Hard times make for opportunistic strategies and rescue capital could see increased adoption in the current climate. How should investors prepare?
In the past seventeen months, the climate for real estate ownership and investment has shifted dramatically for the worse, ending a remarkably favorable investment climate since the Great Financial Crisis.
The real estate industry faces a toxic stew of rising inflation and interest rates, a scarcity of financing, and the tightening of underwriting criteria of both lenders and would-be investors. More troubling, the future of the office, retail, hospitality, and residential sectors is no longer easily predictable, and the trendlines now skew to the negative, given a potential cyclical downturn combined with longer term secular changes due to remote work, internet sales, changing travel patterns, and an increasing treatment of housing as a public utility.
THE CURRENT STAGE
Many properties are already "below water" on a current and prospective basis, giving rise to a wave of distressed debt transactions and properties being surrendered to lenders, even by established real estate players. However, many other properties, while still generating positive net cash flow (even taking current debt service into account), face a large gap in their capital structure and a projected drop in occupancy and rental income that, if not addressed, may or will result in catastrophe.
But why?
First, the cash flow of these "zombie" properties is fragile. The demand (and price) for office space in new leases projects to be materially less than for leases entered into pre-2022. The long-term prognosis for retail is unclear. Hospitality trends are at best opaque. Housing is being impacted by governmental initiatives to reduce or cap rents or deter evictions.
Contemporaneously, terms of available financing are unlikely in many cases to generate sufficient principal to refinance existing debt. This is particularly the case for development properties or properties under construction, properties with impending vacancies, and properties refinanced at the valuations characteristic of the years immediately preceding 2022.
Third, there are few flight capital or "Prince Charming" investors ready to purchase properties at prices that will solve these problems.
Fourth, many properties need substantial capital infusions for lease-up, repositioning, upgrades, or environmental retrofitting. Ground-leased properties may face substantial rent resets, and "B" and "C" properties are especially vulnerable.
Fifth, some ownership groups are unable to provide additional capital, even where the return might justify the investment (for example, fund owners facing redemption calls or trigger dates for liquidation).
On the other hand, up to $200 billion has reportedly been stockpiled by investors, including funds and family offices, to fill the emerging equity gap. This so-called "rescue capital" is not necessarily focused on property purchases, but may elect to negotiate an acquisition of a substantial (and usually preeminent) equity interest in existing property owners, sometimes with full control rights, sometimes not.
PLACING RESCUE CAPITAL
The key to these rescue capital deals is that they are opportunistic investments, with considerable risk and with proposed returns consistent with the risks assumed. The days of core, core-plus, or even value-add capital seem somewhat remote.
We are seeing a return to deal structures and approaches similar to those in the early Reagan presidency, with equity squeeze-downs, "debt-flavored" equity, "equity-flavored" debt, split debt-equity investments, conversion rights, and the like. Moreover, these are not "win-win" transactions. Existing capital will be impaired, perhaps severely. Many of these transactions will provide existing ownership with the equity equivalent of a "hope note," so that they are effectively subordinated to a return on and perhaps of any new money invested.
Why would existing ownership cooperate? One reason is that the alternative may be a total loss or years of litigation with lenders. Reputational risk may be at stake. There may be tax benefits to a rescue capital solution. The new investor may be willing to allow management rights and fee income to remain with existing management. And, at bottom, a "hope note" may be preferred to wipe-out.
Up to $200 billion has reportedly been stockpiled by investors, including funds and family offices, to fill the emerging equity gap.
NEGOTIATIONS AND CONSIDERATIONS
Rescue capital transactions are complex. Joint venture agreements are complicated to negotiate ab initio and even more difficult to restructure, where there are clear winners and serious losers and less security of outcome.
- Given the sensitivity of rescue capital negotiations, both nondisclosure agreements and agreements negating oral agreements should be considered before discussions are commenced.
- Underwriting is more complicated. The new investor must not only perform due diligence on a property, but on the historic operation of the entity's business and the peculiar liabilities and tax attributes of the entity, most of which would not be relevant in a property sale. The existing ownership must be vetted on a know-your-client basis. The new investor is concerned with undisclosed (e.g., tax) matters that are not easily diligenced.
- Representations and warranties are more extensive and contentious, covering matters not usually mentioned in a property purchase. Someone is generally left liable for these expanded representations and warranties that, due to their nature, usually have a longer survival period and greater potential damages. Indemnities, security, and reserves are often required, which some existing owners cannot provide, and which others will not provide. Representation and warranty insurance, or tax insurance, can often fill this gap, although many real estate professionals are not experienced with these products. In corporate transactions this insurance has become widely used.
- In the current environment, projections of future net revenues, capital expenditures, and financing, and requirements for future capital inputs, may be somewhat speculative. Yet the new waterfall and the commitment of the new investor are harder to negotiate without some consensus on these items.
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Originally Published by AFIRE's Summit Journal
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
