Rising concerns about real estate stand to accelerate the secondaries market for limited partnership interests in these assets. Even before the capital markets further tightened due to the fallout from Silicon Valley Bank, researchers were predicting a higher number of recaps in 2023.
In such a faster-paced, higher-risk real estate environment, due diligence will be critically important. Below are a few tips for real estate limited partners seeking to maximise returns and ferret out risk.
Put the waterfall under the microscope
Secondaries investors buying LP interests in real estate deals need to understand all aspects of their potential ownership position. That includes taking a close look at the GP’s historical financial performance and, in particular, how the asset was stewarded during challenges such as covid-19 and the onset of the US Federal Reserve’s rate hikes.
The inquiry should include the GP’s broader position and track record, beyond the target asset itself. While the LP might be interested in buying into just one high-performing property, what if the GP’s other assets are in deep trouble, or perhaps cross-collateralised with the subject asset? The potential for such shadow risks should not be ignored.
In addition, real estate LPs should closely scrutinise partnership cash records and general ledgers, and make sure all payments have been made correctly, per stipulations in the waterfall agreement. The effort could include running more “what if?” analyses than perhaps would have been typical back when interest and real estate cap rates were lower and more stable. That could include game-planning scenarios for what will happen, per the waterfall, if asset values fall, or if occupancy at the property decreases. For commercial assets, be sure to take a hard look at lease expirations. For any property type, it is important to be clear on any loan expiration dates as well.
LPs need to pay particular attention to the waterfall pro forma models. Typically, both GPs and LPs will maintain their own accounting processes and spreadsheets, and as a result their distribution calculations are rarely in alignment.
Often, timing is the issue – one party books entries earlier than the other, with the differences in interest accrual leading to significant daylight between the two calculated distributions. Objective third-party analysts can review the partners’ waterfall trackers, analyse the underlying financial data and files, and help everyone come to a timely consensus.
Look at the asset with fresh eyes
Much has changed in the real estate market in a short period of time. Relying on older information such as comps and valuations could be a mistake when buying into a deal.
By contrast, timely updates of the property’s value and performance can give LPs greater confidence in the transaction.
These should include at least three years’ worth of quarterly performance reports created by the GP for the LPs, as well as an updated report on the business plan, rent rolls, partnership agreement and contributions/distributions.
In one recent recap involving a large shopping centre in North Carolina, having such information in hand reassured the secondaries investor that the departing LP was exiting the deal simply to pursue another opportunity – not because there were “hidden surprises” with the property.
In other situations, however, the departing LP could indeed be fleeing a looming, unannounced anchor tenant vacancy or an upcoming refinancing that will put the partners in a bind. Given such risks, secondaries investors need to have a clear picture of what’s happening with the tenants involved in any prospective office, industrial or retail deal. A thorough review of retail leases, for example, could uncover impending termination dates for critically important retailers, or problematic co-tenancy provisions that, if triggered, could open the door for other operators to vacate the centre.
Scrutinise the debt structure and loan covenants
It is also important to be clear about the debt structure and any applicable loan covenants. Some third-party analytical firms offer tools that can automatically detect potential default triggers in the covenants, giving the partners more time to adjust. Such tools could reveal, for example, an upcoming lease rollover date that will trigger a default if allowed to pass without that tenant being re-signed or quickly replaced.
Property values are declining across much of commercial real estate. Sponsors need to know in detail how covenant violations, should they occur, will play out. If income is not covering the mortgage by enough of a margin, for example, how much time will the lender wait before taking legal action? Is refinancing out of the question? What are the risks of dilution in the event of an unsuccessful capital call? Specialty real estate firms can thoroughly analyse all loan documents and produce abstracts that make it faster and easier for LPs to move forward with confidence.
Today’s real estate sector is more challenging, but tighter capital markets are also creating strong opportunities for LPs. With the right due diligence, they can make smart, low-risk investments that will yield strong return on investment when the real estate market rebounds.
Mike Harris and Mike Jaworski are managing directors of CREModels, with a combined 50-years’ experience in commercial real estate and technology. The firm offers due diligence, document abstraction, financial modelling, acquisition underwriting and other services across all real estate sectors.