Anyone in real estate with financing coming due within the next 12 to 18 months is struggling with the uncertainty of where needed debt and equity will to come from – and at what cost. Do they find a way to stay in the investment, or is now the time to exit?
Such financing discussions are the topic of the day across the commercial real estate industry, and those conversations take a different course depending on the situation. “It really depends on where the specific investors are positioned in the market as to whether they view this current environment as an opportunity or a risk,” says Kurt Koegl, CPA senior real estate tax partner in the New York Office of Marcum LLP, a top-ranked national accounting and advisory firm.
Koegl specializes in real estate transactions, partnership taxation, REIT compliance, and fund structuring and planning. These days, much of his attention is focused on helping clients navigate the risks and opportunities emerging in the dynamic capital markets environment across a full spectrum of issues ranging from tax to recapitalization and new fund formation.
There is no “one-size-fits-all” approach to recapitalizing deals. Given the current economic circumstances, every situation is different, and each property or fund needs to be analyzed separately to determine the best course of action going forward. “The most important thing when forming a new fund or going into a deal is that you make sure you have your advisors involved on the forefront,” says Koegl.
“It’s always easier to figure things out in advance than to try and unwind it after the deal is complete or almost complete.”
Raising fresh capital
Certainly, there are examples of ownership groups considering handing keys back to their lender. Others are looking to do recapitalizations where they’re bringing in new equity to make up that gap between the financing that they had and the financing they can currently secure given the decline in values and the higher interest rates. “For some of the longer-held assets, those recapitalizations are accretive to value. Even though values have declined in the last 12 months, they have still appreciated over the last five years,” says Koegl.
Koegl has worked with a number of clients this year who are recapitalizing their investments and are finding different and unique solutions to financing challenges. In one case, a mid-sized investor group chose to conglomerate a pool of assets into a new fund to provide diversification and a more attractive pool of assets to attract new investors.
“To the extent that existing investors are looking to exit because they’re hitting the end of the investment period, they’re offering them the opportunity with a recapitalization monetization event,” says Koegl.
The sponsor takes in cash from new investors to buy out existing investors who want to exit. Investors who want to rollover their investment can stay in the deal with no tax consequences and have their capital “upsized” based on the property’s fair market value at the time of the recap. A recap transaction also allows the sponsor to crystallize some of their promote or carry in the form of cash or LP equity. “Recapitalizations are a good way to accomplish multiple goals. Sponsors get paid out on their promote, new capital can come into a new deal, the waterfalls restart on current market terms, and old investors have a chance to exit the deal or rollover tax-free,” says Koegl.
In another case, Koegl worked with a group with an existing fund of 10 garden-style apartments in the tri-state area that was coming up to its maturity date. The sponsor sold five of those properties in a bulk transaction and held onto the other five that they believed could continue to operate profitably. The sponsor structured a recap transaction that offered its existing investors the opportunity to stay in the deal and resize their capital account based on current ownership at fair value. The new structure also provided a cash distribution to pay the tax burden on the transaction and also provided fresh depreciation deductions in the newly recapitalized fund. They ended up with a 60% rollover rate and a 40% exit rate. The sponsor was able to bring in enough capital and refinancing proceeds to cover the 40% exiting investors and the tax distribution, as well as their carry payment on the deal.
Structuring ‘loan-to-own’ strategies
Debt strategies have become more attractive to institutional real estate investors in the current market. A number of groups have started debt funds or are contemplating starting debt funds, either to generate an attractive yield or to position their capital to acquire distressed assets.
“A lot of funds that were in the formation phase when interest rates started going up still have dry powder to deploy. It’s just a question of finding the deals for that capital,” says Koegl.
Significant capital has been raised to pursue “loan-to-own” strategies – acquiring property through taking out a primary loan or taking a mezzanine debt position as their entry point into a deal rather than a straight acquisition. The opportunity ahead for capital providers is – if things work out, they get a nice return on their mezzanine debt. If things don’t work out, they take control of the property.
Koegl is working with one client positioning to take advantage of opportunities in the hospitality industry. Some hotel operators are either thinly capitalized or have debt coming due and aren’t able to go back to the existing LP capital to pull additional equity into the deal. The client is looking to come in as a mezzanine debt provider as a possible loan-to-own play and has already done a few deals to date. One of those deals was paid off with a premium on the loan, and in another deal, they will be converting into ownership of the hotel.
“I think we’re going to see more people looking towards the debt side as an entry point into real property ownership, and I think there will be more interest in LP capital creating a mezz fund or a rescue capital type of fund that can make those second priority loans to troubled property holders that are looking for help that the traditional lenders or capital markets can’t provide,” says Koegl.
Get advice early
Whether clients are managing risks or capitalization on investment opportunities, Koegl recommends working with a tax advisor early on. When forming a new fund, groups need to make sure it is being structured correctly for the different investor classes, such as taxable domestic, tax-exempt domestic, and foreign investors. Foreign investors, in particular, require different structures depending on the country and source of capital, such as a sovereign wealth fund or private capital group. “Each of those investors has a different tax motivation, and you need to set up different sleeves for investors to come into your fund and provide some significant tax advantages to those investors,” says Koegl. With rising interest rates lowering returns and compressing cap rates and investment returns, good tax planning is more important than ever to preserve or increase post-tax IRR.
The good news is that there are a lot of tax advantages to owning real estate for domestic investors, such as the ability to use 1031 exchanges to exit and defer the gain. “Even if you are exiting a property at a higher interest rate, if the value is accretive, you are still able to pull cash out and make distributions to investors on a tax-free basis,” says Koegl. “So, there are a lot of attractive ways to provide good returns post-tax to domestic investors.”
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