Real Estate sponsors looking to refinance or exit their investments are doing so in a significantly changed environment from when their financing arrangements on those investments were first originated. Notably:
- commercial property valuations have declined c.20% over the past 18 months (and more in certain sub-sectors);
- loan-to-value (LTV) ratios being offered by senior lenders have reduced from 60-65% to 50-55%;
- certain debt providers have a currently significantly reduced appetite for CRE; and
- interest base rates have risen from nominal levels to c.5% for SONIA and c.4% for 3m EURIBOR.
As a result, debt funding gaps are appearing in the market as existing facilities approach maturity. According to AEW, the cumulative debt funding gap will reach €93 billion euros across the French, German, Dutch, Spanish, Italian and UK markets alone across 2023-26.
Unlike the global financial crisis in 2008 (the GFC), where legacy LTVs for real estate financing were much higher, the debt funding gaps today principally pose an equity problem rather than a debt problem. Traditional bank lenders now possess stronger balance sheets owing to more stringent post-GFC regulation and are, because value on most deals is not breaking within the senior debt levels, likely to be able to recoup their debt and costs on enforcement. Instead, the challenge (given the reduction in transactional activity and the falls in value) will be for the significant number of sponsors who need to refinance in the near-term: last October, Bayes estimated that 45% of outstanding commercial real estate loans were expected to mature over the following two years, rising to 75% by 2026.
Faced with this funding gap on refinancing, sponsors have a variety of options open to them as their existing loans approach maturity. We are seeing de-leveraging asset sales, but it is often the crown jewels that are sold first (in an effort to maximise price and avoid a re-pricing of remaining assets). At the other end of the spectrum, the sponsor may be willing to inject additional equity into a financing structure themselves, albeit at the cost of diluting their future returns.
An increasingly popular alternative, ‘capital solutions’ give sponsors a set of tools to bring third party capital into a structure without the disposal of the asset by the sponsor. Although they don’t necessarily involve a true disposal, such a transaction can help to validate the valuation of the underlying asset in a private transaction. Accordingly, capital solutions potentially offer an attractive alternative for liquidity-constrained borrowers to meet their refinancing needs whilst retaining much of the upside in the future. Notable capital solutions options include:
- “preferred” equity financing;
- holdco financing;
- joint venture arrangements;
- mezzanine financing; and
- sale and leaseback transactions.
Common elements of these transactions include the new financing partner taking a risk/return position that sits between the existing sponsor’s equity and the underlying financing. Unlike a pure equity financing, however, those returns are commonly fixed (albeit at a more attractive rate than would be available to senior financiers), and come with enhanced rights for the capital solutions provider to have the option to take over the asset in the event of a default.
The choice of which capital solution to use is highly situation-specific and will depend on the nature of the underlying assets and debt, whether the sponsor group has other restrictions (for example under group level financing), and the requirements of the capital solutions provider.
Particular considerations when looking at debt capital solutions
As capital solutions transactions are more complex than a standard real estate financing transaction, it is important to be alive to a number of additional key considerations that are especially pertinent, for example:
- Reviewable transactions. Most jurisdictions allow certain transactions entered into prior to the onset of insolvency to be reviewed and set aside in an insolvency scenario. In the UK, for example, transactions at an undervalue and preferences are the two most common reviewable transaction concerns. For non-stressed real estate financing transactions, these concerns can be less prominent given the protection afforded by “hardening periods” (after which the relevant transactions are no longer reviewable). However, in capital solutions transactions, there is normally a higher risk that a stressed borrower or vendor may be subject to a formal insolvency process in the near future and so additional consideration has to be given to these concerns.
- Enforcement planning. In a stressed market, where lenders are more concerned about protecting their downside risk, it is important to consider enforcement options (at least at a high level) going into a transaction. This may be necessary because, for example, underlying tenants may themselves be subject to stress and restructurings, potentially jeopardising the cashflow coming into the structure. This is especially prudent in relation to operational real estate, such as pubs or hotels, where lenders need to understand how to operate the business should the worst-case eventualise.
- Competing claims risk. When injecting capital above an existing structure, lenders should also be mindful of the risks of structural subordination. A junior lender will not have access to the assets of the borrower until any subsidiaries’ creditors within that existing structure have been paid. A careful due diligence process is therefore necessary to identify any competing claims that may exist within a particular capital structure, such as existing debt and tax liabilities, which may not necessarily be obvious. Operational companies may also have additional liabilities in relation to their suppliers and employees, such as pensions.
- Insolvency remoteness. Finally, lenders should look to build in contractual protections and structure transactions so as to mitigate as much risk as possible on the downside. Where a capital solution involves the creation of a sub-group, for example, any transfer of assets to that new group should be ideally made on a true-sale basis to protect those assets against the risk of an insolvency affecting the wider group.
Particular considerations when looking at equity capital solutions
The four points above are equally relevant to an equity structure but there are additional considerations which can be tricky to navigate. The main reason for adopting an equity structure is to de-lever the group on a consolidated basis but, unfortunately, it is not as simple as issuing shares. Equity will be accounted for as debt if it has too many debt-like features and such a result would be a disaster for the group (who could probably have taken on cheaper debt). The tension in these deals arises because many protections that an investor wants commercially are the same things which auditors and ratings agencies take issue with from a debt v equity standpoint, for example (in general):
- Shares should not be true preference shares, they should be common equity which ranks alongside other equity in a liquidation of the issuer.
- The “preferred” equity can have an outsized share of distributions but there has to be meaningful value in the distributions to the regular equity and no hard requirement to distribute anything to shareholders.
- Equity is perpetual, and so hard rights aimed at repayment on a certain debt (such as put options or liquidating assets with a distribution requirement) point towards debt treatment, though it is possible to create a package of incentives to encourage a fixed term.
- The investor cannot take too much control, including negative control, such that it deconsolidates the issuer.
None of this is black and white. We have seen differences between firms of auditors and between jurisdictions on where to draw a line within the grey area. It takes time and creativity to find a balance which works for both sides.
Capital solutions provide a valuable tool for existing equity holders in today’s uncertain environment. Most transactions need, in practice, to consider both debt and equity options, and obtaining the right advice early is therefore particularly important.