But despite built-in risks, lenders say mezzanine loans are beginning to resurface, albeit slowly.
“It’s become something people want to do again,” said William Shanahan, a vice chairman at CB Richard Ellis who specializes in investment properties in New York. “I think it’s fair to say that right now the desire to place mezzanine debt outweighs the demand for it, but a lot of people are looking to put mezzanine loans on their properties. There are a number of players out there right now.”
Like the level between the first and second floors for which it is named, mezzanine loans come second in priority to the first mortgage. The loans are typically secured by stock in the company, so that if a property owner defaults, he risks not only handing over the keys to his building but also the equity tied to the asset. By comparison, when a borrower defaults on a first mortgage, only the property itself is at stake.
As a result, many building owners who financed property at the height of the real estate bubble, including the proprietors of the W Hotel and the Hancock Tower in Boston, were at the mercy of mezzanine lenders after the economy turned down, profits shrank and junior loans swirled into default.
In March 2009, Normandy Real Estate Partners, based in New Jersey, took control of the Hancock Tower, the tallest building in New England, by quietly buying up mezzanine debt shortly after the property’s owner, Broadway Partners, defaulted on loan payments.
But as banks begin to provide more senior financing on commercial assets and investor confidence returns to the market, so too will increased demand for new mezzanine loans, lenders said.
Since January, an estimated $374 million in mezzanine and other secondary loans have been issued across the country, an increase from just $210 million in all of 2009, according to data provided by Jones Lang LaSalle, the Chicago-based commercial real estate services firm.
Typically, borrowers who are unable to secure all of their financing needs for a property acquisition with a first mortgage have few options other than a mezzanine loan, mainly because first mortgage lenders usually demand locked-in agreements barring a second mortgage with similar terms.
“Little by little, you’re going to have more liquidity in the market, which means the volume of mezzanine lending is going to increase,” said Bruce Batkin, the president of Terra Capital Partners, a real estate investment company based in New York. “I think that’s going to be happening in the second half of the year.”
The Pembrook Group, a fund management company based in Harrison, N.Y., is expected to originate as much as $100 million in mezzanine debt by the end of the year, including half a dozen pending deals in Chicago, California, Florida and Texas, said John Garth, a managing director in the New York City office of the six-year-old company.
In late January, the group placed a $12 million mezzanine loan at an existing office park outside Pittsburgh owned by the Keystone Property Group, which secured a $42 million mortgage from Deutsche Bank, Mr. Garth said.
“Money has become much more available and at much more attractive rates in the last 90 days, and business is getting signed up and closed,” said Mr. Garth, who said Pembrook originated about $250 million in mezzanine loans in 2006, at the peak of the market. “It’s literally been since the first of February that we’ve seen a lot of competition on high-quality deals, from Wall Street shops, banks and insurance companies.”
At the Partners Group, a private asset manager based in Switzerland, demand for mezzanine loans has escalated significantly since January, said Eliza Bailey, a senior vice president in the company’s San Francisco office. She predicted that by the end of this year the group would place upwards of $300 million in mezzanine debt, both nationally and globally.
Among the Partners Group’s recent deals, she said, was a $10 million mezzanine loan on a portfolio of commercial buildings throughout the United States, as well as an $11.3 million loan on a collection of residential assets in Germany.
“It’s improved dramatically in 2010 as far as the quality of the new asset deals that are in the market,” Ms. Bailey said. “There’s more visibility to value the underlying assets, and there’s a little bit more of a market acceptance of where we are in the cycle. In 2009, I don’t think anybody was clear about where we were or where we were headed.”
Dan Gorczycki, a managing director at Savills, said that until banks ramped up efforts to foreclose on defaulted loans, rather than extend them indefinitely, mezzanine lending opportunities would continue to be relatively scarce. The so-called extend-and-pretend strategy practiced by banks, he said, has prevented many commercial properties from returning to the market and, subsequently, from being refinanced with the help of mezzanine debt.
“Now that the market’s recovered, some banks are getting tougher, but other banks are saying, ‘Let’s give these guys some more time to work things out,’ ” Mr. Gorczycki said. “It’s been a combination of factors that have led these banks to do this, but it’s really frustrated the mezzanine lenders who were hoping to make yield.”
“When nobody’s forced to sell, there’s nothing left to buy,” he added. “The real estate market goes up by just that factor alone. It’s no different than the stock market.”