Real Estate Fund Recapitalizations, Redux

June 2020

When bad balance sheets happen to good managers, an article by StepStone’s Jeff Giller 

In some ways, the global financial crisis seems like yesterday; in other ways, it feels like it was ages ago. “Stay alive till ’95” was our battle cry— wait, no, that was from the savings-and-loan crisis three decades ago. Time does fly.

With the inevitable real estate market crash we’re now staring in the face as a result of the COVID-19 pandemic, this will be the second major real estate recession for our colleagues starting to show strands of gray hair, and the third for those of us truly graying or gray who have gone through both the S&L and global financial crises.

Until March, I was certain we had another five to seven years before the next major downturn. The global economy was in good shape, real estate operating fundamentals were strong, supply was in check, and properties were generally not over-levered. Despite conventional wisdom that up cycles only run for seven or eight years and we were due for a market correction, I am a firm believer in the real estate market supercycle: market up cycles that run for 15 to 17 years, usually with a couple of relatively minor and survivable corrections in the interim (i.e., 1973–1990 and 1993–2008).

So, like many of us, I thought the market still had some time to run; boy, did I get that wrong! We were keeping our eyes on a number of factors, including trade wars, the economic impacts of global warming, and exploding levels of national debt. My team takes risk analysis very seriously, but the “pandemic causes the global economy to shut down” downside sensitivity case somehow slipped past us.

Toward the end of 2010, I wrote an article for this publication titled “Real Estate Fund Recapitalizations: When Bad Balance Sheets Happen to Good Managers,” which discussed ways to deal with the pervasive illiquidity fund managers were facing in the wake of the global financial crisis. The publisher of Institutional Real Estate Americas and I thought it could be interesting to dust off the article, see how history is likely to repeat itself and update the piece to address the current situation. I am not sure if history is going to repeat itself exactly, but I am quite certain it is going to rhyme, so we’ve decided to run most of the article I wrote during the global financial crisis — with a few minor adjustments noted with elisions (…), strikes and [brackets]. Although the precipitating crisis has changed, the impacts of distress and dislocation will be similar, and the choices faced by fund managers will be largely the same.

Bear in mind, as the article was written in the thick of the global financial crisis period of distress, its orientation will be prospective; in other words, think as if you’re reading this six to 12 months from now.

I am not sure if history is going to repeat itself exactly, but I am quite certain it is going to rhyme.

Real estate private equity funds have a big issue: They need more capital, and it’s not that easy to get, at least not anymore. …Until recently, obtaining equity or debt capital was relatively easy for funds, but now it is scarce, and scarce at a time when funds need capital the most. In this post–credit crisis [COVID-19 pandemic] environment, it is generally understood why fresh capital is so scarce, but why are real estate funds now so in need of capital? With all the money made available to them in their newly mega-sized funds, shouldn’t  managers have set aside sufficient reserves to cover their investments’ long-term capital needs? Managers did in fact, set aside enough reserves to carry their investments for their intended three- to five-year holding periods, but they were unprepared for the significantly longer holding periods brought on by the sudden freeze in transaction activity. In addition to being under-reserved, managers financed their investments with short-term debt to match their intended short-term holding periods, and that debt is now maturing. Not only were managers unprepared for the longer-than expected durations of their holds, but they were equally unprepared for the devastating impact that the precipitous fall in property values would have on their balance sheets

.… After 2007 [first quarter 2020], when market activity ground to a halt and values dropped, real estate funds were left holding large portfolios of over-levered properties that had become in breach of their loan-to-value debt covenants, had impending debt maturities, and did not have enough capital to continue to carry their assets or fund their business plans.

How will these challenges be addressed? As in all market troughs, the real estate market today is not only replete with problems that need to be solved, but also opportunities that can be seized by savvy managers with a war chest of fresh capital. Below is a discussion of the critical uses that funds in today’s market have for fresh capital, both for defensive and offensive purposes, followed by a brief overview of the potential sources of this capital and structures of recapitalization facilities.

