Use of mezzanine finance is increasing in popularity across property types and geographic regions.
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Hinckley |
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Stephen Hinckley
Published online 01-10-2006
The use of mezzanine finance continues to grow throughout the real estate industry, across all product types and in cities big and small. These loans — which decrease the amount of equity a developer or investor needs to contribute to a loan — were once used almost exclusively by extremely well capitalized large corporations. In recent years, however, lower interest rates have created a nationwide trend toward more sophisticated financial structuring for all types and sizes of commercial real estate transactions. Developers are recognizing the potential for the use of mezzanine finance in projects as diverse as large-scale home building, grocery-anchored retail centers, bulk distribution centers and build-to-suit office properties. Many investors are realizing that the math can be very simple: if less capital is required per project, the same amount of capital can satisfy more investment opportunities or developments. This means more risk — but also more potential for profit, and the additional risk is spread across multiple opportunities. Developers using mezzanine financing may also have greater ease in obtaining standard financing, therefore lowering the amount of equity required for each deal. By using mezzanine finance to reduce the amount of equity needed for each project, developers can produce more projects more efficiently, and in the highest-quality locations.
Historically, the comparatively higher-risk nature of this type of financing meant that only developers of large-scale real estate projects used mezzanine debt. Today, owners and developers of all property types are accessing more sophisticated financing solutions to optimize the value of their transactions. When structured to complement the permanent loan, using mezzanine debt actually lowers the overall cost of capital by bridging the gap between senior debt and equity. A mezzanine loan might carry a high cost when compared to a permanent loan, but it is more financially attractive when compared to paying industry-standard returns to a group of private investors.
The retail sector shows how the availability of mezzanine finance has created a win-win situation for all involved. Retailers gain a stronger negotiating position and increased site selection options because more developers begin to compete for locations. For developers, larger deals and/or a higher quantity of deals create higher returns. Economies of scale are created for both the developer and the retailers, while sustaining the developer's corporate growth.
Many smaller retail developers can also profit from mezzanine financing. Smaller developers cannot launch several new shopping centers concurrently unless they have access to capital beyond private investors. Using mezzanine debt to contribute equity reduces the number of financial stakeholders involved while also allowing developers to finish projects faster to meet the tight timeframes that highly competitive retailers require. In a retail property with a high quantity of small leases, lowering the amount of investor approvals for each lease negotiation can contribute not just to the developer's bottom line, but also to its ability to meet the aggressive lease-signing timelines of the retailers.
Pipelines continue to seek active retail developers, and using mezzanine debt has become progressively more popular to keep the deal volume flowing. For example, if a developer can raise enough capital to launch one to two grocery-anchored retail centers on its own, mezzanine equity could allow that number to become five or six.
Intelligent Infill The redevelopment of regional malls as power centers or lifestyle centers offers a particularly relevant example of the use of mezzanine finance for retail development. These projects typically have immense capital requirements, so it makes sense for a developer to seek a mezzanine loan for the project. The higher capital requirement results from a relatively high market risk for the leasing of the new property. Borrowers for these redevelopment projects tend to be privately held regional developers with sizable amounts of capital, who can simply put their equity to better use than keeping it tied up in a single project. Conversely, grocery-anchored retail developments are only encouraged by the use of mezzanine finance when a developer is seeking capital to increase the quantity of smaller developments in its pipeline rather than financing a single large-scale project. The lower leasing risk in these projects leads to lower equity capital requirements — creating less leasing risk, higher senior loan earnings, and thus less of a likelihood to use mezzanine financing.
For capital providers that lend in the markets in which they live and work, the community impact of the projects for which the bank provides financing is a critical consideration. In urban areas in need of redevelopment, the availability of mezzanine debt can make a difference in a project's realization or failure. Everybody wins when loans close more rapidly: stores open, rent checks start coming in and the unsafe empty lots and buildings that weigh down the character of a neighborhood are replaced by vibrant shopping destinations.
As the use of mezzanine finance continues to grow across the nation, the details of the transactions, the size of the developers and the needs of the tenants will continue to evolve with it. From small towns to major markets, mezzanine finance remains a win for end-users and developers alike. Providers of mezzanine finance will continue to provide the resources necessary for developers to support economic growth.
— Stephen Hinckley is a managing director and senior vice president in KeyBank Real Estate Capital's Private Equity Group. He is based in Carlsbad, California.
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