Opportunistic Transactions: Distressed Investing Mastery Lesson 1

Lesson One: Start Here

1.1 Orientation

Before you get started in this course, please read the orientation blog to help you understand the key points of real estate investing. Use the following link to view the orientation:

Total Commercial Real Estate Strategy

Then, please familiarize yourself with my blog post on this:

The Definitive Guide to Commercial Real Estate Capital Raising

1.2 Here’s What to Expect

This course will focus on opportunistic transactions and distressed investing. Distress comes in many forms, including property distress, tenant distress, leveraged distress, and sponsor distress. We will focus on the distressed asset life cycle here, as well as the opportunities that exist within distressed properties.

Course Objectives:

  1. 1. Explain why deals go bad
  2. 2. Discuss the borrower’s options to avoid foreclosure
  3. 3. Discuss the options for buyers for purchasing distressed properties
1.3 Types of Commercial Real Estate Transactions

There are three types of stabilized properties. The first type is the Stabilized Properties. Permanent financing is for stabilized properties. Stabilized properties are fully leased with rents at market rate and current cash flow within the properties. With these properties, there is no more work to be done on the property to “grow or groom” the NOI. Finally, in regards to risk, the lenders are betting that nothing “bad” will happen to the project cash flows in the future.

The second type is Unstabilized or Value-Added Properties. The properties’ typically shorter term or floating rate financing is more appropriate for value added properties. These properties are not fully leased, and/or rents are not at market. In addition, there is usually substantial work to be done before the property becomes stabilized. Finally, in terms of risk, something “good” needs to happen to the property cash flow in order to stabilize the property and achieve the business plan objectives.

The third type is Opportunistic Properties. These properties typically require “specialized” financing. With these properties, there are several exit strategies to consider.

  • The exit strategies for these properties require one of the following:
  • Residential sale exits: Typically relates back to the strength of the consumer (i.e. residential land and condominiums).
  • Commercial sale exits: Typically relates to commercial land that has an exit strategy of sales to commercial developers.
  • Development/construction: The property needs to be built and leased (which creates construction risk and lease-up risk).
  • Extensive renovation or change of use: The property has no cash flow in the beginning and may need to go through a change of use (i.e. office to apartments).
The risk: Numerous good things need to happen.
1.4 The Total Commercial Real Estate Strategy

In previous courses, we discussed the total real estate capital strategy. In this course, we are dealing with capital structure. To begin this course, let’s review the capital strategy in its entirety. This will begin to showcase how value-added transactions “fit” into the strategy.

The capital strategy involves structuring the deals. This is where the fun comes in. After you’ve gone through this, you’ll understand why vetting your deal is so important. This is where you add value and where the paydays come in. If you’re planning on doing consulting, you’re going to want to pay close attention here.

There are generally three ways to make money structuring your deals. You’ll want to have these in the back of your mind when you’re pre-qualifying these deals.

Capital Placement
This is placing capital from one institution to a buyer looking to purchase or refinance a property. We call these folks “sponsors” or “owner/operators.” These institutions are usually real estate private equity funds, otherwise known as discretionary lenders, family offices, pension funds, life and reinsurance companies, endowments or hedge funds.

These same institutions generally provide capital across the entire capital structure – meaning sometimes their debt, sometimes their equity, and sometimes both. What you need to know is that the capital structure is comprised of the total debt and equity at the asset level.

Sponsors are important because a sponsor with equity is more valuable than someone with no money down.

How You Make Money

In any deal where you’re placing capital, you as the Intermediary are usually incentivized in the form of points or a percentage of the total loan amount.

For example: if you arrange and place $5,000,000 from a capital provider, such as a bridge lender, you’ll usually get paid between 1 and 1.5% of the total loan amount, or $50,000 to $75,000.

Depending on the deal – and the market – it isn’t uncommon for you as the Intermediary to get a percentage of the deal after all improvements have been made.

So if that same $5,000,000 loan is placed on a property that will be worth $10,000,000 after all improvements are made (we call this the “terminal value” of the property) and if you are good at negotiation and able to score a 10% equity stake (otherwise known in the industry as “hope certificates”), then that is another $1,000,000 in equity.

Lastly, depending on how plentiful capital is, you may also be able to make a yield spread on this.

Let’s put this into context: When you deposit your money into a savings account at the bank, you expect to make somewhere between 1 and 2% in interest. What the bank does with that money is lend it out at 7% interest, then pay you the paltry 1% interest (with a straight face) and pocket the 6% interest rate spread.

You can do this too. Let’s see how.

Debt vs. Mezzanine vs. Equity: Not All Capital Is the Same

The parts within the capital structure comprise of what are called “structured products,” that all have different levels of risk. This is something you must absolutely understand if you’re going to swim in the deep end with these institutional capital providers.

Want to solidify your credibility instantly? Always ask your sponsor or operator who is looking for capital these questions: “What kind of capital do you want? Where do you want your capital provider to be in the capital stack?” These will allow you to really effectively communicate to institutions.

