THE MEZZANINE FINANCING market is heating up. All-in rates dropped in the first quarter of 2010, as more lenders reemerged from the shadows, and industry players expect rates to stay stable or even continue to drop throughout the year.

Although the rates and terms being offered today aren't exactly aggressive, they are starting to come back down to earth and resemble historical norms.

“The market has loosened up incredibly in the past 60 days; it's really done a 180,” says Gary Mozer, managing director of Los Angeles-based George Smith Partners. “People are trying to put money out now, which is a big difference from last year. We're seeing a lot of money getting cheaper and more flexible.”

Mozer is working on a multifamily mezzanine deal now that has received quotes in the 10 percent to 14 percent range, 400 basis points below what was being quoted a year ago.

But for the most part, mezzanine debt is being priced in the 12 percent to 16 percent range, down from 14 percent to 18 percent a year ago, according to New York-based RCG Longview, one of the industry's most active mezz lenders. The cream of the crop can access rates near 10 percent these days, while riskier transitional assets may access up to 18 percent. The long-term average for mezz loans is around 12.5 percent, so the prices are a bit high by historical standards.

Still, it's a turnaround from last year. Throughout 2009, the mezz market was effectively stalled. Lenders began focusing more on the losses racked up in their existing portfolios. And uncertainty over the depth of the recession muted activity. Plus, Fannie Mae, Freddie Mac, and the Federal Housing Administration were offering leverage levels around 75 percent, lessening the need for mezz.

“People are a little bit more comfortable that, no matter where the bottom is, it is not going to be too far from here,” says Dave Valger, director of RCG. “And both Fannie Mae and Freddie Mac have pulled back to where you are seeing average loans in the 65 percent range. Underwriting, performance, and values are all reducing senior loan proceeds, and creating a larger void for us to fill.”

Playing Defense

Indeed, RCG remains active. And there are a handful of large mezzanine providers that have grown more active recently, including mortgage REITs Starwood Capital Group, Ladder Capital, and Colony Capital. For the most part, these providers are offering 1.05x debt service coverage ratios, though given today's fundamentals, very few deals make it down that far.

For instance, consider RCG, which closed a $600 million debt fund last year to originate bridge and mezz loans. When the fund was closed, the company saw a lot of opportunity in lending to owners with significant amounts of deferred maintenance. But in a sign of the times, RCG—which has invested about 30 percent of its fund so far but still has about $500 million in capacity—is targeting its program more to lenders who find themselves unwitting owners and struggling to deal with poorly maintained REO. RCG will put up some mezz or other slices within the capital stack, and either monitor the owners or become the sponsor themselves, to do what's necessary to stabilize the property.

“In most cases, once it's re-stabilized or when market conditions allow, the lender will sell the property,” Valger says. “We make our return, and then instead of losing 50 percent or more of their principal, the lender may lose 5 percent or 10 percent or 15 percent.”

Most of the demand for mezz is on the defensive side: to recapitalize an asset through a discounted payoff or to fill the gaps on a refinance. The focus for RCG this year is cash-in refinancings, where a borrower with a maturing construction loan or other short-term loan seeks to refinance. Interestingly, RCG and other firms may receive a helping hand from a recently announced Freddie Mac program. [See “Partnering Up” at left for more details.]

The Best and Worst

Like perm loan providers, most mezz lenders are targeting stable, cash-flowing properties. Transitional assets draw far less interest. “Either everybody wants to lend on it, or nobody wants to,” says Mozer of George Smith Partners.

But it's a lender's market; borrowers are highly motivated in this environment. The best distressed asset acquisitions—for example, buying notes at such a deep discount that the high cost of mezz is offset—is one popular application now. On the flip side, the worst distressed situations—owners in imminent danger of losing an asset—are also aggressively reaching out for mezz.

To a lesser degree, mezz is helping to get some new construction deals off the ground. Sometimes, it fills in the capital stack above a conservatively underwritten construction loan; sometimes it's more than that.

This is where multifamily REITs with mezz debt funds—such as Addison, Texas-based Behringer Harvard and Houstonbased Camden Property Trust—can come into play.

REITs will often offer “loan to own” mezzanine debt in joint ventures, which helps projects get going by virtue of a deep-pocketed partnership. “A lot of people are going to the REITs now because they might not have the net-worth liquidity for the construction loan,” Mozer says. “They're going to take a majority of the deal, but they're also going to get the whole thing done because they have the [cash on hand], which a lot of sponsors don't have now.”

Before the recession took hold, mezzanine capital was often used in the valueadd game. In fact, RCG partnered with Fannie Mae on the company's DUS Plus and Mezz-Mod Rehab programs, which paired a senior loan with a mezz piece from RCG. While the pace of that business was very slow last year—the notion of raising rents was a hard sell—RCG expects the pace to pick up as rents slowly begin to stabilize this year.

“I have a couple of deals in front of me that for the first time in a year are starting to make some sense,” Valger says. “We're definitely looking forward to some more DUS Plus business this year.”