Financing Focus

Entrepreneurial Mezzanine Financing Sources Offer Flexible Equity

In recent years, mezzanine debt and equity financing has been growing steadily into a major source of funding for all types of commercial real estate projects. On a marketwide basis, the real estate mezzanine financing sector represents 10 percent of the $4.5 trillion dollar total property market, Prudential Real Estate recently estimated.

Further, the providers of mezzanine financing constantly are changing and evolving. Notwithstanding the presence of large financial companies, growing numbers of small entrepreneurial companies are finding success and opportunity in this market niche. Almost daily, non-institutional backed companies express commitments to the mezzanine financing arena. Generally speaking, these providers offer greater flexibility in structuring a mezzanine vehicle and tailoring deal terms to the needs of the borrower.

This amount of activity clearly points to the growing market demand for mezzanine financing. At the same time, this type of financing covers a wide range of territory in terms of deal structures being offered and sought by various capital providers and borrowers.

Why Mezzanine?
Recently, commercial real estate owners have been turning to mezzanine, or gap, financing sources in response to the decline in the loan-to-value ratio available from first-lien lenders and to constraints on the amount of equity available for certain property types. In addition, the growth in mezzanine financing is simply a continuation of the tiering and partitioning of the capital structure within real estate deals that are done so efficiently in the commercial mortgage-backed securities senior loan market.

Of all property sectors, hospitality has seen the most significant decline in the level of senior mortgage financing and equity available. This disproportionate decline is due to factors unique to this sector, such as the worldwide decrease in discretionary business and personal travel.

Because primary lenders pulled back and have remained conservative since last year, hotel owners and potential buyers have far fewer traditional loan options from a capital market standpoint, even in the face of recovering operations. This decline in available first-mortgage debt for hospitality properties is being felt in new construction projects as well as on deals requiring a near-term capital market execution to complete sales or refinancing.

In many deals, a large bid-ask gap remains. Even if a sale price is agreed to, transactions are difficult to close with maximum first-mortgage debt levels on hotel assets at the 50 percent to 60 percent of value range. The inability to obtain senior debt levels is restrictive when considering how much capital is needed to renovate or reposition an ailing hospitality property.

Deal Structures
When looking for mezzanine financing, one key ingredient is finding a provider that is flexible in structuring the financing terms to meet the unique needs and circumstances of each particular deal. Mezzanine financing is structured as either an entity loan -- secured by partnership or limited liability corporation interests -- or as preferred equity. In some cases, particularly for construction deals, the mezzanine provider may require a second lien. Typical mezzanine financing terms provide for a term of two to five years. For the most part, the mezzanine lender will structure its deals with a minimum interest or preference payment, which is paid monthly. Financing terms generally provide some additional sharing of cash flow to the mezzanine provider.

At a sale or refinance, mezzanine deals generally are structured with an internal rate of return lookback to the mezzanine provider, with some additional profit participation to the provider on a negotiated amount. A lookback refers to the comparison of the overall required annual return to the mezzanine provider against the actual payments received. For example, if prior to a capital event the mezzanine provider received a 13 percent annual return and the lookback return was established at 18 percent per year, the difference between the 13 percent annual return actually received and 18 percent lookback return would be due at the time of the capital event, with a return of the mezzanine investment amount.

Generally, mezzanine financing providers are looking to realize IRRs from the low teens to the low twenties, again depending on the particulars of each deal. For example, deals in which the provider is asked to reach 75 percent of the capital structure or less may require an IRR in the low-to-mid teens, but deals in which the provider is asked to lend more than 85 percent of the capital structure, the required IRR may be more in the high teens or low twenties. Borrowers need to examine the yield requirements of the mezzanine financing provider in the context of the overall cost to finance a project to the desired level.

Given the lack of traditional financing options and the ability to layer in mezzanine financing on a cost-effective basis, an increasing number of real estate owners are finding mezzanine debt and equity financing to be the answer to their funding needs. Because of their flexibility, entrepreneurial sources of mezzanine financing are likely to remain a key funding source for the foreseeable future.

Donald Braun

Donald Braun is president of Hall Financial Group in Frisco, Texas, and leads the company\'s real estate structured finance team. Hall Financial Group is a diversified investment company, with a focus on real estate ownership, management, and development, direct equity investments, and mezzanine debt funding. Contact him at (972) 377-1111 or dbraun@hallfinancial.com.

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