Once a novelty, mezzanine financing has become almost routine in the U.S. real estate market in the past few years. Nonexistent in the early 1990s, these loans totaled about $7 billion by 2001 and last year surged to roughly $12 billion, according to Capital Trust, a New Yorkbased real estate investment trust.
As the name implies, mezzanine loans are in-between financing -- more secure than direct equity investments but junior to bank mortgages if the borrowers get into trouble. Potential returns vary with the amount of risk the lender is willing to assume: A high-leverage tranche can net the lender a double-digit interest rate in addition to such bonuses as exit fees or participation in profits and cash flow.
For borrowers the lure of mezzanine debt is simple: a new source of money to supplement other financing options.
“Mezzanine financing has really come into its own,” says John Klopp, CEO of Capital Trust.
In mid-December, Mack-Cali Realty Corp., a Cranford, New Jerseybased REIT, made a $16.3 million mezzanine investment in One River Center, a three-building office complex in Middletown, New Jersey. The complex is owned by a partnership that needed money to help cover the costs of leasing the property, which is nearly half vacant, says Mack-Cali CEO Mitchell Hersh. His firm received an 11 percent interest rate for the loan’s three-year term, plus an option to convert the mezzanine piece into a 62.5 percent ownership stake in the asset. “This is a complex that I’m hopeful we’ll have a very significant ownership position in ultimately,” says Hersh.
The securitization of commercial mortgages has given mezzanine financing a big push. So-called commercial-mortgage-backed securities are pools of various mortgages, sliced up into tranches of securities and then sold to bond investors. The rise of the CMBS business in commercial property financing in the past decade has led to stricter underwriting standards and lower loan costs for borrowers. Mezzanine financing, notes Capital Trust’s Klopp, often fills the gap between what mortgage providers will lend and “the amount that the borrower needs to make his deal work.”
Institutional investors tend to participate by investing in a fund like those managed by New Yorkbased Black Rock or in REITs like Capital Trust, iStar Financial and SL Green Realty Corp., which include mezzanine lending in their portfolio strategies.
Like most solid moneymakers, however, mezzanine lending has begun to attract a crowd. Recent entrants include CWCapital (whose parent is Montreal-based CDP Capital Real Estate), KeyBank Real Estate Capital and a number of big pension funds, which are considering going the direct route.
As a result, says Doug Vikser, managing director in the Los Angeles office of Prudential Real Estate Fixed Income Investors, which manages a mezzanine investment fund, returns have come down by roughly 100 basis points in the past 18 months. Lenders that provide less-risky financing based on 75 percent loan-to-value for stable, high-quality properties now generally get a range of 5 to 6 percent over one-month LIBOR. “Many mezzanine lenders won’t be able to provide their investors with the return that they promised,” says Vikser. “They just won’t get there.”
The returns nevertheless remain attractive to George Jahn, the assistant real estate officer for debt investments at New York State Teachers’ Retirement System, which is considering expanding its roughly $400 million mezzanine investment program to include direct lending. “Mezzanine debt produces cash flow, which is what pension funds need these days,” he says. He concedes, however, “it has become a pretty crowded playing field.”
