No matter what current market conditions may be, money still makes the real estate industry go 'round. So what happens when lenders adopt stricter underwriting standards? Opportunity funds dry up and money doesn't flow as easily as it once did.

According to Prudential Real Estate Investors, the result of these and other factors colliding in the current economy has created a booming market for "mezzanine" financing.

Simply put, mezzanine investments are a cross between debt and equity instruments. They generate returns higher than typical bank interest, but are lower than the kinds of returns expected by equity investors. But Prudential says that when they are properly structured, mezzanine investments can generate equity-level returns at debt-level risk.

The mezzanine market has not been studied or measured as assiduously as the real estate debt and equity sectors. Yet these investments could be worth between $65 billion and $135 billion, according to Prudential.

Prudential's "estimate represents the first time a firm has tried to quantify the size of the U.S. real estate mezzanine market," said Shekar Narasimhan, managing director of Prudential Real Estate Fixed Income Investors, which manages commercial real estate debt funds for institutional investors. "This market is not fully developed, but provides a broad range of opportunities, particularly for institutional investors."

PREI built its estimate around the $4.5 trillion value of commercial property in the United States. Of that total, 10 percent to 15 percent of the property carries some kind of mezzanine financing, representing about 15 percent to 20 percent of the property's value.

"While this is admittedly a wide range, the mezzanine market is clearly large enough to provide a potentially significant source of investment opportunities," said Youguo Liang, Prudential's managing director of research.

As the economy has weakened, and demand for new construction has slowed, traditional mortgage lenders have understandably become more cautious.

"Tighter underwriting standards have widened the gap between borrowers and lenders -- and between debt investors and equity investors," Liang said. "Mezzanine loans can act as a bridge over this gap."

So what makes these investments so attractive? According to Prudential, mezzanine investments can be created in an almost endless variety of combinations. They can be structured to emphasize debt or equity characteristics. For example, the can allow lenders to share in excess profits or to convert from a debt to equity position, much like preferred stock or convertible bonds.

There are some risks inherent to the market, chief among them the risk of non-performance. Yet as the financing gap widens, borrowers will be more and more willing to accept their lenders' terms.

As the market remains wobbly at best, look for mezzanine financing to become an even more common -- and perhaps more profitable -- solution for lenders and borrowers.

For more articles by Lesley Hensell, please press here.

Published: July 19, 2001

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Lesley Hensell covers commercial real estate and financial issues for Realty Times. Based outside of Dallas, Lesley works with high-tech and real estate clients as an independent marketing and public relations consultant. She also writes for several publications, including the Dallas Morning News. E-mail Lesley at: lhensell@earthlink.net