Asset Arbitrage

In residential real estate it’s called “wholesaling.” That’s what the little investors call it. In commercial it’s called “crossing a trade,” or arbitrage. Now that we’re grown up and we’ll be facing off with grown up men and women in the industry, we’ll want to use these cocktail terms.

This is simply identifying an asset that is undervalued, locking it up under a contract or an option, then either selling it or assigning it to an end buyer. You are “arbing” the asset. You are buying at a low and selling slightly higher. Not at retail or full market value because you want to leave enough meat on the bone to make your buyer truly interested and activate his or her greed glands. Got it? Good.

Remember that you need to be careful of the Real Estate Commission rules of getting paid a commission on the sale of real estate without a real estate license. Get the property under contract and then sell or assign your contract for a fee, since the contract is personal property and not real estate.

Now that we have that out of the way, here’s what you need to do to make sure your deal is legitimate:

  • Lock Up the Property at a Low Basis

This means that there is strong market equity in the deal today. We call this imputed equity. It’s being sold for a number of reasons, such as a partnership having blown up and everyone wanting out, or the bank having taken it back through foreclosure, or filing foreclosure, where time is of the essence to ensure the property is sold.

In other words, if I were to offer you a house for $60,000 that is worth $100,000 today, that’s a strong basis, as it means you’re getting $40,000 worth of imputed equity today for that $60,000. But if I were to offer you that same $100,000 house for $95,000, that doesn’t sound as strong, does it?

  • You Need to Have Your End Buyers Identified and Pre-Qualified

This is where everyone fails. They find an opportunity and then scramble to find a buyer. This rarely works out and what usually happens is that the deal or your credibility (or both) is lost because someone who tells you they were a buyer really isn’t one, and they don’t perform and, instead, go radio silent. It’s extremely frustrating and if it’s your first deal, you will become easily discouraged.

The best use of time during the day is to spend about 30 minutes with yourself or someone else in your office – such as an intern or a domestic VA – finding and calling Qualified Institutional Buyers (“QIBs”). You’ll want to reference this blueprint below when speaking to them.

There are several types of QIBs out there, all of whom have different motives. A publicly traded REIT, for example, will pay close to retail for most assets, as it’s easier for them to raise more capital by issuing more shares of stock that is publicly traded.

Smaller private partnerships, comparatively speaking, have a higher cost of capital; therefore, they are more concerned about the basis at which they are buying an asset.
Of course, it’s far easier to cross a deal when you can get terms. If the buyer can assume the existing financing, then that makes the deal as a whole look much more compelling. Your retail investors, such as mom and pop investors – like doctors, dentists and accountants – will almost always be more inclined to purchase these types of deals that are structured with existing financing.

Capital Formation

The third strategy is to raise capital yourself to take the asset down to place into your portfolio. These deals are usually structured one of two ways: using a fund or a joint venture structure. Those who are proficient at raising capital have the appropriate tools to do so and are able to effortlessly raise capital on demand. They’ve lined up prospective investors – retail or institutional – and know how to approach each.

They have an evergreen pitch book (a PowerPoint presentation) that they can use over and over again. They are prepared and have planned to be nimble whenever an opportunity comes. They simply “call the capital” when they need to. They have leveraged other people’s proven systems to pull down the right tools from the shelf when they see opportunity.

Now, after reading this, you can probably come to the conclusion why most people who look to raise money around real estate deals fail immediately: it’s simply because first, they fail to pre-qualify their opportunities. They can’t seem to look at these numbers dispassionately, usually because they are desperate to close a deal or are being strong-armed by a seller or investment professional who has a stronger personality than they do. Additionally, they simply cannot communicate the deal in a convincing, persuasive, and logical format.

And if you’ve even been pitched by someone who doesn’t know what they are doing, this scenario will likely be very familiar to you:

They send you a 20MB Investment Offering via email from a broker. It clogs your email.

They can’t explain the deal, so they tell you to read the whole 200-page Investment Offering.

The only thing they know about this deal that they are asking you to put your hard earned savings into is that it’s “great,” and “a sure bet.”

You have to do all your own research. There is a tremendous amount of pressure and sense of urgency to get you to invest. They have to close immediately – if not sooner.

No documents are drawn up, and you come to the conclusion that your operator or sponsor has no experience. You wasted all this time for nothing, or…

You implicitly trust this operator to make the right decisions and pray you don’t lose your hard-earned money.

Incidentally, there is a blueprint you’ll want to review that we created for some larger news publications which discusses why, as a passive investor, you should run from any crowdfunded real estate deals.

Crowdfunding is seen as being “the next big thing” in real estate. History has yet to be written on the effectiveness of this approach; however, here’s a blueprint you will want to download and use to quiz your brother-in-law who is bragging about the $10,000 he dropped in a “very significant real estate deal.” The point here, of course, is that if you truly desire to be successful, you need to wear the right clothes to this party.

And, quite frankly, it isn’t that difficult. Those who aspire to become Real Estate Private Equity Fund Managers need to focus on using proven system to do only two things: find deals, and fund them.

