Understanding Recaps vs. Acquisitions in Real Estate
By Adam Gower Ph.D.
When a sponsor offers an opportunity to investors, the property they wish to finance will either have just been acquired (or is under contract) or was purchased by the sponsor at an earlier time using a different financial structure than the one being proposed.
This defines the essential difference between an acquisition and what is called a recapitalization (‘recap’) of the property.
In an acquisition, the property is new to both sponsor and investor.
In a recap, the sponsor already owns the property and is attempting to replace the existing capital structure with a new one using new debt (probably) and new investor finance.
Before deciding to make an investment in a real estate recapitalization (‘recap’) rather than in a straight acquisition, investors should understand what the nuances are for this kind of finance.
There are two types of recaps that are commonly seen.
One of them is the type where the sponsor is going to step-up their basis during the recap.
That would be if they bought the property some years previously and wanted to sell, say, 20 percent of the partnership that owns the asset.
In this situation they will base the price on some measure of increased value.
More commonly seen is the other kind of recap, where a sponsor will close a transaction using their own equity, and then will immediately recapitalize the deal without stepping up the basis.
This is sometimes referred to as ‘backfilling’ with investor capital.
In these circumstances a sponsor may take an acquisition or finance fee proportional to the equity being raised, but would not otherwise benefit from the transaction.
Sophisticated investors will tend to avoid doing recaps where the sponsor is stepping up the basis because it can create a valuation risk where you don't have the market pricing an asset.
It leaves open to question how the recapped value was determined, and how that value relates to the true value of the asset.
Even if there is parity between the assessed value and the true market value of the asset, there can be a misalignment of interests if a sponsor is cashing out on a recap.
For example, let’s say a sponsor buys an asset and needs $3 million of equity to close the transaction.
In the no step-up scenario, the sponsor would contribute $3 million of their own equity, in order to facilitate the closing, and then immediately after that, would start syndicating out that $3 million to investors.
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Alignment of Interest
In the step-up scenario, a sponsor may have bought a property five years ago for $10 MM, and now it's worth $20 MM.
In this case the sponsor might sell a 20-percent interest in the partnership that owns the property and retain some of the money raised through that sale.
Indeed, they might end up with negative equity in the property because they may have cashed out entirely plus taken a profit.
In some cases, a sponsor may set up a new entity to recapitalize the building completely.
Using the example above, the sponsor may raise $5 million of equity of which they may also ‘contribute’ $1MM.
However, because of the step-up, what is actually occurring is a cash-out by the sponsor where they are investing no new money into the recapitalized deal, but in fact capturing $5MM through sale of their original ownership interest and leaving $1MM of that gain in the project.
Having a sponsor recapitalize a property has its advantages, of course; the sponsor is likely very familiar with the buildings and the risks normally associated with missing something during the due diligence process is mitigated.
However, investors want to make sure that the sponsor has a reasonable co-investment in the recap, that they bring new money to the table that is net of all fees and that is not made up solely of paper profits due to property appreciation, to ensure a proper alignment of interests.
ADAM GOWER PH.D.
Adam Gower is a 30+ year veteran real estate investment and finance professional. He expands investor networks for real estate developers by implementing best-of-class digital marketing programs. Dr. Gower has written several books, the latest, Leaders of the Crowd, chronicles the legislative origins of crowdfunding and how real estate came to dominate the industry.
This article is dedicated to my friend, Ed Mansell whose intellect was matched only by his humility and humanity. He will be missed by all.
Copyright 2018 - ADAM GOWER PH.D. - All Rights Reserved