Developers' Turn To Mezzanine Financing Carries Some Risk

Law360
July 24, 2012
Developers’ Turn To Mezzanine Financing Carries Some Risk
Kaitlin Ugolik
Mezzanine financing is booming among some developers looking to fill the gap between the value of
their projects and the amount banks are willing to lend, though experts say the current legal and
regulatory environment could cause new headaches with regard to such subordinate loans.
Banks and other financial institutions are increasingly reluctant to make senior loans for real estate
projects in the wake of the housing crash and the lead-up to new regulations imposed by the Dodd-
Frank Act, and the loans they do agree to make often fail to cover the total value of the property, said
Mark Fawer, chairman of Brown Rudnick LLP's real estate practice.
As a result, developers that are unable to make up the difference by raising new equity are turning in
larger numbers to mezzanine loans, which lend at higher rates and can be riskier because of their
subordinate status, but in some cases provide project-saving financing.
“Even though mezz loan interest rates are higher than those for senior financings, on a blended basis,
when taking into account currently low prevailing senior rates, the combined financing is affordable
and often generates a more attractive after-debt service cash-on-cash return to the borrower than if
the borrower raised and invested more equity,” Fawer said.
Mezzanine loans have long been a popular way to finance deals that include a commercial mortgagebacked
securities element, but now developers looking to complete projects like the acquisition of a
condominium development or the discounted payoff on a matured hotel loan are entering the mezz
market, where they can pledge equity to another entity with an interest in the property in lieu of
taking out a second mortgage.
More common, however, is the use of mezzanine financing in restructurings on existing debt, though
it hasn't yet reached prerecession levels, experts said.
In one recent example, luxury hotel company Gansevoort Hotel Group refinanced $160 million in
construction debt on its Park Avenue location in Manhattan with the help of Citigroup Inc., Redwood
Trust Inc. and Deerwood Real Estate Capital. The debt was restructured in June to include the hotel's
original $140 million mortgage, refinanced by Citigroup, plus $20 million in mezzanine debt from
Redwood.
Redwood is one of a growing number of real estate investment companies that is entering or reentering
the mezzanine finance market after stepping back for a few years during the crisis. Private
capital abounds in the real estate industry, and many previous participants in the subordinate lending
market have raised enough since 2008 and 2009 that they feel comfortable making riskier loans to
help developers make up for inadequate bank loans, experts say.
But mezzanine financing isn't for every developer.

Finding an entity like Redwood to back a mezzanine loan can be difficult in the current economic
and regulatory environment. And while many banks were happy to originate mezzanine loans before
the crash, most now tend to steer clear of the practice, unless they can be certain that another entity
— a hedge fund or real estate investment company — will buy it at closing.
Most banks are not willing to originate mezzanine debt behind their mortgage loans without a
buyer in place at closing, according to Mitchell Williams, a partner at Hunton & Williams
LLP.
“It's not something they're interested in potentially getting stuck with,” he said.
After the financial crisis, banks drew considerable ire for holding no part of the bad loans they had
originated. The risk retention rule proposed under the Dodd-Frank Act, in its current form, would
attempt to curb such behavior by requiring banks to retain the riskiest tranche of their loan pools.
The reform would make borrowing safer for most customers but could have a chilling effect on
mortgage-backed securities and other subordinated lending structures, experts say.
Some lenders are also put off by the lingering effects of the New York Supreme Court's 2010
decision regarding the Stuyvesant Town foreclosure. That court surprised many in the real estate
industry when it held that foreclosure is contingent upon the curing of all defaults, which would
mean that in order to foreclose on mezzanine debt, it would have to be accelerated.
In some cases a new guarantee can be put up at the time of foreclosure to avoid acceleration,
but since the opinion was issued, most mezzanine lenders require the establishment of a
“replacement guarantor” when originating subordinate debt, Williams said.
This makes it harder for banks to justify making mezzanine loans, and has kept such financing from
returning to the popularity it enjoyed before the financial crisis, especially when it comes to
construction.
While developers looking to make new acquisitions or restructure existing debt are beginning
to feel healthy enough to take on subordinated debt, if they can find a lender, those seeking
construction financing are more likely to try their luck at finding an additional equity partner,
according to Hunton & Williams partner Laurie Grasso.
It's hard enough to get a construction loan, and adding a layer of mezzanine financing to the
capital stack makes finding a lender that much harder, she added.
But the appetite of those who are looking for this type of financing is being sustained by alternative
lenders such as debt funds, portfolio lenders and real estate investment companies.
In addition to the Gansevoort hotel restructuring, such lenders have stepped in recently to back a
variety of projects. For instance, Carlyle Energy Mezzanine Opportunities Fund saved a Sunoco Inc.
refinery in Pennsylvania from foreclosure, and Berkshire Property Advisors helped finance private
equity firm Savann’s $196 million purchase of a Long Island apartment complex.
“There are certainly a number of debt funds that have finished their capital raise and are
interested in returning to mezzanine lending, so I believe that the market will get interesting in
short order as these funds enter the marketplace,” Grasso said.