Inside Baseball The Total Capital Strategy ACPARE

1.5 Sponsor and Sponsorship

In the section above, we briefly touched on sponsor and sponsorship equity. Value-added transactions have an inherent risk, and good operators are a key to success. In a lending situation, good sponsorship is essential, as he/she will have to navigate problems and be adept in refinancing or selling the project as the exit. In lending situations, the sponsor’s financial strength may need to carry the deal during soft periods.

Sponsor equity is also known as “skin in the game.” The investor should note that not all sponsor equity is created equal. The good investor will know the sponsor’s sources of equity. The first is cash equity. Cash equity is money that the sponsor is personally investing. It is always the most preferred type of equity for lenders because it means that the sponsor has something to lose. The second equity type is market equity. This is gained when the sponsor has owned the asset for a period and its value has increased. Any new investment is then based on the market equity, or the equity already in the project.

The third equity type is syndicated equity. This is also known as “other people’s money.” The sponsor gets others to invest, puts little or no money in, and is paid for putting the deal together. As a rule, avoid syndicated equity. Beware of sponsors that only use other people’s money. Their motivation is focused on closing deals first and then protecting principal second.

The fourth equity type is large investor or limited partner equity. This is a capital source when sponsors team up with large institutional investors or limited partners. These limited partners bring the majority of the equity. The final equity source is friends and family. Their money comes into play when a sponsor has raised money from friends and family and cobbled together enough capital for the transaction. This is typically good capital, as sponsors want to protect their reputations.

One final factor to consider for equity transactions is debt equity. A good equity investor must be very conscience of the amount of debt and type of debt the sponsor wishes to put on the property. Remember: in equity investments, debt should enhance returns – not make the returns work. A good investor always compares the risk profile of the transaction to both its leveraged and unleveraged returns to determine whether the debt is being used appropriately.

There are several key features to consider for debt in equity transactions. Please review these below:

  • Term: The term of the debt needs to match the term of the project.
  • Rate: Fixed-rate debt lowers the risk profile of the debt.
  • Sponsor Fees:
  • Acquisition Fees: Typically asked for by the sponsor, but can be negotiated. For proper alignment of interests, these are best treated as “success fees.”
  • Asset management fees: Must be paid to allow the sponsor to run the day-to-day business of the asset.
  • Disposition fees: Not unusual, but for alignment purposes, best treated inside the waterfall.

The sponsor or owner/operator in a commercial real estate transaction needs to be suitably qualified in the following areas:

  • Capital: Have sufficient capital to co-invest in the transaction
  • Infrastructure: Have the appropriate organization to take on the project
  • Construction: Be qualified to manage the construction needed to rehabilitate the property
  • Management: Be qualified to manage or oversee the day-to-day operations of the property
  • Leasing: Be qualified to oversee the leasing effort
  • Staying power: Have sufficient net worth to support the property if unexpected costs overrun the budget or delays occur.

The sponsors need to be experienced and have a staff, an operating business, and a background in the type of property being purchased. A good rule to remember: good sponsors can work through bad deals; bad sponsors will make good deals go bad.

Sponsorship Equity Co-Investments

The basic concept with co-investments is that if the project does well, everyone does well. However, if the project does poorly, the sponsor should suffer material consequences. Institutional lenders and other capital providers who finance equity transactions are aware that the sponsor stands to gain disproportionately if the project succeeds. It is only fair that the sponsor suffers if the project does not perform as projected!

In each transaction, the equity investor must negotiate the amount of capital or co-investment that the sponsor is bringing to the transaction. The answer to this question can be telling about macro-level market conditions, and it speaks volumes about the sponsor’s conviction to the asset and the improvement plan. Many institutional investors describe the ratio of sponsor capital to investor capital as “alignment of interests.” Remember: the amount of co-investment offered by the sponsor on an equity transaction is a telling sign of the sponsor’s conviction. A good investor always seeks sponsors with a high level of conviction.

Guidelines for Sponsor Co-Investment

When considering the co-investments, there are four guidelines that you should follow. The first is the 5 percent co-investment. This is not very desirable, as it creates an “option value” for the sponsor. An investor who accepts a 5 percent co-investment would be well advised to make up for this low investment amount with additional structure.

The second guideline is the 10 percent co-investment. This is considered a marginal investment. This type of deal must have “going-in” merits that make the probability of success high. The third guideline is the 15 percent co-investment. This is considered a normal and acceptable investment and a good starting point. The final guideline is the 20 percent or more co-investment. This type of investment indicates a sponsor who truly believes in the asset and the business plan.

Where is the Equity Really Coming From?

A good investor must understand the alignment of interests between all parties and not just the sponsor. Different investors will likely contribute different levels of capital to a project, but all investors must try to understand one another’s interest and expectations.

Most importantly, this means understanding the source of the sponsor’s equity. In many cases, the investor must dig deep into the sponsor’s ownership structure to understand the motivations of all parties. Some of the questions that investors might need to ask include the following:

  • How are the ownership interests structured?
  • What is the sponsor’s risk (e.g., cash equity, personal guarantee)?
  • Who has the upside potential and how is it shared?
  • Who has the downside risk and how is it shared?

Remember: don’t be afraid to ask the difficult questions, like “Where is the money coming from?” and “How will profits and losses be shared?”

Sponsorship and Sponsor Equity ACPARE