy business. You need a dedicated team."

Narasimhan sees two kinds of borrowers seeking mezzanine deals.

Some want to take out equity from their properties that have appreciated significantly in recent years. Rather than paying substantial prepayment penalties involved in refinancing, they opt to obtain a second mortgage or mezzanine loan.

Other borrowers want to increase leverage for acquisitions and rehabilitations needed to reposition properties.

Most deals entail floating rates and three- to five-year terms. Typically, excess cash stream is used to pay the mezzanine loan interest and principal. Money is generally raised from institutional investors - pension funds and life companies. Companies must be large if using their own balance sheets, he warns.

"You can be wrong," he warns. "Maybe the market turns. Maybe the development project falls through."

In addition, the mezzanine lender's asset management fee for managing a defaulted property, he adds, "is grossly inadequate."

Nomura Capital used mezzanine financing to win conduits deals before the capital markets turmoil struck in 1998. However, rating agencies are now are nervous about the structure and employ strict guidelines.

This article was previously published in the December 2000 Issue of Commercial Mortgage Insight.