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From the Mezzanine Section

The market for office towers, apartment buildings and shopping malls is in an awkward middle stage -- the boom is clearly over, but no bust has happened.

So it is no surprise that an obscure slice of debt that occupies the middle ground between the equity of a building's owner and the debt held by its creditors is suddenly in vogue with traditional real-estate players.

Mezzanine debt has been around for years, but the combination of more-attractive yields, few real-estate deals and stubbornly high prices for what does sell has attracted many of the real-estate world's best-known players. A number of big investment firms are raising funds, some of which are expected to go into mezzanine debt.

Investors in mezzanine debt see it as a no-lose bet. The rate of return is generally in the teens if things go well and the owner makes the interest payments. If things go badly and the owner gets behind on payments, the owners of the mezzanine debt have the right to own the building. The logic behind this "loan to own" strategy is that investors who buy the mezzanine debt believe they can make the mortgage payments on the building and still make a profit.

"These investors are happy to take a good return on their money but hoping for a home run if the underlying mortgage goes into default," says Mark Edelstein, a partner with New York-based Morrison & Foerster LLP.

Here is an example: When 660 Madison Ave., a well-placed midtown Manhattan office building, was auctioned this summer, Shorenstein Properties lost out. The building -- recognizable as the home to fashion retailer Barneys New York -- eventually was sold to a subsidiary of Gruppo Zunino, an Italian property owner, for $375 million, or more than $1,400 a square foot.

But Shorenstein didn't give up hopes of one day owning the tower, so in October the firm made a $50 million mezzanine loan on the building. If Gruppo Zunino pays off the loan on time, Shorenstein gets its money back, plus its return. But if the borrower should default, Shorenstein could foreclose and become the general partner in the building, en route to owning it. Moreover, Shorenstein would be able to do that at a lower price, because the original borrower's equity would be wiped out. Shorenstein's cost basis would be about $1,000 a square foot -- a relative bargain.

"We think the property is very attractive, but we were not that interested in the property at the price in which it traded," says Robert Underhill, head of capital transactions for Shorenstein, a San Francisco-based real-estate operator. "In the very unlikely event that we were to take over the property, we're comfortable that the property would sell at a price that would pay back all of our debt."

Just this week, Shorenstein announced its purchase of a $39.5 million junior mezzanine loan on another midtown Manhattan office tower, 1180 Avenue of the Americas, which is just south of Rockefeller Center -- the fourth subordinated-debt position acquired by one of its funds in the past three months.

Shorenstein isn't alone. Lloyd Goldman, president of BLDG Management Co., says he has been buying mezzanine debt as well as first-loss positions on first mortgages because he would like to own the buildings. Lenders, he says, are happy to see him take this position, because they know he has the ability to take over the debt payments.

Vornado Realty Trust, a New York-based real-estate investment trust, disclosed in a federal filing in October that it had acquired a 42% interest in two mezzanine loans totaling $158.7 million for $66.4 million in cash, on four Manhattan office properties bought by New York developer Harry Macklowe this year from Equity Office Properties Trust. The loans come due in February and bear interest at a floating rate equal to about 9.8%, as of Tuesday.

Vornado's bet is that Mr. Macklowe, a New York real-estate developer, can't make the payments and Vornado will be in line to get the buildings. Vornado declined to comment.

During the commercial real-estate frenzy of 2006 and early 2007, cheap debt and easy lending terms allowed many bidders to push up the price of buildings to record levels. Many winning bidders needed mezzanine debt to bridge the gap between the often slimmed-down down payment and the mortgage.

Yet, before the recent credit crunch, many investors felt yields on mezzanine debt didn't sufficiently compensate for risk associated with the lax underwriting common during the frenzy, says Gary Koster of Ernst & Young. Some office buildings were financed with projections of rental-rate growth now seen as overly optimistic.

Today's yields are perceived to be more appropriately priced. For example, in 2005, mezzanine debt on some properties offered yields between 8% and 10%, reflecting not only the commercial-property bubble but also short-term interest rates that were at a 50-year low, says David Tobin, a principal with Mission Capital Advisors. Now, mezzanine debt on loans originated in 2006 and early 2007 can yield returns as high as 20%.

Investing in mezzanine debt isn't without risk. The value of real estate doesn't always go up. The holder of the mezzanine loan could end up with less than the amount owed -- or nothing at all -- if prices fall and the borrower can't pay off all the debt when the building is sold, says Jay Rollins, president of Denver-based JCR Capital, which specializes in structured real-estate finance.

Many investors in mezzanine debt on condominium projects are already learning that hard lesson as prices plunge in many residential markets. Nonetheless, although prices are believed to be softening on office buildings, fundamentals remain fairly strong, making mezzanine debt attractive -- at least for a while.

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