There continues to be very strong demand for high-quality commercial real estate. From 2011–2015, the volume of commercial real estate transactions nationally grew at an annualized rate well in excess of 10%, and projections for the next 24 months suggest that transaction activity may again approach the levels seen at the height of the market back in 2007. While there is a combination of factors that have fueled this resurgence, including historically low interest rates, reduced vacancy, rental growth following years of stagnation, and large amounts of capital looking to be placed, the end result has been clear… much greater competition among potential purchasers that are chasing deals and a spike in prices being paid. The biggest challenge many real estate investors are facing is that there are just too few well-positioned assets being marketed for sale, and there are just too many other bidders looking to buy these properties at extremely aggressive prices.
For many buyers looking to pursue new investments in such a competitive market, the primary tactic being used to secure potential acquisitions is through multiproperty portfolio deals. From a seller’s perspective, portfolio deals allow for the sale of struggling and less desirable properties that are often pooled together with prized, high-demand assets. Portfolio sales also potentially reduce the time and transaction costs that might otherwise be required to sell numerous individual properties on a one-off basis. For a buyer that might otherwise be outbid on a single property, portfolio transactions can provide greater potential returns and possible discounted pricing based on the volume of the overall deal. Of course, the buyer is then often stuck acquiring additional challenged real estate that may be in a poor location, have environmental concerns, require retenanting or redevelopment, or have other red flags.
Structuring a Portfolio Transaction
Whether a deal involves two properties or 20 or more properties, acquiring multiple properties brings about many additional challenges and unique considerations than are encountered when just a single asset is being purchased. Perhaps the biggest initial question the parties will face is if the portfolio transaction will be an all-or-nothing deal. A seller typically wants to ensure that a buyer is going to acquire each property in the portfolio, effectively being forced to take the good with the bad. From a buyer’s perspective, they may need the flexibility of being able to drop one or more assets from the deal, especially if circumstances arise that are beyond the buyer’s control.
For example, if a piece of real estate is subject to a casualty or condemnation action, can the buyer kick out that property from the deal? Similarly, what if previously unknown environmental contamination is discovered, a major anchor tenant at a certain property was to declare bankruptcy during the course of the transaction and look to terminate its lease, or the seller provided inaccurate representations in the purchase agreement as to a specific property? In all these circumstances, a buyer may want the right to remove a property from the deal so as to avoid incurring significant transaction expenses only to have one unexpectedly “rotten apple” spoil the entire deal right before closing. Conversely, a seller would push to force the entire portfolio to remain a package deal, especially since the best assets are typically priced at some discount, and it is that very discount that is intended to compensate for the added risk surrounding the less desirable properties that a buyer is expected to acquire.
The parties also need to determine if a straightforward real estate transfer is most appropriate, or if the transaction should be structured as a stock or membership interest purchase where the actual ownership entities are acquired. This issue is often largely dependent on how the selling entities are owned and structured. The parties should also carefully review the tax considerations that come into play, the buyer’s proposed debt and equity sources, and if there will be an assumption of any existing loans or other liabilities.
Another key issue to initially address will be how the aggregate purchase price is allocated across the various properties. Again, prime assets will often sell at some discount in exchange for the purchase of second-class assets that are in the portfolio. However, it may make sense to spread the total pricing across the properties in a manner that better promotes tax and transaction cost efficiencies. For example, transfer tax rates, title insurance premiums, and mortgage tax applicability vary across jurisdictions and should be considered when allocating pricing.
Furthermore, current and future real estate tax rates and property assessment values should be reviewed across the portfolio so as to not inadvertently trigger significant property tax increases on certain assets.
The structure of the selling entities across the properties will also be an important factor in negotiating a portfolio transaction. Should there be a seller default during the course of the transaction, or should there be a post-closing breach of a representation or warranty made by a seller, a buyer will typically push to have all the selling entities jointly on the hook for any potential liability. However, if all the selling entities have ownership structures that don’t mirror each other, or if the selling entities are part of a joint venture among unrelated parties, then those selling entities may be unwilling to allow for joint liability.
Juggling Due Diligence and Loan Issues
Perhaps the greatest challenge on a sizable portfolio transaction is coordinating the due diligence needed to review a large number of properties in what is often a very condensed period of time. It is not uncommon for portfolio buyers to have only 30 to 60 days (and sometimes even less) to review all aspects of a pool of properties, including title status, environmental, property condition, zoning and leasing matters. Given these time constraints, it is crucial to have your diligence team assembled quickly and to rely on a team of third-party service providers that can facilitate the process, while also maintaining comprehensive diligence checklists throughout the transaction. Also, to the extent the properties are spread across several different states, then local counsel may need to be obtained at the outset of the deal.
If much of the necessary diligence materials can be compiled and thoughtfully organized by the seller when the properties are first being marketed for sale, that can also help streamline the diligence process.
To avoid getting bogged down by the vast amounts of information to be reviewed and synthesized in such a short period of time, it is important that buyers focus on those crucial issues unique to the portfolio that may present the greatest risk of exposure or lost value. Each deal may have different primary considerations that demand immediate attention, whether it is focusing on potential third-party or tenant purchase rights, property condition matters, opportunities for add-on development, or potential leasing issues (including violations of existing tenant exclusives, ongoing cotenancy requirements, and leakage on tenant reimbursements of property expenses). The key is understanding what those critical issues may be on each different portfolio deal very early in the process. Many of these issues can also be examined during diligence through estoppel requests, although sellers will typically push to limit any estoppel requirements that might otherwise impede a potential closing.
Financing is another key item typically addressed during diligence, although many buyers will have this largely resolved even before bidding on a portfolio so as to make the buyer’s bid more attractive. If a large equity raise is required, if many different lenders will be involved on the transaction, or if existing loans are being assumed, this can make the overall deal much more complicated and can add to the time and expense necessary to get the deal closed.
Getting Over the Finish Line
Closing portfolio transactions presents another unique set of issues. Depending on the number of properties involved, the sheer volume of closing documents to be signed and delivered may require lengthy planning and careful coordination. Also, will all the properties close simultaneously (which may be imperative on an all-or-nothing deal), or will there be a staggered closing in stages? Many buyers often look to immediately flip portions of a portfolio to unrelated third parties, which then also brings additional parties to the closing table and may complicate funding issues and the closing process.
Furthermore, the greater the number of properties that are part of the portfolio, the greater the chances are that there may be ongoing work or repairs at a property at the time of closing, or that new leases are in the process of being put in place as closing occurs. Accordingly, the parties may need to address whether seller will retain, or buyer will assume, the responsibility for some or all of such ongoing work and tenant leasing costs. Additionally, Mechanic’s Lien issues will need to be resolved from a title insurance and lender approval perspective based on any such ongoing work.
As portfolio transactions continue to be prevalent in the market, buyers can realize significant gains but will also face many unique obstacles and risks to be overcome that are not typically found on sales of single properties. With careful planning and a strong team in place to manage the transaction, portfolio deals offer the chance to acquire prized assets that might otherwise be difficult to secure in today’s real estate market.