Mezz: The New Four Letter Word

George Carlin was famous for developing the seven dirty words you can't say on TV. Five of those seven were four letter words, and if you aren't familiar with them, you've probably uttered most of them each morning when opening the business section of your morning newspaper of choice, or late each afternoon when visiting www.bloomberg.com to check on the market.

In commercial real estate, there are several four letter words that have become tantamount to the taboo four letter words to which we are accustomed, among them are "deal," "math," and "jobs." All of these are relative terms whose perceived impact on individuals has been negative. Well, time to add a more specific four letter word to the list...MEZZ.

Mezz, short for mezzanine debt, was all the rage in the waning years of the commercial real estate boom. Firms made an estimated $50 billion to $75 billion in mezzanine 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.

For borrowers, it was a convenient way to additionally leverage their deal, given the cost of mezz was usually still cheaper than the cost of equity. The spread between the two provided extra internal yield to the borrower, and thus, became an all too comfortable trend of overleveraging. The attraction of mezz debt to investors/providers 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. All they would have to do is continue to pay the first mortgage debt service. Sure, their yield would be lower, but they would become owners of great properties...in theory. And therein lies the problem mezz has today.

Real estate values have dropped off the face of the map, to a point where, in some cases, values are lower than the amounts owed on the senior debt.

The biggest and best example, among many, is the largest private transaction in commercial real estate history, the 5.4B purchase of the Peter Cooper Village and Stuyvesant Town apartment complex in Manhattan. This deal had $1.4 billion in mezz financing provided to a venture of developer Tishman Speyer Properties and BlackRock Realty Advisors. As the weakening New York economy hinders the venture's ability to boost the rental income of the complex, 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.

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 even worth something. Often the mezz debt is broken up into slices with different degrees of risk and claims on the property.

No wonder investors want to scream out #$%&! when they realize they're great investments are knee deep in $*@#. And if you are one of the borrowers, please try to keep things civil and refrain from telling your creditors to go "mezz" themselves.