I am writing about investing dollars – and receiving dollars – in real estate, and seeking to answer two questions:
- Where are you Overpaid for Risk as an Investor?
- Where are you Underpaying for Capital as a Sponsor?
Overpaid for Risk
There are often times when Investors have the chance to be Overpaid for Risk. These occur usually as a result of extraneous factors, including:
- Media over-hype/under-hype holds sway
- A major challenge to the asset class
- Investors are shunning the asset class, making capital raising difficult
- General macro forces, such as political unrest, etc.
For me, at least, it is pretty easy to see where to get overpaid for risk, since it is almost always in the places where I find it difficult to raise capital. Here is what is being shunned that I see as opportunities:
Office – many locations, including NYC – have already started to boom, but I still think most investors are shunning this asset class, hence opportunities are still there.
Development – I think out of 100 potential Investors for a deal, over 90 and maybe even over 95 of them will not be open to development deals. There is a desperation from Sponsors to get this capital and they will offer an awful lot for it – with IRRs targeting the twenties and even the thirties – but there are few takers.
Small deals – these are still harder to put together than large deals due to the hassles of doing them. As investment pools get larger, everyone is forced towards larger deals, which have worse risk/reward profiles.
Providing Up-Tier Capital to Developers – Sponsors are perennially short of cash and optimistic or even over-optimistic about their business prospects. This leads some of them to be open to taking debt – usually structured as preferred equity to avoid consent requirements – at the up-tier level, i.e. at the top of the company’s capital stack. There are risks here, as there are no hard assets as security, which weeds out almost all capital providers. Those willing to take the risk are richly rewarded with excellent terms.
Underpaying for Capital
These are places where a Sponsor should be hunting for capital, as there is a lot of competition to provide it:
Preferred equity/high-yield debt – in the past, there was an equilibrium of parties in this space, but over the past five-ish years almost all of the equity providers have moved into this space, which has made it extremely competitive. Sponsors typically seek pari passu capital, but my sense is the risk/reward profile merits them taking this type of capital if the cost is not too high. For example, taking some of the sought-after LP capital and turning it into preferred equity. I note that the Investor gives up its upside for downside protection in return for which the Sponsor’s upside is even higher. And if the project is a dud, I doubt that the difference between having lower overall leverage is going to save the day anyway.
C-PACE Financing – it cannot be used all the time due to the restrictions on its availability; however, it is fantastic for the Sponsor in a workout situation since the C-PACE financing is so much less expensive than rescue capital, which costs a proverbial arm and a leg. There are other uses for it too, including sometimes obviating the need for a first mortgage at all. There are a bunch of subtleties, but overall I advocate that this should definitely be in the Sponsor’s toolbox.
Long-term assumable debt – I love long-term debt for a Sponsor since most of the time what goes wrong is a maturity date default when times are troubled. Long-term debt takes this off the table. Of course, it is critical that it be assumable and prepayable. Then heads the Sponsor wins, tails the Sponsor also wins.
Both
There are also some areas where I think the Sponsor can be Underpaying for Capital and, at the same time, the Investor is Overpaid for Risk. I believe the reason for this is that these transactions are complicated to put together. These are five that come to mind:
Ground Leases – I have said before that I perceive ground lease financing as a tectonic shift in US real estate that is going on right under our noses. I think that most real estate players still don’t realize the power of ground lease financing, which overall shrinks the need for capital in the applicable transaction. Ground lease financing, I think, goes both ways from a risk/reward perspective, by which I mean that it both allows the Sponsor to get less expensive capital and at the same time allows the Investor to be Overpaid for Risk.
Platform Investments – I guess this is the most complicated and high-risk investment profile, but since it offers the most upside for the complexity, I think it is solidly in the Overpaid for Risk camp, yet at the same time it is the best way for the Sponsor to Underpay for Capital. This involves investing in – or taking full ownership of – a real estate platform.
GP Capital – this is a tricky area and requires a good deal of savvy about (i) real estate transactions with a multi-level capital stack, (ii) interlocking joint ventures, (iii) legal risks, and (iv) creativity about keeping legal costs under control; however, for those who really understand the joint venture space, the Investor can be Overpaid for Risk and at the same time the Sponsor can be Underpaying for the Capital. To maximize the benefit here I suggest the parties consider this with a twist, which is to take more GP Capital dollars into the Sponsor than usual. What I mean is that typically a Sponsor seeks a so-called 90/10 deal with its LP. This allows the GP Capital provider to get its share of the promote without a lot of dollar investment. This is a negative for both parties since the GP Capital provider has to spend a great deal of time and dollars for a small investment, plus the Sponsor is giving up a part of the promote for a small investment. However, if the deal with the LP is, say, 75/25, then the GP Capital provider has to put up more money to get its cut of the promote. This shrinks down the needed LP money and at the same time increases the bargaining power of the GP in negotiations with the LP.
Power Niches – Power Niches are a place where the Investor can be Overpaid for Risk and the Sponsor can be Underpaying for Capital. The heart of it is that the Sponsor and the Investor are, together, creating value as opposed to seeking it. I note (again) my warnings here from prior articles – e.g. You Will Never “Find” a “Good” Deal Again – and You Will (Definitely) Never “Find” A “Good” Deal Again - Redux – and emphasize that they are even more current. AI is eliminating competitive advantage and equalizing risk factors in most typical real estate transactions.
Operating Businesses Mixed With Real Estate – I love this as a place for both — the Investor gets Overpaid for Risk and the Sponsor gets to Underpay for Capital. And the simple reason is that most real estate players simply refuse to be in these types of deals, which shrinks the competition. When it is a new-ish business people shun it, but then when it becomes more ubiquitous, more jump in. Hotels were this kind of thing long ago, but now they are everyday. And dare I say Data Centers are the latest in this space.
So, there you have it. The Real Estate Philosopher’s thoughts about where to be Overpaid for Risk and at the same time where to Underpay for Capital.
Finally, on behalf of my law firm, Adler & Stachenfeld LLP – www.adstach.com – I cannot help adding that every single one of the above investment profiles is in the heart of the firm’s expertise. We have partners with in-depth experience on all of these matters and do these deals every single day.
I wish everyone in my beloved real estate industry the greatest success.
Bruce Stachenfeld, aka The Real Estate Philosopher™