What is Real Estate Recapitalization?

In order to understand what recapitalization is, it is first necessary to understand how a property is financed.

Typically, when a property is purchased, the funds come from a combination of debt and equity. Debt is money that comes from the loan proceeds and usually accounts for 75% of the total purchase price. Equity is the money that makes up the difference between the purchase price and the loan amount. On occasion, some additional funds may be put into the property as working capital or operational reserves.

Against this backdrop, recapitalizing a property means changing the capital structure of a property – usually to make it better for the investor.

What is The Purpose of Recapitalization?

Practically, there are two reasons that a property could be recapitalized:

• Distress: If a property is in financial distress, a new investor or group of investors may bring additional capital to a property to take care of needed repairs, pay down debt, and/or replenish operational reserves.
• Value-add: Or, at the other end of the spectrum, an investor or group of investors could join the ownership group of a property and bring additional capital to fund growth. For example, a property that has some extra land could bring in new partners to construct a major addition to a property that will bring in new tenants and revenue for investors.

When done correctly, recapitalizing a real estate investment can be a big win for both real estate investors and tenants.

Real Estate Recapitalization vs. Real Estate Acquisition

From the description above, it may sound like a recapitalization is very similar to an acquisition. They are, in fact, very different.

In a recapitalization, an investor or group of investors uses their capital to acquire shares in the LLC or partnership that owns an investment property – which entitles them to a share of the cash flow and profits produced by it. This investment represents a partial acquisition, and many investors prefer this approach because it has the potential to generate passive income. They may not have the time, expertise, or resources to acquire a property in full. This arrangement might also allow the investor group to purchase other assets as part of a diversification strategy. Or, existing investors may not want to sell their all shares and cash out of the deal.

In an acquisition, an investor or group of investors acquires the entire property from the seller. They may do this for purposes of operational control or because they believe in the future potential of the asset.

Real Estate Recap vs. Refinancing

Recapitalization may also sound very similar to refinancing. The key difference is ownership.

In a refinance, the owner or owner(s) obtain a new source of debt for the property, often at more favorable terms (longer amortization, lower interest rate, non-recourse, etc.), and use it to pay off the old debt. Sometimes there may even be some extra money left over in which case investors can put it in their own pocket.

As described above, a recapitalization may have a number of different financial aims including reducing debt, increasing operating capital or funding improvements.

What Are Distressed Real Estate Assets?

The easiest way to describe a distressed real estate asset is as one that is in some kind of trouble.

The more technical definition is that distressed real estate is a property that is sold at a discount due to one (or more) of the following reasons:

1. Physical Condition

The physical condition of a distressed property is deteriorating.  For example, they may have a roof that needs to be replaced or they may have suffered significant damage due to a storm.  In other words, the condition relative to the market is poor and the costs associated with the necessary repairs mean that it will sell for a below market price.

2. Pricing

For a variety of reasons, a distressed property may be priced incorrectly.  For example, it may have been purchased by an investor who put a lot of money into it and they need to get a certain price for it, otherwise they will lose money.  If there is a significant difference between the market value and the asking price, and the owner has limited flexibility for reductions, the property could become distressed.

3. Management

To retain their value over time, commercial properties must be actively maintained.  The grass has to be cut, air handling systems need to be cleaned, and carpet and paint need to be replaced.  If this work is not done in a timely manner, the impact on the property can be significant.  If the physical condition falls into a state of disrepair, a new buyer may have to inject a significant amount of capital to bring it to market standards, which also means they probably won’t be willing to pay market value.

4. Environmental Conditions

A real estate asset could become distressed if there is some sort of environmental condition that makes it unattractive on the open market.  For example, suppose that a dry cleaner tenant has an accident and cleaning chemicals seep into the groundwater, contaminating it.  These types of issues can be exorbitantly expensive to mitigate, which can cause a property to sell for a discount.

5. The Market

Finally, market conditions can cause real estate to become distressed.  For example, one common scenario is that rents decline to a point that a property is no longer cash flow positive.  If this condition remains for an extended period of time, the property owner could run out of money and the lender could foreclose on it.  This type of “distressed” sale usually comes at a discount because the lender wants to get rid of the property.

While many of these descriptions sound quite negative, and they can be, they may also represent a potentially profitable opportunity for the right investor.

Advantages of Investing in Distressed Real Estate Assets

There are three reasons why investing in distressed real estate assets may be a good idea.

1. Lower Price

By far, the most obvious advantage of investing in distressed real estate assets is the price. Because these properties are in some sort of trouble, opportunistic investors are able to purchase them at a price that is very attractive relative to the market.

2. High Potential Return

Second, because the acquisition price is low, the potential return is higher relative to the market.

3. Debt Structures

Finally, because the distressed asset class involves unique scenarios, lenders and financiers may be willing to get more creative with debt structures.  For example, if a bank is selling a foreclosed property, they may also be willing to finance the purchase with favorable terms just to get it off their books.

The bottom line is that distressed investing has the potential to yield substantial returns.  But, there are a number of noteworthy risks that investors must also be aware of.