Structuring Real Estate Deals can be tough and tricky sometimes. Many investment managers struggle closing a real estate deal due to limited knowledge of the subject matter. In this post we will try to see how a real estate deal can be structured for a win-win situation.
Despite the subprime crisis, investments in the real estate assets have become one of the most attractive propositions in the recent time. In the emerging markets, private equity investment in the real estate assets has increased many folds over the last five years period.
Apart from directly owning real estate property, there are various instruments available to the investors - property derivatives, REITs, real estate funds and numerous debt instruments are few to name. These instruments offer different risk/reward features and have different liquidity characteristics.
In this post we are going to discuss, as an investor, what parameters should we consider before investing and how to structure a real estate deal.
How is this post structured?
This post is structured in question & answer format. As a real estate investor you should be asking these questions.
Ok, let's get started.
What are the portfolio-level implications?
You must be asking yourself how this particular investment is going to correlate to your existing portfolio. How this investment is going to impact the risk/return characteristics of your existing portfolio?
As pointed above there are direct and indirect investment opportunities in real estate through various instruments. You can invest directly in real estate asset or you can invest via indirect instruments with real estate as underlying collateral. These range from synthetic instruments, indices, mortgage-backed securities, collateralized debt obligations (CDOs), collateralized loan obligations (CLOs), real estate investment trusts (REITs), to mortgages, and real estate funds.
Some of these assets may correlate well and enhance your existing portfolio objective and some others may not.
What are asset-level characteristics of this investment?
You have shortlisted a few real assets and other instruments which correlate well with your existing portfolio. The next step is to analyze each short-listed assets for the followings:
Risk/return profile: What is the risk/return profile of each asset? How much you can lose in the worst situation and how much you will make in the best situation? If the worst happens, can you live with the loss? If you can't tolerate the outcome of the worst situation, you should remove this asset from your shortlist immediately.
Liquidity Profile: What is your liquidity preference? Some of these real assets and other derivatives can become illiquid in the worst situation. Can you live with it? How does the liquidity profile of the shortlisted asset correlate with the liquidity profile of your overall portfolio?
Sensitivities: Now you know the outcomes of the worst and the best situations. Now you should find the most likely situation, it can be somewhere between these two extremes. You should do some sensitivity around these.
Risks and performance drivers: By now your shortlist should be really short. You should be left with 2-5 assets. What are the risk and performance drivers of these assets? Do you have any type of control over these drivers? How much control the counterparty is willing to give you? You should select the assets which give you some kind of control over these drivers. It may also happen that none of these shortlisted assets give you any kind of control over risk/performance drivers; but this is ok. Your preference should always be to have some control.
How do I invest?
Real estate deal structuring is all about identifying and mitigating risk; thus, it is critical to consult with experts for legal, market and technical due diligence.
How do you invest also depends on your domicile, tax status and the country you wish to invest in. An institutional investor from USA is subject to a different tax environment than an institutional investor in India. Individual investors are subject to different set of taxation rules.
You should be asking yourself what is the most appropriate form of the legal ownership of the assets you have shortlisted. What can be the most tax-efficient legal structure and are your interests aligned with the counterparty'[s?
How much do I invest?
This decision depends on two factors - your financial capacity and the diversification you want in your existing portfolio.
Your risk tolerance also impacts this. You want diversification but don't want to increase your risk level.
With whom do I invest?
Selecting the counterparty for your investment can be tedious. Even the best documents cannot mitigate your risk of selecting the wrong counterparty. You should be very careful. You should be asking - who is the counterparty? What is their reputation in the market, are they best in the industry and can you develop certain level of trust with them?
What do I get for my investment?
By now, you must have developed preference for certain assets from the shortlist, and would like to finalize a few. But still we have long way to go. In this section we will be discussing the nitty-gritty of the investment. Some of these may have legal implication and you may want to consult a legal expert for advice.
Term: Most of the private investments in the real estate have a finite life. The exit is pre-defined with certain extension clauses. You should be asking - Does the term of the investment fit well into your existing portfolio? What are the terms for extensions? How will the event of extension impact your liquidity preference? Can you sell this investment to a third party before the maturity or during the extension period?
Counterparty's skin in the game: What is the counterparty contributing, and in what form? If the contribution from the owner is land, how is that valued? Is there any clawback provision?
Preference: Are you getting any preference as an investor? It means a priority or preferential return on your investment before the counterparty receives any available cash. What happens when there is insufficient cash to pay the preference? Are the unpaid preferences not paid or accrued; and if they accrue, do they do so at a simple or compounded rate in a monthly, quarterly, or annual form?
Distribution: What is the distribution formula after preferences are made? Are there any hurdles or waterfall events? How are they calculated? How and when is original capital returned? Before or after the preferences? Before or after the distributions?
What Protections Do I Have?
There are generally four types of protection: 1. the fee structure, 2. the guarantees, 3. the clawbacks & creeping equity provisions and 4. the control provisions.
You should be asking these questions - What are the fees being paid to the counterparty? and in what form, and how? There are numerous ways the counterparty can make money in a deal at the expense of the investor. Counterparty can charge Asset management fee, Property management fee, Credit enhancement fee, Leasing fee, Project management fee and Development fee. You should be careful and read the full document and seek expert advice if necessary.
As a passive investor you need protections. Most of the times, the counterparty provides various types of guarantees for which they may charge a fee. The Project completion guarantee is the most common of them. There can be others like performance guarantee.
What are the penalty provisions allowing you to creep into the equity of the counterparty?
What are the anti-dilutation provisions? If there is a cash shortfall of any kind, what can the counterparty do to recapitalize? Can the investor be diluted?
What are the control mechanisms? What items need a majority or super-majority (75%+) of investor vote? Critical decisions like approval of business plans or changes to a plan, material budget variances, major leases and sale or refinancing transactions should require a majority.
Exit - When and How Do I Get Out?
Most private investments in real estate have pre-determined maturity date. There can be extension clause. As a good investor you should know your exit strategy before you investment.
Exit mechanisms come in many forms. Exits could be in the form of dividend distributions, sale of shares, sale of asset, interest payments on debentures, refinancing, or all of the above.
In certain circumstances, investors and counterparties use a forced sale to an independent third party or a buy-sell between the parties.
If your objectives and counterparty's objectives are not aligned, there can be delay in the exit. For example, the counterparty may value the fee stream as opposed to realization on a marginal deal.
You should also be asking - What are the obligations of the counterparty to liquidate the investment? When and how can you as investor force liquidation?
These are the steps to be followed to structure a real estate deal and before investing in any real estate asset or any other instrument with real estate asset as collateral.
Hope you enjoyed the post. What do you think, use the comment section below.