Defensive capital needs

Paying off maturing debt and funding equity gaps: Although lenders are now starting to get back into the business of making loans, they are sizing their advances at very conservative loan-to-value (LTV) ratios. … Applying these lower LTV ratios to property values that may have fallen by 30 percent to 50 percent from the time they were originally financed results in refinancing proceeds that fall substantially short of the amounts required to pay off maturing loans. The difference between the refinancing proceeds and the amount required to pay back the original loan is referred to as the “equity gap,” and funds that want to avoid foreclosure must find the capital to fill it. …

Paying down maturing debt to secure term extensions: Lenders may be willing to grant term extensions to borrowers with maturing loans but, as a condition, often require some sort of a principal pay down. Therefore, funds are in need of capital to extend maturities and avoid foreclosures.

Covering property and fund-level carrying costs: With operating cashflow lower than originally projected and an inability to sell properties at the right prices to generate liquidity, a number of funds require capital infusions to cover property-level carrying costs and fund-level management fees and costs.

Buying out or covering obligations of defaulting partners: Fund managers may require fresh capital to cover shortfalls caused by limited partners who are unwilling or unable to fund their future capital commitments.

Opportunistic capital needs

Buying back debt at discounts: As banks’ earnings and capital reserves continue to improve and regulators begin to increase pressure on lenders to mark their loans to their actual market values, the days of “extending and pretending” seem to be moving behind us. As a result, lenders are increasingly able and willing to sell their loans to borrowers at discounts. These so-called discounted payoffs create a win-win by allowing lenders to improve their risk capital ratios by removing challenged loans from their books and, at the same time, allowing funds to restore some of the equity lost through the market value decline. With credit markets  now loosening, a fund’s challenge is not so much to find sources to refinance loans as to find fresh capital to fund the equity gaps often required to take advantage of discounted payoffs.

Executing value-added business plans: In most cases, fund managers intended to finance value enhancement projects, such as property development, renovation or tenant improvements, with debt or equity reserves. With debt availability for these uses still constricted and equity reserves depleted, managers must seek alternative sources of capital to finance these sorts of accretive activities.

Making opportunistic acquisitions: In certain circumstances, funds may benefit from taking advantage of the distress in the market by raising fresh capital to make strategic acquisitions or to enhance the value of their existing assets.

Potential sources of fresh capital

Although the credit crisis appears to be waning and institutional investors seem more open to making new investments, fresh capital for fully drawn funds is still relatively hard to come by. The potential sources of fresh capital for real estate funds, and their merits and challenges, are discussed below.

Limited partners’ undrawn commitments: There is an estimated $30 billion [$314 billion] in undrawn capital commitments outstanding in real estate funds … that could potentially be drawn to provide the much needed fresh capital to funds. … But even if undrawn commitments from fund limited partners did provide sufficient liquidity to solve funds’ capital requirements, another problem exists: Some real estate fund investors either cannot, or simply will not, make additional contributions to funds, contractual commitment or not. Those that cannot fund are often suffering from their own liquidity constraints due to poor performance across their investment portfolios, and declines or delays in the timing of distributions. Those that can but will not fund often express a reluctance to continue to invest in funds that have delivered poor performance and are nervous about suffering even further losses by putting good money after bad.

New commitments from fund limited partners: One of the most obvious sources of fresh capital for funds is their existing limited partners. The advantage to procuring fresh capital from existing limited partners is that they are already familiar with the manager, the fund and its assets. The challenges, however, are many. Most institutional investors have lengthy and cumbersome approval processes, they are typically not staffed to conduct deep ground-up due diligence and make asset-level investment decisions, and it requires the consensus of all participating limited partners to effectuate a single recapitalization transaction. As such, in many cases managers have elected to pursue third party recapitalization sources to avoid the complexity and execution risks of transacting with their existing limited partners.

Real estate private equity funds have a big issue: They need more capital, and it’s not that easy to get, at least not anymore.

Traditional lenders: Although some lenders are now back in the market and extending credit for high-quality, conservatively leveraged acquisitions, debt remains elusive for transitional assets requiring funds for capital improvements, leasing costs or to refinance near-term maturities.

Liquidating assets: Although some funds are selectively selling off assets to raise capital for defensive purposes, most managers seek to avoid disposing of assets in a market bottom. Also, contractual limitations on recycling capital can preclude managers from reinvesting sale proceeds.

