Real estate “platform investments” have long been considered to be the purview of sophisticated financial players in the real estate world. These investments are typically made by institutional investors, pension plans or other private equity players.
In platform investing, institutional capital is typically backing an “operator” — a development or investment firm responsible for sourcing, developing or managing multifamily assets.
Platform investments provide a minority-stake ownership of the entity that employs key people making strategic investment decisions as well as the entity’s intellectual property. They also allow the investor the right to receive a portion of the capital returns and promoted interests in the underlying investments.
Platform investments are frequently used to fund the general partner (GP) portion of investments made by the real estate investment manager. The platform investor may also provide a pool of capital to be invested as a “fund-of-one” or separately managed account.
Traditional commercial real estate investors and developers have often shied away from seeking platform investments because they view themselves as developers, rather than investment managers, and instead seek capital on a deal-by-deal basis.
The combination of recent industry dislocations, inherent growth limitations of deal-by-deal capital raising, a lack of current liquidity and underlying solid multifamily housing fundamentals have created an emerging opportunity set that is a win-win for both developers and investors.
Through platform investments, developers can unlock value by aggregating underperforming assets with a larger portfolio as well as source growth capital (and investors can receive attractive multiples supported by both fees and property performance).
The Problem: The Balance Sheet Paradox
Industry Dislocation. The recent real estate challenges including COVID and rapid (and sustained) interest rate increases have created unique circumstances. Owners may have performing assets in their portfolio along with other assets that are impaired. This can occur because the developer took on floating-rate debt that has since spiked or if the developer has non-income producing land, construction projects or other assets that were underwritten based on now defunct assumptions that will require capital in order to capitalize or refinance. Lastly, impaired assets can occur because the developer employed leverage that is no longer available in today’s lending environment.
Deal-by-Deal Growth Limitations. Successful developers have successful investors who want to reinvest. This initial stage of developer growth is essential, but it has a ceiling. At some point, developers need to find deeper pockets or they will be in a pattern where they need to liquidate assets in order to raise capital for the next project, or, even more urgently, in order to raise capital to stabilize an impaired asset.
Lack of Current Liquidity. Many developers and owners have faced uncertainty around the pandemic, rates, tariffs and other general macro-economic factors over the past half-decade. The result has been a lack of clarity on pricing and liquidity in the market as well as more conservative leverage tolerance by lenders and others in the capital stack. Without functioning capital markets, a sale at arms-length or a refinance will not yield the same proceeds as it did during the recent prolonged period of low interest and cap rates.
Strong Underlying Fundamentals. The good news is that the demand for multifamily assets remains historically strong with rent growth projected in the near and medium term in many large metropolitan areas.
The result is what we call the “balance sheet paradox” whereby developers have high-performing balance sheets because of strong market fundamentals driving high appraisals and substantial equity, but they are unable to raise capital, utilize equity from other assets to solve issues on impaired assets within the portfolio, or otherwise create liquidity to operate their portfolio without distress.
The Solution: Platform Investing
Platform investments allow for a partial or complete recapitalization of existing assets and can provide growth capital for additional investments. In a platform, the developer’s existing investments are typically bundled together into a single portfolio against which leverage can be applied.
More specifically, the developer and investor would create a new joint venture, which is a variant on the tried and tested OpCo/PropCo (operating company/property company) structure. There is a top tier entity, or “TopCo,” that holds the non-real estate assets of the developer, such as employees, intellectual property and any physical assets (desks, computers, office space), and serves as general partner of the PropCo.
Most importantly, TopCo provides management services to the underlying real estate and collects the “promote” — the extra share of profits — as well as the development, property management and similar fees. Investors’ stake in TopCo allows it to collect a portion of these fees and have a say in overall management.
Underneath TopCo sits PropCo, which is where the investments are pooled (both the good and the impaired). The developer contributes its existing investments to PropCo, and the investor would separately contribute capital to PropCo.
This investment provides the developer with sufficient funds to rebalance and potentially refinance property level debt and provide for growth capital to acquire new investments. The returns to the investor are also crossed among the portfolio of properties, which allows for a hedging of risk against underperforming investments. PropCo, now a capitalized entity with assets, can raise capital from either the investor or third parties on a property-by-property basis more easily.
Because of the long-term relationship between the developer and investor, platform transactions require significantly more negotiation and documentation than a one-off investment. In addition to the economics, the parties need to determine the investor’s exit and liquidity rights, corporate control rights, ability to approve investments and dispositions of assets and more.
Since platform investments tend to blur the lines between traditional developers and investment managers, as the investment is as much in the management team as in the underlying real estate, the platform investor will want to ensure that the developer’s key people remain in place during the term of the platform.
This is usually accomplished through employee incentives, such as granting employees a portion of the promote. It can also have dire consequences. An investor can remove the developer as manager if the key people fail to run the platform.
Platform investments can unlock tremendous value in a developer’s portfolio while also providing an attractive long-term multiple for investors who believe in the sponsors and their business plan. As real estate investments tend to look more and more like private equity investments, the demand for platforms will increase both from investors and developers.
Ryan McCaffrey is partner, and Brian Blitz is partner and corporate group co-chair at Adler & Stachenfeld LLP, a law firm devoted entirely to real estate, based in New York City.