Investing Education

Real Estate Financial Engineering: Top 5 Traps Investors Should Avoid

5_Financial_Engineering_Traps-Thumb

Commercial real estate and private equity investing are closely linked, and financial engineering—the application of borrowing and opaque reporting to ostensibly improve a transaction’s bottom line—has long been common in private equity. Financial engineering can be used in many ways, and not always to shareholders’ benefit as we learned from the 2007-2008 financial crisis. Given the complexity of real estate property transactions today, investors’ due diligence is more important than ever.

At its core, financial engineering increases internal rate of return (IRR) through high leverage or shortened investment hold periods. In real estate asset management, Origin’s underwriting process uses forecasting and pricing tools­ to find and evaluate risk factors. However, financial engineering is also applied to debt financing structures that can backfire on investors—such as the holding company debt that led to the bankruptcy of gunmaker Remington, or the collateralized debt obligations that touched off the financial crisis.

Debt financing, in short, puts investors at more risk than they may think. Real estate asset managers may not disclose these risk factors, or may not understand them. For that reason, below are the top five financial engineering traps we see that aren’t necessarily apparent or disclosed in deal documents—and the due diligence steps to spot the potentially manipulative use of financial leverage.

  1. Manipulating the Timing of Real Estate Sales. Some real estate asset management firms sell their holdings within two or three years. That’s typically too soon to see significant profits, yet flipping the asset will show a high IRR that looks impressive to the unaware investor. Shorter horizons produce higher IRRs, but not wealth. This approach can be not only deceptive, but also risky. A deal laden with short-term, unsecured borrowing—based on hopes for a quick sale—will turn sour if interest rates rise and a sale isn’t possible.Due Diligence: If real estate asset managers are selling early, they should explain why the business plan has changed. And investors should hold managers accountable for the expected equity multiple—the total return to the investor—rather than the IRR alone. “You can’t spend IRR” and “it doesn’t build wealth,” my partner Michael Episcope always notes.
  2. Abusing Subscription Lines of Credit. Borrowing in private equity real estate is often backed not only by the asset, but also by investors’ capital commitments. This is a type of bridge loan, and the real estate asset manager should repay it within a few days of a capital call. If the subscription line extends to 180 or 365 days, the investor is providing collateral without collecting interest in return. It’s also another way of inflating IRR, which doesn’t account for the extended time investors’ capital is committed but not yet put to work.Due Diligence: Investors can ask real estate fund managers how they use subscription lines, and the average length of their borrowing. The equity multiple also will suffer if subscription lines are abused, since this borrowing produces no added profit.
  3. Taking on Higher Financial Leverage. Deals with a loan-to-value (LTV) ratio of 85% or 90% have less investor equity, and thus show healthy return-on-equity numbers. But returns can evaporate quickly if the business plan encounters challenges. Fully leased commercial or multifamily real estate might seem like a safe investment, but depending on its class or condition, it can allow little leeway to raise added revenues for loan payments. In an economic downturn, lenders could force the asset’s sale even as real estate market conditions deteriorate.Due Diligence: Investors should understand what kind of returns they need to substantiate the level of risk they’re assuming. In the case of leverage, the WACC (Weighted Average Cost of Capital formula) lets them quantify what the return should be to substantiate the risk. They should be wary of LTV ratios above 75%, and make sure the rate of return compensates them fairly for the risk of assuming a higher cost for equity.
  4. Refinancing to Pay a Management Team. Once a real estate asset manager creates added value by renovating a property, it’s possible to raise rents, have it reappraised and refinance the property with a bigger loan. If the larger loan proceeds are used to compensate the manager alone, then the investor is left with only the higher risk of the increased debt. Further, many managers are paid through IRR-based hurdles, which incents them to refinance sooner and with larger loans. All of this means more risk for the investor.Due Diligence: A refinance should benefit both the manager and the investors. Investors should look for investments that are structured with at least three to five years of refinance lockouts.
  5. Hiding Ground Leases. Some commercial real estate owners sell the building and keep the land it sits on, and the buyer must assume a payment on the ground lease for the land. The lease payment is basically another form of debt financing. The building is collateral on the lease, and investors could lose the building if the lease payment isn’t made. Such a deal should come with a lower price.Due Diligence: A ground lease would be a material risk factor in a private equity real estate deal, which should be disclosed to investors. The lease must be considered part of the cost of capital. Watch for short-term ground leases in particular (ones that are less than 50 years), which add even more risk because they become difficult to finance with lenders.

Tougher regulations such as the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 have made it much harder to use financial engineering unethically. But it’s still very easy for a prospectus to mislead shareholders or an asset manager to hide deal fundamentals that increase risk. Investors need to understand risk factors fully, quantify their expected returns and consider whether the profits justify the added level of risk. And real estate asset managers must be transparent about each deal’s fundamentals.

This article is intended for informational and educational purposes only and is not intended to provide, and should not be relied on, for investment, tax, legal or accounting advice. The information is provided as of the date indicated and is subject to change without notice. Origin Investments does not have any obligation to update the information contained herein. Certain information presented or relied upon in this article may come from third-party sources. We do not guarantee the accuracy or completeness of the information and may receive incorrect information from third-party providers.