Mezzanine Debt Loses Its Shine With Investors

By LINGLING WEI In the fading years of the commercial real-estate boom, mezzanine debt was all the rage among yield-chasing private-equity firms and hedge funds like Fortress Investment Group LLC, Fillmore Capital Partners LLC and Petra Capital Management LLC. Today, for most, mezz is a four letter word. Firms made an estimated $50 billion to $75 billion in mezzanine -- dubbed "mezz" -- loans, debt that fills the gap between the borrower's equity and the first mortgage. Billions of dollars already have been lost and the figure is likely to balloon as the steep downturn in the commercial-property market deepens. The losses are sending shock waves through the rough-and-tumble world of office buildings, shopping centers, hotels and other commercial properties, which are only now facing the full brunt of the recession. Mezz debt was one of the biggest culprits that enabled commercial real-estate investors and developers to participate in the broader speculative binge on Wall Street. View Full Image Associated Press Mezz loans on Donald Trump's project in Chicago face big losses. Now mezz investors are suffering a massive casualty rate with some mezz funds facing total losses. Almost all the firms that specialized in the once-promising investment are spending their days fighting with borrowers to salvage some of their loans while defending themselves against creditors who financed their operations. "If you count the total number of mezz loans there are, you have gotten close to the number of mezz loans that are going to have problems," says David Tobin, a principal with Mission Capital Advisors, a loan-sale adviser. The attraction of mezz debt to investors was twofold: the rate of return on such debt -- once levered up -- was in the teens if the borrower kept current and, if the borrower defaulted, the investor in the debt would have the right to take over the property. "We were very comfortable when we underwrote these assets," said Mark Nunneley, chief accounting officer of Ashford Hospitality Trust Inc. a hotel real-estate investment trust that also invests in mezz debt. "If we end up owing them, then that's just great." He made the remarks on an earnings call in November. But that strategy isn't working in many cases because properties are no longer generating enough cash to cover the first mortgages, much less the mezz debt. For the mezz investors to take over the property, they would have to reach into their own pockets to pay debt service on the first mortgage. Ashford made a $21.5 million mezz loan to Transwest Partners, a real-estate investment firm, for its 2007 purchase of two Westin hotels in Tuscon, Ariz., and Hilton Head, S.C. Transwest has defaulted on both Ashford's loan and the $209 million first mortgage. Ashford isn't racing to foreclose since that would require the REIT to pay, for starters, all the interest owed on the first mortgage, now totaling about $2.7 million. A spokesman for the Dallas REIT declined to comment. In another case, a group led by Fortress is facing what could be a write-off of its $130 million mezz loan to Donald Trump for his now-troubled condominium and hotel project in Chicago. Sales of both the hotel rooms and the condos in the 92-story Trump International Hotel & Tower have come in below expectations and the project's estimated revenue isn't enough to pay off even the senior lenders. A Fortress spokeswoman declined to comment. An even bigger whopper was the $1.4 billion in mezz financing provided to a venture of developer Tishman Speyer Properties and BlackRock Realty Advisors for its $5.4 billion acquisition of a sprawling Manhattan apartment complex in 2006. As the weakening New York economy hinders the venture's ability to boost the rental income of the complex, called Peter Cooper Village and Stuyvesant Town, the project is running the risk of defaulting on the mammoth debt unless the venture is able to persuade its investors to pony up more capital. Richard Parkus, head of commercial-mortgage bonds at Deutsche bank, said there is "significant risk" that the current owners will either give up the property or attempt to negotiate "very substantial loan modifications" over the next 12 to 18 months. A spokesman for Tishman declined to comment. Among the 14 mezz investors who could see their investments wiped out: property financing specialist Gramercy Capital Corp. and SL Green Realty Corp., an office REIT. During its fourth-quarter earnings call in January, SL Green indicated that it may write down its piece, totaling $75 million, if the Tishman/Blackrock venture doesn't raise more equity capital. A spokesman for both Gramercy and SL Green declined to comment. Investment firms that specialized in mezz debt have been shown the door when they have asked investors for more capital to salvage deals. Take the case of Fillmore Capital, a San Francisco hedge fund that holds as much as $400 million in mezz financing on two office towers that had been owned by New York developer Harry Macklowe. A week ago, Fillmore thought it had a deal to buy the buildings from the senior lender, Deutsche Bank AG, which took control of them in 2008, according to people familiar with the matter. Deutsche Bank was willing to grease the wheel by providing additional financing to Fillmore. But the deal fell apart as a big Fillmore investor, the State of Washington pension fund, backed out of providing capital for the transaction, according to people familiar with the matter. A spokeswoman at the Washington State Investment Board didn't return a call for comment. Firms that have invested heavily in mezz debt first began running into trouble because they borrowed heavily, using their loans as collateral. As the value of those loans tanked, they faced margin calls. Late last year, a debt fund run by Guggenheim Partners LLC, one of the best-known names in investing commercial-property debt, had to turn over tens of millions of dollars of collateral to its lender, J.P. Morgan Chase & Co., after it failed to come up with additional capital to meet the lender's demand for additional cash. It isn't clear how much is left of the $770 million Guggenheim originally raised for the fund. Most recently, borrowers have begun to default on mezz loans, forcing the mezz investors to try to foreclose. But this isn't easy even in cases in which the mezzanine holders believe their position is worth something. Often the mezz debt is broken up into slices with different degrees of risk and claims on the property. Also, for the mezz holders to take over the property, they often have to pay what is owed or refinance the first mortgage, a difficult feat in this credit-starved environment. "No one wants to throw good money after bad," says Mark Edelstein, head of real-estate group at law firm Morrison & Foerster LLP in New York. —Alex Frangos contributed to this article. Write to Lingling Wei at lingling.wei@dowjones.com