Recapitalization facility structures and pricing

Fund recapitalizations are typically structured as either subordinated debt or preferred equity. In either case, the proceeds are usually the last money in and the first money out. In other words, repayment is senior to distributions to limited partners but subordinate to secured asset level debt or fund-level subscription financing. Whether or not, and to what degree, a facility’s return on capital is also senior to the limited partners’ distributions is subject to negotiation. Because most fresh capital is being invested into highly levered positions (often as high as 80 percent to 90 percent of the real market value of thefund) and is typically not secured by properties, risks are more equity-like than debt-like, and therefore, facilities are typically priced similarly to opportunistic equity.


Most real estate funds require some form of fresh capital today, and this need will only increase over the next two to three years, even if property values stabilize. A fund-level recapitalization can be used to fend off impending foreclosures or to avoid forcing managers to sell assets into the bottom of the market to raise capital. However, the unfortunate truth is that some funds’ equity is so deeply underwater that life support is not the right solution. To determine whether recapitalization proceeds will create value or be tragically

With operating cashflow lower than
originally projected and an inability to sell properties at the right prices to generate liquidity, a number of funds require capital infusions to cover property-level carrying costs and fund-level management fees and costs.

lost as good money after bad, potential investors must conduct a detailed, bottom-up analysis of each asset in a fund, including a determination of its present and future liquidation value; its cashflow profile and risks; its lease rollover and tenant-quality profile; its debt-level, debt-maturity, debt-covenant and cross-default provisions; and its fund-level actual and contingent liabilities.

When evaluating the opportunity to recapitalize a fund, it is critical for the investor to be certain that there will be sufficient future distributable proceeds to return the new capital advanced and the intended return thereon because no matter how attractive the stated yield, it is absolutely meaningless if the fund’s equity is at risk of falling underwater.

[Now back to the future: How it rhymes

We’re entering this downturn from a better position.

Most real estate professionals came out of the global financial crisis as more prudent and conservative investors, and as such, we are entering this downturn on more solid footing. By way of example, U.S. commercial real estate vacancy rates averaged 7.5 percent in first quarter 2007 compared to 5.3 percent in first quarter 2020, and comparing the same periods, leverage averaged nearly 70 percent then versus 62 percent now, and debt-service coverage ratios averaged 1.9x versus 1.4x. That said, the unprecedented immediate shutdown of the global economy (more than 36 million unemployment claims, consumer spending down 20 percent, and industrial production down 11.2 percent in April alone) could result in a much deeper recession and quickly erase the benefits of real estate’s stronger starting point.

We have learned from experience.

As we have seen from early and decisive actions like the TALF initiative, governments around the globe have learned a lot about how to blunt the blow of a major recession with fiscal and monetary stimulus. Similarly, institutional investors and real estate professionals are much better at this than they were in 2009.

Last time around, many LPs froze and could not or would not advance unfunded commitments, even to protect properties, much less lean in to new investment opportunities. Today, even with distributions drying up, most LPs seem to have adequate liquidity to meet their unfunded commitment obligations, and many are anxiously awaiting the opportunity to lean into the market and invest at lower pricing.

Real estate professionals have also learned a lot. There were 17 years between the savings and loan crisis and the global financial crisis, which meant many seasoned professionals had forgotten how bad things could get. Also, a large number of professionals that had reached senior ranks in the industry had never been through a severe downturn and seemed to operate with a view that real estate values could only go up. As a result, there were a lot of monumental mistakes made that cost GPs their assets if not their businesses during the global financial crisis, and solutions were being invented on the fly. By contrast, with the global financial crisis in close sight in our rearview mirrors, almost all mid to senior-level professionals have the playbook, and seem to know the plays to make.

There is a lot more capital in the market.

While liquidity was a significant constraint during the global financial crisis, there is an unbelievable amount of capital on the sidelines ready to take advantage of the impending distressed market. With an estimated $314 billion of dry powder in real estate funds alone, more capital being raised, and non-fund capital from sovereign wealth channels around the globe anxious to invest, bidding wars are likely to be prevalent, cap rate levels are likely to remain sustained, and prices may not drop as far as many think.]

Institutional Real Estate

Copyright © 2020 by Institutional Real Estate, Inc.

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