Managers are coming to terms with the fact that they have not set enough money aside in their funds for a rainy day – and they are turning to their investors for help.
“I think it’s fair to say that in some cases the reserves are not adequate,” said David Hodes, a founder and co-managing partner of New York-based capital advisory firm Hodes Weill & Associates.
These shortfalls in fund reserves are arising in a few different scenarios, he noted. One is where the manager is seeking additional capital to provide “some breathing room” to execute the business plan for an asset. Borrowers face a host of new property costs, whether it is the cost of decarbonizing assets under new regulations like New York’s Local Law 97, or higher property taxes, he added.
“The cost of stabilizing an asset today, it’s a lot of heavy upfront cost, whether it’s a complete refurbishment or the expensive tenant improvements that tenants are demanding even for good buildings,” Hodes continued. “So it’s not just: ‘I need capital to satisfy my lender on a partial paydown to refinance.’ It’s also the additional cost of completing assets given some time delays.”
Another scenario is where the manager is making so-called net capital calls for partially-drawn funds, with the fund capital going toward deleveraging, not for acquiring new assets.
Managers typically hold approximately 10 percent of a fund’s capital in reserves, according to Hodes. However, with most assets having depreciated as cap rates have risen, 10 percent is now insufficient to address the liquidity issues with many funds.
“Most assets probably would need another 15-20 percent to address refinancing if they had to do it today based on current lender appetite for risk,” he said.
Many firms have been highlighting potential pressure points in a fund’s portfolio to their limited partners. “They may or may not be making a specific ask of their LPs yet,” Hodes said. “But I’m sure they’re highlighting it since it’s an obvious topic of conversation for them, where discussions are going to go with lenders.”
He added these types of dialogs have only just started. “I don’t think we’re at the middle innings on this,” he said. “I think we’re at a very early inning on this.”
Good money after bad?
The gap in fund reserves will vary by sector and situation. The office sector overall will have the biggest gaps, while an industrial property leased to a strong credit-quality tenant likely will not have a huge refinancing gap. “But in multifamily, there could be a 15 percent gap on a good-quality asset that is just taking longer to achieve its stabilization or if the manager had the financing off the timetable a little bit, based on when they expected to be either selling or refinancing out,” Hodes pointed out.
However, “it doesn’t mean that something’s wrong with the assets or they made bad decisions. It’s a function of just how quickly rates rose,” he added. “And those are the ones where I think LPACs are going to spend the most time on because it always comes back to that question: ‘Is it good money after bad or is it good money?’ And those are the ones where you can make the argument that by stabilizing with some additional capital today, you get an attractive return.”
Investors typically are not in 100 percent agreement on new capital requests. While some only want to put their capital toward new investment opportunities, others may agree to invest more capital in existing assets. However, with the latter, “investors are expecting that the return on that capital is going to be commensurate with other things they could be doing with capital at this point in the market,” Hodes said.
Co-investment vehicles – which have been a major driver of new deployment over the past several years – add another layer of complication, since such structures do not always anticipate the need for additional capital. “Anyone that does not put up new capital is going to have a dilution,” he noted. Meanwhile, the manager needs to ensure that those providing the capital “are being adequately compensated for whatever new risks they’re taking.”
This brings up ongoing challenges around valuations. “There’s going to be a lot of bright lights on: are these values correct?” Hodes said. “And we know we’re in a market with somewhat limited transparency on pricing. I think that this is going to pop up increasingly as part of the investor dialog.”
Investors generally are receptive to recapitalizations, however. “LPs often take comfort in knowing that there is a new source of capital that is prepared to come in and establish the pricing around that,” Hodes said. “You have the benefit of somebody that’s greater than arm’s length outside the fund, establishing some economic terms that they are prepared to offer to provide this additional liquidity to the portfolio.”
Bringing in outside capital to stabilize a portfolio is the best thing a manager can do as a fiduciary – if that is possible, he added. “But they may find that the external source of capital doesn’t exist either. So the existing LPs are saying, ‘We’re not going to try to be smarter than the market. If the rest of the market doesn’t want to do this, why should we?’”
What then results is the manager giving back the asset. “It’s because there’s no capital or because they’re looking at it and saying, ‘We just don’t think it’s a good use of capital at this point,’” Hodes said. “In some cases, I think it’s part of the negotiating strategy. A lot of the assets that have been given back, though, they’ve been financed by CMBS and it’s sometimes just not worth the brain damage.”
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