A few months ago, we published a legal alert regarding the $1 trillion+ wall of debt that is maturing in the U.S. commercial real estate market by 2025.1 Our view is that, due to historically high interest rates, rather than refinancing, many property owners will, if their lenders are unwilling to extend the terms of their existing financing facilities, likely either sell their properties (in particular, office and retail properties) or will otherwise default on their loans and hand the keys to their lenders, who would then look to unload those properties from their portfolios – in either case, at a steep discount. This scenario will in turn represent an opportunity for savvy real estate investors who are not as reliant on financing to acquire premium commercial real property at a discount.
As we had anticipated, we are now starting to see this scenario play out not only in the news2 but also among our own clients in such markets as New York City and London. For example, we recently assisted a client in purchasing two prime retail properties in Manhattan. Both properties were acquired at significant discounts from the prices at which they previously traded. In one case, the seller decided to unload the property in question at an approximate 30% discount rather than refinance at current interest rates.
How, one might ask, should interested investors jump on this opportunity? Traditionally, there are a handful of ways in which to invest in commercial real estate, three of which we will explore here.
Number One
The first and most obvious method is for an investor, acting alone, to conduct a straightforward acquisition of a real estate asset. In such a scenario, the investor will be handling and paying for all aspects of the acquisition and post-closing development and management of the property. The investor will hire its own professionals (i.e., lawyers, accountants, consultants), negotiate a purchase contract, conduct its own diligence on a property, and usually create a new corporate entity to take title to the property. If financing is involved, the investor will negotiate the loan agreement and mortgage (or local equivalent) directly with the lender and typically provide a limited guaranty for the loan. Post-acquisition, the investor will be directly responsible for the development and day-to-day management of the property, including dealing with any tenants in occupancy. Often the investor will hire a reputable property management company to assist in such day-to-day management. This is the most involved form of property ownership and is for investors who feel comfortable (a) handling all aspects of real property ownership and (b) investing on their own in a given jurisdiction.
Number Two
Another way to acquire property is through a joint venture (JV). In this scenario, there are usually two (or a handful) of partners in a venture to acquire, develop, manage, and eventually sell one property. The partners form an investment vehicle and enter into an operating agreement governing such vehicle. The operating partner (sometimes called a "sponsor") will often make an equity contribution, but its primary contribution is typically "sweat equity" – i.e., the sponsor is usually an experienced developer and manager of real property and, as a result, will be in the driver's seat with respect to the acquisition, financing, and post-closing development and day-to-day management of the property. Equity partners, on the other hand, invest capital into the JV, but do not run the acquisition process (although they may hire their own professionals to review the sponsor's diligence and the relevant purchase documentation) and are not involved in the day-to-day management of the property.
Equity investments in a JV can be a good way for an investor to dip its toes in a real estate market (especially investors attempting to invest in a foreign country) and are particularly attractive for those investors who can leverage relationships and/or connections with trusted operating partners on the ground. An equity investor who invests a substantial amount of capital in a JV also usually has a great deal of leverage to negotiate favorable provisions in the JV agreement and stands to reap significant rewards if the JV is successful. On the flip side, there is also significant risk as well, particularly if the operating partner does not uphold its end of the bargain. Equity investors who make smaller investments in a JV will usually have reduced leverage vis a vis the operating partner but will also be exposed to less risk. Provisions to watch out for in the joint venture agreement include the "waterfall" provisions (i.e., how returns are distributed after payment of expenses and liabilities), the rules governing capital calls (including potential dilution of membership interests for failure to answer a capital call), the circumstances under which equity partners have decision-making rights, exit options, and rights of the partner(s) to remove and/or replace the manager of the JV.
Number Three
A third way to invest in real property is to invest in a real estate investment fund or a real estate investment trust (REIT). REITs are companies that own, and in most cases operate, large-scale, income-producing real property. In some cases, they will hold loans rather than property. Some REITs are publicly traded, while others are private. Investing in a REIT can be a good option for those who are interested in diversifying their investment portfolio and receiving a steady stream of income. Shares in publicly traded REITs can also be easily bought and sold on stock exchanges, which makes such an investment a very flexible one. However, there may not be much upside in terms of capital appreciation. Additionally, the investor is usually just "along for the ride" and has (a) very little leverage (if any) to negotiate investment agreements and (b) no say in any decision-making by the REIT. As to a real estate investment fund, the way this investment works is that the investor invests money into the fund, which in turn invests in securities issued by publicly traded REITs. While investment in a REIT pays out regular dividends, investment in a fund is meant to provide value through appreciation.
In addition to the above, there may also be other opportunities to invest (for example, participating in a loan buyout from a lender that decides to clear a loan from its portfolio at a discount). Ultimately, the current state of the commercial real market presents a great opportunity for savvy investors to invest in a variety of ways. Please contact your Withers attorney or the author for guidance or with questions on this timely topic.
Footnotes
1. The original alert can be found here: https://www.withersworldwide.com/en-gb/insight/read/looming-debt-maturity-presents-an-opportunity-for-real-estate-investors
2. See, for example, the following recent articles: https://www.ft.com/content/ac7e5b0e-bde3-4d1b-8cd2-d89918e4c4b8, https://finance.yahoo.com/news/kering-acquisition-prestigious-fifth-avenue-171600882.html
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