PHILADELPHIA-Welcome to the Philly 411, our monthly column on real estate happenings in the Metro area supplied with intel from David Jacobs, a director at Llenrock Group, a local commercial real estate investment-banking firm. You can also follow their blog here. Opinions are the author's own.

10 Rittenhouse, a soaring luxury condominium at the northeast corner of Philadelphia’s storied Rittenhouse Square developed by ARCWheeler, has fallen into control of the mezzanine lender, locally based union pension fund Delaware Valley Real Estate Investment Fund (DVREIF).  Why is this more significant than the average distressed deal?  Not only is it a high profile property, but it serves to shed light on the smorgasbord of risk associated with all levels of the capital stack.

The developer sits in the riskiest position of the capital stack, and is the first to lose its equity investment if the deal goes awry.  In this case, it was not so much a function of poor location, but one of unforeseen timing issues.  Developer ARCWheeler got in at the right time in 2004-05.  However, there were unforeseen litigation issues with zoning and the neighborhood association that delayed the start of construction for years.  As time elapsed, the luxury condo market gradually passed them by.  When they were finally ready to build and start pre-selling units, many condo buyers had already purchased elsewhere.  Additionally, those potential buyers who had not yet purchased were stuck with their McMansions in the suburbs, and could not afford to buy until their current houses were sold.  Additionally making transactions difficult was the ability to obtain jumbo mortgage financing (for home loans greater than $400,000) in a suppressed credit environment.

Next we have niche mezzanine lender DVREIF.  It is worth pointing out that many people get confused about mezzanine loans. While they are often described as subordinated debt or a second mortgage, the loans are not collateralized by the property.  Rather they are secured by the partnership interest of the sponsor (equity).  This allows the mezz lender, as in the case with 10 Rittenhouse, to take over the equity interest in the property by taking over operations and management of the deal should the borrower default on the mezzanine loan.  This allows the mezzanine lender to protect their interest in the deal.  If the mezzanine lender decides at some point that the deal is no longer salvageable, only then would they raise the white flag and default on the loan payments, allowing the senior lender to foreclose on the property.

The interesting interplay between a mezzanine lender and a senior lender begins with the drawing of loan documents between the senior lender and the developer, or sponsor of the deal.  Many senior lenders do not allow mezzanine loans to be made for the sake of securing their interest in the property.  Not only do mezz loans impact the cash flow available to service the senior debt, but it also could drastically impact the way that lender interfaces with their client.  If, in the case of 10 Rittenhouse, the original borrower triggers a default on the mezzanine loan, the mezzanine lender usurps the borrowers position, and begins making debt service payments to the senior lender in the original borrower’s place. Furthermore, mezzanine lenders have different prerogatives than do borrowers in some cases. 

Obviously, neither wants to lose their investment, but take DVREIF as an example.  They act as a mezzanine lender only for construction deals.  This is because they represent construction union pension money, and it serves as an additional incentive not only to invest money for a solid return, but also to create jobs for union workers. This added bonus often makes DVREIF a cheaper alternative to competing sources of mezzanine financing, one that many area developers take advantage of, especially if they are building within city limits, where building with union labor is essentially a must (unless you want a giant inflatable rat in front of your project to be the least of your problems).

Finally we have the senior lender, in this case iStar Financial.  Normally, suggesting that the senior lender is purposely trying to defraud the borrowers is an argument with little merit.  A lender typically has no reason to prevent a borrower from servicing the debt on a property.  As long as the lender is getting paid what they are owed on time, they are generally happy, especially today given all the other troubled loans that likely are scattered throughout their commercial and residential portfolios. 

 However, because this is a residential condo deal, and the only income being generated is by the ground floor commercial condominiums and the relatively few sales that have taken place, there is no significant constant stream of cash flow.  Rather than wait for what may seem like an imminent default by the borrower, the lender may decide to actively work against the borrower, looking for any clauses in the loan documents that could possibly trigger a default.  They would do this in order to foreclose on the property and recoup a portion of their original $216.5-million investment so they could write down and subsequently clear this gargantuan loan from their books.  With many troubled commercial lenders dealing with regulatory authorities, sometimes the best interests of the property are overshadowed by the lender’s interests at a much higher level. 

This of course is bad news for all those involved with the deal, because instead of working together towards a common goal (i.e. doing whatever it takes to sell units briskly at the highest price possible) parties work against one another.  10 Rittenhouse is essentially an amalgamation of the complex issues and various vantage points expressed above by the various members of the capital stack. Understanding how the parties’ interests can be in conflict with one another, we can begin to understand the stagnation of progress in any direction that so many of us have been waiting for in the marketplace.