Although real estate investors have been using a variety of creative lending combinations and debt/equity structures to finance their investments for decades, mezzanine financing options have been gaining popularity only throughout recent history. In fact, "mezzanine" programs weren't even an option in the real estate industry until as recently as the early 1990s. Despite their relative newness to the industry, many experts estimate the annual capacity of the mezzanine financing market to already be somewhere between $8 billion and $12 billion.

Why the Increasing Demand?

Despite the fact that mezzanine financing programs have only been available for less than 10 years, their popularity has skyrocketed due to several factors -- factors that should continue to make mezzanine investing attractive into the foreseeable future.

ž The securitization of commercial real estate loans - combined with stricter mortgage underwriting standards by banks, insurance companies and other traditional lenders - has resulted in increased equity requirements for borrowers, which also leads to greater demand for mezzanine financing.

ž Many borrowers are having difficulties bridging the gap between a first mortgage and their equity. Mezzanine financing is proving to be a very viable option. And, generally, mezzanine capital is priced more attractively than obtaining all equity capital. It, therefore, provides positive leverage to the deal.

žMezzanine financing is especially attractive to investors who purchased or refinanced assets in the early to mid 90s, near the end of the real estate recession of the 80s. Encumbered by long-term senior loans that frequently carry cost prohibitive prepayment penalties, these investors are commonly looking for opportunities to cash out some of the equity built up in the property. Likewise, mezzanine financing provides a practical alternative to draw equity from a property without having to refinance a senior loan that carries a favorable interest rate.

ž If the decline in buying activity by real estate investment trusts continues as many project, an increasing number of entrepreneurs who need higher leverage will likely be attracted to the industry.

ž There is currently pressure on some pension funds to liquidate portions of their real estate portfolios. Add to this the fact that institutional joint venture capital is not as abundant as in past years.

As in most cases, capital follows returns. And generally, yields for mezzanine financing are superior to both senior debt and going-in equity returns. Moreover, the underlying commercial real estate markets are currently enjoying one of the longest periods of growth and stability in decades. Thanks to recent industry regulatory changes, that trend should remain constant throughout the near-term future.

What are the Benefits and Risks?

In addition to the obvious benefits discussed above, one of the primary advantages to borrowers of mezzanine capital is the ability to maintain control and the flexibility to customize individual deal structures.

But, as with any type of real estate investment, there is risk for both the investor and the lender associated with mezzanine financing. The most significant and probably the most obvious risk is that of a substantial recession that would affect the value of real estate assets and, likewise, the amount and timing of cash flows. The higher leverage nature of mezzanine financing reduces the tolerance for variance between projected returns and actual cash flows.

Although overall commercial mortgage activity has been declining throughout the past year, due partly to higher interest rates, there should not be a significant decline in mezzanine demand. Higher interest rates make financing higher loan-to-value deals more difficult, thus opening the door for mezzanine financing programs.

From a lender's perspective, mezzanine finance programs can certainly be rewarding. However, administering such programs can prove to be very time intensive. Mezzanine transactions also tend to be fairly complex and require protections specific to this type of deal structure. For instance, it is essential to establish the terms of the relationship between the mezzanine lender and senior lender through what is commonly termed an "inter-creditor agreement." The mezzanine lender will also seek protections through non-recourse carve-outs in the loan documents beyond what a senior lender would typically require. And other protections may take the form of ownership structures designed to address bankruptcy related issues.

Forces within the real estate finance industry have evolved to create demand for new types of financing vehicles. In response, mezzanine financing has emerged as a sizable and growing source of capital in the industry. Mezzanine financing has created capital liquidity for borrowers, while providing them with flexibility and control. On the lender side, the investment offers attractive risk-adjusted returns with features designed to protect against some of the inherent risks that come along with the investments.

James J. Mazzarelli is the Southeast Regional Director for MONY Life Insurance Company-Real Estate Investment Management, the principal subsidiary of The MONY Group Inc.

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