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IN A CRUNCH

MEZZANINE DEBT IS COMING TO THE RESCUE OF CREDIT-SQUEEZED OWNERS AND DEVELOPERS

By Steve McLinden

Subprime mortgage woes, skittish lenders, falling commercial property values — all these seem to have colluded to drive retail real estate borrowers into the arms of pricey mezzanine debt.

“The challenge in financing retail acquisitions is that the debt markets are more constrained, which suggests the mezzanine market as an option,” said Sam Chandon, senior economist at Reis, a real estate research firm.

Mezzanine financing is so named because it sits at the center of the real estate lending scale, between bank (senior) debt and equity financing. Mezzanine financing is typically secured by a warrant tied to a company's equity, as opposed to a traditional collateralized equity loan. Because mezz lenders assume more risk than a bank in this scenario, interest rates are typically much higher than prime and can run into the high teens. Senior lenders are now underwriting first commercial mortgages on a conservative 65 percent to 70 percent basis, versus 80 percent to 85 percent only a year ago, say sources at Holliday Fenoglio Fowler, a commercial real estate capital intermediary.

Many of the traditionally structured transactions that were cued up for completion at the end of last summer never happened because of the crunch, says Jeffrey Knowles, managing director in the Houston office of Holliday Fenoglio Fowler. Since then, deals all over the country have cratered, particularly in the wake of downward pressure on commercial real estate prices, says Knowles. Thomas Didio, senior managing director of the Holliday Fenoglio Fowler New Jersey office, saw several deals in the Northeast “go haywire and fall to the wayside.” The firm's mortgage-backed-securities lending is down 70 percent from early last year. “Lenders have simply gotten more conservative and leery of investment-grade deals for shopping centers, particularly without signed anchors,” said Knowles. But this will not be for any want of developer or investor interest. “In fact, the phone has been ringing off the hook,” said Knowles. “People say they're in a situation now and need help and are asking questions about how to structure their deals.”

The frothy period in U.S. capital markets has become a thing of the past, says Scott Lynn, director and principal of Metropolitan Capital Advisors, a Dallas-based real estate investment banking firm. “When we look back at the last seven years, history will show what an unbelievable influx of capital we had,” Lynn said. “Seven years ago ‘mezzanine' may as well have been the level of a seat you bought at a stadium.”

Not surprisingly, the cost of mezzanine capital continues to rise, Lynn says. “It would generally be in the 11-to-13 percent range, but now it is pricing between 14 and 20 percent,” he said. “It is higher because there are fewer players in the markets and because risk has been repriced at all levels.”

Because of concerns over real estate asset pricing and the stability of cap rates, “the act of increasing the extent of leverage on a property is a proposition that has to be approached very carefully at present,” cautioned Chandon. “The dominating concern is, do you want to increase the state of leverage in a property if the value is unstable?”

A drag in retail development has become increasingly apparent in neighborhood shopping centers in new communities where home sales are flat, Chandon said. “Then there is also legitimate concern out there on how debt issued in 2006 and 2007 will ultimately perform,” he said. “The fact that we haven't seen lot of [commercial real estate] defaults thus far doesn't make the case that we are doing fine.” Retail “is the sector we have the most concern about as we go forward in 2008 in light of consumer concerns.”

The market for commercial real estate collateralized debt obligations, once a highly favored vehicle because of its short investment duration and regular cash distributions, ground to a halt early in the second half of last year, largely because of exposure to subprime mortgages. “And that scenario is increasing the capacity to bring mezzanine debt to market,” Chandon said.

The credit crunch has also changed the average commercial real estate lender's profile, writes Jonathan Miller, an Urban Land Institute consultant, in a report he co-authored. CMBS-related debt financing and liquidity problems are pushing leveraged investors out of the system in favor of REITs, pension funds and well-capitalized private equity firms, Miller writes.

Kimco Realty Corp., a shopping center REIT that issues mezzanine debt and preferred equity, expects its lending volume to remain stable this year despite the crisis, says JoAnn Carpenter, managing director of Kimco's preferred equity program. This is partly because there will be less competition, she says.

Kimco “is looking to invest more patient money in a mezz-type structure that has a lower coupon [rate] and a relatively small participation in the upside, since we will fund up to 95 percent of the capital,” Carpenter said. Such a structure can weather the storm and allow Kimco to invest in quality deals with strong local and regional partners who will still have latitude to maximize their properties' values, she says.

But several areas of caution remain, Carpenter says. “With the economy stalling, the deals need to work, assuming somewhat-conservative rental rate projections and cap rates upon sale.” The good news is that the firm remains “very liquid in this tightening market and we would like to increase our investments in 2008.”

From a lender perspective, the mezzanine level not only offers attractive yields, it can position lenders to take over a property in the event of a default, in what is called a loan-to-own scenario. “An astute mezzanine lender better be in position to step in,” said Lynn. “But you better have the wherewithal and market knowledge.”

Lynn says the capital markets are undergoing a paradigm shift. “We have gone away from development to improving current assets,” he said. “Investors are putting their capital to work in this way because prices are still relatively high for commercial buildings and few transactions are taking place. You could say we are all taking a breather.”

The development pipeline may be crimped for a while, but capital continues to be raised for choice projects, said retail REIT officers at Deutsche Bank's 2008 Real Estate Outlook Conference in January. Martin E. (Hap) Stein Jr., chairman and CEO of Regency Centers Corp., said Regency expects to start from $400 million to $600 million in retail developments in 2008.

Kimco has shifted some of its 2008 activity to Mexico, said Vice Chairman David Henry. Several other retail REIT executives said they are building additional leasing time into their operating models this year. Nevertheless, real estate fundamentals for retail and other commercial projects have clearly differentiated themselves from residential, Chandon says. “It didn't have the overbuilding, because we have a debt market that has performed very well to the performance of borrowers,” he said.

Julian Whitehurst, president and COO of National Retail Properties, a REIT that invests in long-term net-lease properties, said the credit crunch “is likely to continue for a while, and the demand for mezzanine money is going to stay robust for the foreseeable future.” Whitehurst said he is seeing mezzanine-lending returns in the mid- to high teens.

In essence, Knowles said, “you'll be paying more to borrow less.”