Backfilling equity post close
Let’s say someone were to buy a real estate asset with their own cash unlevered. Could they raise equity after the initial closing (say 30%), and refi the remaining 70% of their personal cash out with perm debt? How would valuation be approached for equity? Would this just be the sponsor/investors discretion?
In the scenario you're describing, where an individual purchases a real estate asset entirely with cash and then seeks to raise equity post-closing, followed by refinancing a portion of their initial investment with permanent debt, several steps and considerations come into play. This strategy is somewhat akin to a delayed financing or recapitalization strategy. Here's how it might unfold, based on insights from the WSO content:
Post-Closing Equity Raise: After purchasing the asset, the owner can indeed seek to raise equity from investors. This would involve selling a percentage of the ownership in the property to these new investors. The amount of equity raised (e.g., 30% in your example) would typically be based on the current valuation of the property, not the purchase price. This valuation would take into account any improvements made to the property, the current market conditions, and the income the property generates if applicable.
Valuation for Equity: The valuation at which equity is raised would be critical. It would likely involve a formal appraisal or a market analysis to determine the current value of the property. The valuation would consider factors such as the property's location, condition, income-generating potential (if any), and comparable sales or rental rates in the area. The sponsor or owner and potential investors would negotiate the valuation, but it should be grounded in objective market data to ensure fairness and transparency.
Refinancing with Permanent Debt: Once equity has been raised, the owner could then seek to refinance the property with permanent debt, aiming to recover up to 70% of their initial cash investment, as per your example. The amount of debt that can be secured would depend on the property's valuation, the loan-to-value (LTV) ratio lenders are willing to offer, and the owner's creditworthiness. The refinancing process would also involve an appraisal and underwriting process by the lender to confirm the property's value and the feasibility of the loan.
Investor and Sponsor Discretion: The decision to raise equity post-close and the terms of such an equity raise (including valuation and the percentage of equity sold) would indeed involve significant discretion on the part of the sponsor or property owner. However, it's important that these decisions are made with a clear understanding of the market and the financial implications for both the owner and the incoming investors. Transparent communication and a clear agreement outlining the terms of the investment are essential to ensure all parties' expectations are aligned.
This strategy allows the original investor to leverage their investment and potentially improve their return on equity by bringing in additional investors and debt financing. However, it requires careful planning, a clear understanding of the real estate market, and strong negotiation skills to ensure the terms are favorable and the property's valuation is accurate.
Sources: Great Deals You've Recently Done, Investment Sales Vs. Debt/Equity Brokerage, I Want to Learn About Distressed Debt Investing, How Private Equity Owned Companies Fund Add-Ons, Do PE funds stop caring about certain investments once the fund has crushed it?
Driftwood Capital has been known to do this in the hotel space. They acquire an asset out of their fund and then syndicate the deal via their retail platform post-closing to return capital back into their fund. This allows them to do more deals.
I’m sure that they layer in fees to account for capital costs. If no additional value has been created in between closing and syndication, then I doubt they are inflating the purchase price for the third-party capital raise. That’s what REITs do when the IPO…
Great name and yes I was about say Driftwood does this. Funny enough, working on a fund with a similar strategy. Yes, we can only syndicate at our cost basis unless additional value is added. I think the one aspect we need to understand is the tax component though. Its easy when you put in $1M and syndicate out a $1M, but if you put in $1M and syndicate out $1.3M there has to be some funky tax implications or maybe Im overthinking it and you just pay the taxes on the $300K profit.
I think you're right re funky taxes. In addition to the profit on the $300k, you might be required to pay Land Transfer Taxes for the purchase/sale of the ownership interest.
Oh good point, forgot about transfer taxes. Curious how driftwood is doing it. Maybe they maintain the majority share to avoid this?
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