A Long and Winding Road to Equity

by Todd McNeill, Senior Director

Commercial real estate buyers call our firm daily with the next greatest deal that needs to be purchased with a fast “look” and a quick Winding-Road“close.”   Unfortunately, most of these deals don’t come to fruition due to the timing of the trade and the buyer’s lack of deep pockets to move quickly.

Invariably, this discussion evolves to the next level of what a buyer can expect if he needs to locate a partner to provide a majority of the equity to purchase the property or develop a project.  While there is not necessarily an absolute “operating manual” on how to structure joint venture equity investments, there is a general “road map” that provides a guide as to what to expect when you need to bring in an equity partner for your real estate acquisition.

The journey starts with being considered an expert, or at the very least, having a solid track record in the property type you are considering.  It is difficult to ask an equity source to put the lion’s share of the equity into a retail development when the sponsor has no retail experience.  You would be surprised how many times we get solicited from a sponsor known for multifamily trying to buy an office building or, the successful office building developer who is suddenly an expert in the field of medical-oriented developments.

A sponsor’s willingness to put his own cash in the deal correlates to the classic “Skin in the Game Theory.”  This does not mean simply signing up for recourse on the debt side.  Bringing the appropriate financing to the table to complete the business plan is the responsibility of the sponsor.  To the extent that the financing requires recourse is dictated by the market and you are recourse averse, then there are certain deals that you should not consider.  Skin in the game to equity players is usually a 10 percent co-invest by the sponsor that sits parri-passou (side by side) with the joint  venture equity investor.  If you are not prepared to make an investment into the same deal you are promoting to others, then your efforts will usually result in a very quick “pass” by the equity markets.

Moving along the road map, you must be able to procure the debt financing that is needed to complete the capitalization.  Buyers/borrowers that have multiple foreclosures where bankruptcy was utilized, a personal bankruptcy or several maturing loans that cannot be refinanced in the current market need to look at bringing in additional or substitute guarantors.  Today’s joint venture equity does not want to sign on bad-boy carve outs or sign up for recourse whereby the equity provider would have risk on both the equity and debt side of the transaction.

Since real estate acquisitions are usually a leverage play, the answer is never as simple as “find me a partner that can close for cash and then we don’t need a loan.”  A pit stop for leverage will be necessary somewhere along the road to securing a suitable equity partner.  It is rare when a real estate deal can make it to the finish line on one tank of equity.   Equity investors are always focused on the exit strategy and rarely invest when exit by sale is the only alternative.  Even if an equity provider agrees to close for cash, they will want to be assured they can leverage a good portion of their investment in the not too distant future.  Moreover, leverage will “torque” the returns allowing the sponsor to achieve a lower overall cost of capital as well as increasing the ability of the Sponsor to negotiate a more favorable promote structure.

Ultimately, the road map will lead you to the final destination… the negotiation of the sponsor’s “promoted” interest in the deal.  If you get beyond the early stops along the journey (i.e. experience, co-investment and appropriate leverage) and the deal is properly priced, you will have a very high degree of success in finding a suitable joint venture equity partner and arriving with a favorable promoted interest in the deal.  Most joint venture equity underwrites to target an Internal Rate of Return (“IRR”) in the low 20’s depending on risk variables.  Riskier deals tend to move north of 20 percent on the IRR scale.  In the good ‘ole days, sponsors became accustomed to getting a 50/50 split between equity and the sponsor after a ‘Preferred Return’ in the 8 percent to 10 percent range.  In today’s environment, it is not uncommon to see an equity proposal with a 25 percent to 30 percent promote (vs. the old days of 50/50) until an 18 percent to 20 percent IRR on the Equity Investment is achieved.  Upon achieving the 18 percent to 20 percent hurdle, only then do you see the splits of yesteryear (i.e. 50/50) come into play.

These days, equity providers are particularly interested in hearing about distressed deals, foreclosures, note purchases and recapitalizations.  Transactions with an opportunistic twist, a compression of the existing debt or equity stacks and value-added stories seem to get the fastest returned calls and multiple bid traction.  Equity providers are also beginning to come out of their fox holes on development projects with the most interest in multifamily and healthcare-oriented projects.  A few residential lot development deals are also beginning to make sense.  Office and retail development will require preleasing to raise the eyebrow of interest from the equity markets.

In summary, don’t get sticker shock when you see equity providers offering a reduced promote to the sponsor along with requiring the sponsor’s own “skin in the game.”  The pendulum will begin to swing back the other way as more equity providers return to the market and competition for deals increases.  However, equity is still in a recovery mode.  Equity providers remain very sensitive to proper alignment between the equity provider and the Sponsor.  The best way to achieve proper alignment is by insisting on sponsor equity along with minimum IRR hurdles on ALL the equity.  In return, the sponsor should be handsomely rewarded with an extra slug of promote when IRR hurdles are achieved.  Accepting this reality is the best way to create a “win/win” and put your deal on the fast track to getting closed.

Want to learn more about structuring joint venture equity investments, contact Todd McNeill, Senior Director.

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