The Risks of Real Estate Recapitalization

Should you invest in an equity recapitalization?  The answer, like just about everything in life, is maybe.  

There are some very good reasons why a Sponsor would pursue an equity recapitalization and also some very good reasons an investor would want to invest in one. As you probably know from my other articles, I have long advocated for transparency and for investors taking the time to really understand the business plan before investing with a Sponsor. Real estate recapitalizations are no different.

Once we understand everyone’s motives in an equity recapitalization, then we will be able to take a look at the risks associated in investing in one. 

What is a Real Estate Recapitalization?

If you are an investor looking for great real estate investments, you have many options available to you. One of those options is to invest in an equity recapitalization.  

Investing in a real estate recapitalization is different from investing in an acquisition. With an acquisition, investor capital is used to acquire the asset in a purchase. The Sponsor does not currently own the property and needs the new equity to close on the purchase. With an equity recapitalization, the Sponsor already owns the property and is replacing all or a portion of the capital stack with new equity, and possibly also new debt. This is especially prevalent with private equity recapitalizations.

The important thing for an investor to understand is the reason a Sponsor is pursuing a recapitalization. A few legitimate examples:

• Private equity recapitalizations are often done when a Fund must liquidate because of provisions contained in the Fund documents, however, it isn’t the right time to sell a property. There is usually some upside left in the deal and the Fund Manager “rolls” the investment into a new Fund.
• One or more of the significant equity investors want their equity out of the deal, but the Sponsor believes there is still considerable upside in the property.
• The Sponsor has exhausted the “renovation funds” raised when the deal was initially capitalized and wants to take the property to the next level, but needs more funds to do that. In that scenario, the new funds from new (or existing) investors provides the capital necessary to make additional improvements.

There are more potential examples, but I think you get the idea.  

Whatever the reason, one of the things I like most about recapitalizations is the level of familiarity the Sponsor has with the property. Presumably, the Sponsor is much more knowledgeable about the property than when it was initially purchased and has not found anything that he or she believes is a major problem. When a Sponsor knows a property well, they are in an even better position to understand the risks and evaluate them.

Assuming the Sponsor has good intentions, I believe most Sponsors would not want to stay in a deal that he or she doesn’t expect to make money after the recapitalization. If a Sponsor didn’t think there was much upside, it would be much easier for them to sell.

The Risks of Investing in Private Equity Recapitalization

There are risks associated with investing in a real estate recapitalization that may or may not be present in a normal equity raise used to acquire an asset.

In the discussion above, I focused on some legitimate reasons a Sponsor would pursue an equity recapitalization.  Now, I’ll play devil’s advocate and give you some things to consider so you can determine if an investment in an equity recapitalization is right for you.

Many of these risks are associated with the Sponsor’s intent. Here’s a list of things that are important to consider.

• Is the Sponsor just trying to hold onto the asset to collect fees? There is nothing wrong with a Sponsor getting paid to do work, but you want to make sure the upside is really there.
• Is the Sponsor leaving some money in the deal? Most of the time, Sponsors aren’t putting new money in the recapped deal, but hopefully, they are leaving some of their profits in the deal.
• Does the story make sense? It is not uncommon for a turnaround to be a two or three phase process. Just make sure the story makes sense.
• How is the real estate recapitalization being valued? By definition, the Sponsor is on both sides of the transaction and this conflict should be resolved through objective, outside measures of value.

I hope this article helps you to assess the risks of investing in equity recapitalizations. They can be an excellent investment, just make sure you have done your due diligence!

If you have any questions about real estate recapitalization or KRI Partners, please reach out below.