Commercial real estate mezzanine finance: market opportunities.

Mezzanine finance has become an important source of capital for commercial real estate acquisitions, development, and refinancings, as traditional first mortgage providers have become more reluctant to finance projects at loan-to-value (LTV) ratios in excess of 65%. The increased conservatism of lenders, partly in response to regulatory requirements and partly in response to commercial mortgage-backed securities (CMBS) market demands, has created a gap between what lenders will provide and what borrowers want from debt sources. Mezzanine finance has emerged to fill the gap. The result has been increased segmentation of the capital structure for specific real estate transactions. The challenge for finance providers is to price the mezzanine segment to provide compensation for the risk taken.

This paper provides background on the mezzanine finance market including changes in the first mortgage market that helped push the mezzanine market into greater prominence. We identify the primary situations in which mezzanine finance can play a role and discuss the risks and implications of extending mezzanine finance. We posit that examination of a borrower's motivations for using mezzanine finance provides insight on risk for potential providers of capital.

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Mezzanine finance can offer favorable risk/reward opportunities for investors, but we do not embrace providing mezzanine finance in all situations. We recommend providing mezzanine finance to those borrowers whose interests are aligned with those of the mezzanine provider and the first mortgage lender. We do not recommend lending to those borrowers where moral hazard appears to be significant.

FIRST MORTGAGE MARKET DEVELOPMENTS

In order to understand the mezzanine market, a brief review of changes in the first mortgage market will be helpful.

A typical real estate deal is financed with a combination of debt and equity. In the 1980s, some lenders were willing to provide mortgage loans at loan-to-value or loan-to-cost (LTC) ratios of up to 95%, with the investor/owner providing the rest of the capital required for property purchase as equity. Some of these 95% LTC/LTV loans turned into loans with LTVs in excess of 100% as property market and capital market fundamentals deteriorated. In 1989, average LTV ratios exceeded 75%, according to the American Council of Life Insurance (ACLI).