Cash flow is the lifeblood of every commercial real estate asset. When there is enough, all operating expenses can be paid and investors can ensure that there is enough money in a property’s operational reserves. When there isn’t enough, property owners may struggle to pay the bills and keep the operational reserves full. When this happens, the property may need to be recapitalized.
In this article, we are going to discuss the concept of recapitalization. We will describe what it is, the two different types, why it is important, and the risks, benefits, and consequences of doing it. By the end, readers will have the information needed to understand this complex concept and determine if it is an appropriate part of their future investment strategy.
At First National Realty Partners, we specialize in the acquisition and management of grocery store-anchored retail centers. One of the ways that we often add value to a property is to leverage our resources and expertise to recapitalize a property back to normal levels. If you are an Accredited Investor and would like to learn more about our current investment opportunities, click here.
What is Real Estate Recapitalization?
In order to understand what recapitalization is, it is first necessary to understand how a property is financed.
Typically, when a property is purchased, the funds come from a combination of debt and equity. Debt is money that comes from the loan proceeds and usually accounts for 75% of the total purchase price. Equity is the money that makes up the difference between the purchase price and the loan amount. On occasion, some additional funds may be put into the property as working capital or operational reserves.
Against this backdrop, recapitalizing a property means changing the capital structure of a property – usually to make it better for the investor.
What is The Purpose of Recapitalization?
Practically, there are two reasons that a property could be recapitalized:
- Distress: If a property is in financial distress, a new investor or group of investors may bring additional capital to a property to take care of needed repairs, pay down debt, and/or replenish operational reserves.
- Value-add: Or, at the other end of the spectrum, an investor or group of investors could join the ownership group of a property and bring additional capital to fund growth. For example, a property that has some extra land could bring in new partners to construct a major addition to a property that will bring in new tenants and revenue for investors.
When done correctly, recapitalizing a real estate investment can be a big win for both real estate investors and tenants.
Real Estate Recapitalization vs. Real Estate Acquisition
From the description above, it may sound like a recapitalization is very similar to an acquisition. They are, in fact, very different.
In a recapitalization, an investor or group of investors uses their capital to acquire shares in the LLC or partnership that owns an investment property – which entitles them to a share of the cash flow and profits produced by it. This investment represents a partial acquisition, and many investors prefer this approach because it has the potential to generate passive income. They may not have the time, expertise, or resources to acquire a property in full. This arrangement might also allow the investor group to purchase other assets as part of a diversification strategy. Or, existing investors may not want to sell their all shares and cash out of the deal.
In an acquisition, an investor or group of investors acquires the entire property from the seller. They may do this for purposes of operational control or because they believe in the future potential of the asset.
Real Estate Recap vs. Refinancing
Recapitalization may also sound very similar to refinancing. The key difference is ownership.
In a refinance, the owner or owner(s) obtain a new source of debt for the property, often at more favorable terms (longer amortization, lower interest rate, non-recourse, etc.), and use it to pay off the old debt. Sometimes there may even be some extra money left over in which case investors can put it in their own pocket.
As described above, a recapitalization may have a number of different financial aims including reducing debt, increasing operating capital or funding improvements.
Types of Recapitalization
Depending on the circumstances in which the recapitalization is taking place, there are two types that may be used.
Sometimes, to get the best deals, institutional investors (e.g. REITs or private equity firms) have to move quickly to close on a property when they find one they like. To do so, they may use their own capital to complete the purchase and then once the property is in their position they may sell shares in it to investors in an attempt to “backfill” their own equity. In other words, they swap their own equity for investor equity without stepping up their cost basis.
This is the most common type of recapitalization.
Step Up Recapitalization
Commercial real estate assets tend to appreciate slowly over the long term along with the broader real estate market. So, if an investor has owned a property for many years and has seen the value of their holdings increase, they may want to cash out some of their profit by selling a portion of the property to investors.
For example, suppose that an investor owns 100% of a property (no debt) that is worth $1,000,000. After ten years, the property is worth $2,000,000. If they wanted to, they could sell a piece of the property and use the funds to recapitalize the asset. But, because it is sold for more than the original price, this is known as a “step up” in cost basis.
Risks Associated with Real Estate Recapitalization
In general, recapitalization is a good thing because it can provide properties with needed liquidity that can help drive higher valuations down the line. But, as an asset management strategy, there are three potential risks that investors should be aware of.
Every deal is unique, but there are certain scenarios where a step up recapitalization can trigger a taxable event for the real estate investors involved in the deal. Investors should work with the deal sponsor to determine if they filed for a 754 election, which ensures that new partners entering an investment aren’t negatively impacted by the appreciation/depreciation of an asset when considering gains/losses for tax purposes.
If there are any doubts about the tax consequences of a recapitalization, investors should always check with their financial advisors, CPAs, and/or tax attorneys to be sure they are aware of the impact.
Again, a recapitalization is generally a good thing. But, most loan agreements – particularly those associated with larger deals and those with institutional investors like hedge funds – prohibit a change of ownership or any sort of restructuring without the approval of the lender. When a borrower does a recapitalization without the approval of the lender, it could technically be a covenant breach, which could have negative consequences.
Although unlikely, it is possible that new investors could be held liable for some sort of incident that happened prior to their joining the ownership group. For example, suppose that a resident of a multifamily investment property slipped, fell, and sued the owner – an event that was not disclosed during the recapitalization due diligence process. If, after the recapitalization occurred, the resident won a verdict against the property, the new owners could be liable for their share of the damages.
For this reason, it is usually a good idea for new investors to negotiate an indemnification clause as part of their involvement in a recapitalization.
How Do Private Equity Firms Use Recapitalization?
We discussed the two most common types of recapitalizations – backfilling and step up. Let’s explore how these are used in practice.
We’ll start with a backfilling recapitalization. Let’s suppose that a firm like ours is attempting to close a private real estate in a strong market. There is a lot of competition for the best properties, and it isn’t always possible to go to the capital markets to obtain debt financing right away because it would slow down the offer process and might allow a competitor to come in and buy the deal. To mitigate this risk, private equity firms with strong balance sheets will often pay cash or draw from readily available revolving credit facilities to purchase a property. After closing on the deal, the firm will pursue a backfilling recapitalization where they will sell a portion of the property to a group of real estate investors. The proceeds from the partial sale will allow the firm to pay down the revolver or refill their coffers.
The other recapitalization scenario is when an investment firm has owned a property for a long period of time and has built significant equity. The firm might want to sell a portion of the property for several reasons, including to diversify into another asset class, guard against the impact of a real estate downturn, focus on the allocation of capital to improve other properties they own, or make a distribution or dividend payment to investors. All of these are common reasons to pursue a recapitalization.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. We utilize our liquidity and decades of experience to find multi-tenanted, world-class investment opportunities for our partners.
If you are an Accredited Investor and want to learn more about our investment opportunities, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.