Equity today is more demanding than ever. Brian Ward, chief investment officer TCG Capital Markets LLP, supplies a guide to structuring investment partnerships and points out important trends in equity preferences today. Since 2002, Ward has overseen the investment of over $355 million in equity and over $1.0 billion of debt into multifamily investments in 17 major markets throughout the U.S.
In his capacity as CIO of TCG Capital Markets, Ward helps oversee capital markets and investment banking functions for the firm, including debt, structured finance and equity solutions for clients looking to acquire, refinance or restructure the capitalization of their multifamily assets. Ward also manages all strategic capital relationships for the company with global, institutional and private capital resources.
MHN: What is the range of options for structuring equity investment partnerships today in the market-rate apartment sector?
Ward: The first consideration when evaluating today’s range of options for multifamily equity capital is the nature of the capital source. Equity capital sources vary from institutional providers—such as private equity funds, opportunity funds and real estate hedge funds—to high net worth individuals and family offices. It is important to align the style and needs of the capital source with a similar operator. For example, an operator with a long-term investment horizon would be poorly matched with a private equity fund that required shorter-term investments to meet yield and asset allocation requirements. Similarly, trying to marry an operator that has traditionally used high-net-worth, “friends and family,” capital with a large Wall Street private equity firm could be a recipe for misalignment of style and expectations.
Once you have resolved the “style alignment” question, the next considerations should focus on strategic, asset-level issues such as property age, location, underwritten investment thesis, risks, investment term and required capital. Consideration should also be given to the expectations of the parties about whether this is a one-time investment or part of a series of investments.
MHN: What types of arrangements and returns are we seeing in the market today under each of those types of equity options?
Ward: Once you have stylistic and strategic alignment, the focus can turn to structural options. It is dangerous to make general statements about equity capital options and their relative structural components because they vary so greatly. That said, equity capital today can be generally classified into two buckets: preferred equity or common/“joint venture” equity, with the following attributes (see table).
MHN: What general trends are you observing in the structuring of investment partnerships for apartment development and/or investments today?
Ward: It remains very difficult in today’s equity markets to raise large discretionary “blind pools” of equity—even the best and most sophisticated operators have had trouble executing this type of equity raise. The more common equity transaction today seems to be a “strategic relationship” structure where equity capital invests with a qualified operating partner on a programmatic basis, but retains approval rights over each transaction. In addition, many equity capital providers have modified their strategies. Prior to the 2009 market correction, the prevailing business model seemed to be geared more towards an “asset allocator” model where the equity capital took a passive role in the day-to-day execution of the investment with its operator. Today, many if not most equity capital providers are taking a very active role in the day-to-day operations of the investment—not just major decisions.
Another trend in today’s equity markets is known as the “local knowledge” requirement. In the past, equity investors were more willing to invest capital with operators that were buying multifamily assets all around the country. However, when the 2009 market correction hit, both lenders and investors found that the bulk of their losses and troubled assets were from operators that were traveling more than an hour or two to manage their investments. Today, both lenders and investors want their operators close by, and a Los Angeles operator attempting to make an investment in Miami is going to have a tough time raising debt and equity without an established presence on the ground in the Southeast.
Equity investors are requiring their operators to have real “skin in the game.” The days of little or no co-investment from the operator are generally gone. The question of “skin in the game” depends upon many factors such as the financial strength of the operator, the size and location of the investment, underwritten investment period, amount of senior debt leverage, etc. As a general rule, an operator should expect to invest cash in the range of 10 percent to 25 percent of required equity for a joint venture equity structure and at least 10 percent of total capitalization for a preferred equity structure. Using “attributed land/ hard asset value” to meet an operator’s co-investment requirement is challenging—most equity capital is reluctant to credit an operator this value unless they have owned the land/ hard asset for a long time; even then, equity capital is generally unwilling to accept a full market value for the attributed land/hard asset when considering the co-investment requirement. For land/hard assets that are being contributed by an operator to meet its co-investment, it is safest to assume the attributed value will closely match the actual cash consideration paid by the operator.
Fees remain a major sensitivity for equity capital. Up to 2009, the equity capital markets were generally willing to allow operators to take acquisition fees, asset management fees and, in some instances, asset disposition fees. While fees are still allowed, the amount and manner varies significantly upon the nature of the investment and operator. Generally, equity capital is tolerant of a reasonable asset management fee but more reluctant to pay acquisition and disposition fees, the exception being an operator that has sourced an “off-market” investment opportunity.
MHN: What are some of the challenges?
Ward: The primary challenge in today’s market is finding multifamily investment opportunities that can be prudently underwritten to meet the required returns of the equity capital markets. With average cap rates on Class A assets back to near historically low levels, it is almost impossible to achieve the returns required by equity investors unless they have a very low cost of capital and a long investment horizon. There remains opportunity in the Class B and C multifamily markets, but there are fewer of those properties trading right now. The equity capital markets strongly prefer off-market multifamily investment opportunities that have not been fully marketed by the brokerage community.