The good the bad and the ugly: assessing liabilities correctly can return a few dollars more, as Wendy Arntsen finds

When it comes to investing into real estate funds one of the greatest dangers lurks at the bottom of the balance sheet. Everyone knows that debt can be both friend and foe and that the level of leverage is extremely important to the volatility of equity returns. A fund level loan to value (LTV) ratio does not, however, tell the full story. Investors assessing investments into real estate funds must look a lot deeper than this, or they might find that seemingly innocuous debt starts to consume their new equity. This means asking a lot of questions, as the detail of debt arrangements is not always provided in quarterly reports or due diligence packs.

Cash shortage is the main reason that businesses go bust. The same is true for funds. A requirement to repay a loan, either to bring it into compliance with loan covenants or to repay part of a loan during refinancing, creates a need for cash. When a fund is already fully invested a precarious cash position means investors will perceive it as a risky investment; therefore raising new equity or debt to meet cash requirements could be very expensive and detrimental for existing equity.

All leverage is not the same but investors will have to sift through the detail of loan terms to understand the nature of the beast that they are dealing with.

Some facilities do not contain loan to value LTV covenants or even income cover ratio (ICR) covenants at all. Funds with managers lucky, or astute enough to have obtained long-term debt without defaultable LTV or ICR covenants will not be forced to inject further cash as a consequence of any covenant breach or as a result of loans expiring. This can be very valuable in a market correction when capital values fall significantly and LTVs start to shoot through the ceiling. These funds may be able to cling on to their equity positions and ride out the cycle without paying increased payments to the lender and without threat of asset foreclosure.

The devil is in the detail
These ‘covenant-lite' facilities are admittedly rare and in most cases the devil is in the detail. Assuming that a loan does have defaultable LTV or ICR covenants, understanding these covenants is an important area of due diligence on a fund. Getting to the bottom of this detail takes a lot of time and sometimes investors will need to persevere to obtain all of the necessary information from either the fund manager or market counterparty.

Loans might be either single-asset-backed or might be secured against a whole portfolio of investments (cross-collateralised). Each and every loan can have separate covenants and individual loans can pass, or fail, covenant tests on an independent basis. These loan covenants might be tested at different intervals. The penalties may vary as may timetables granted for remedying breaches. Each loan needs to be considered independently to understand associated risk.

The structure of debt is also important when it comes to isolating problem investments. Cross-collateralised debt can be cheaper but it also increases the lender's security and reduces the fund manager's ability to isolate problem investments.

Let us assume that one investment in a pool of 10 investments all forming cross-collateralised security on a single loan becomes a problem investment. It suffers from a tenant going bust and consequent high vacancy. The market valuation of this investment falls below the value of the loan. The lender is not too concerned since the security it has over the other investments in the loan security is sufficient that the borrower will still need to repay the entire loan.

If, however, a single non-recourse loan had been taken out against the problem asset, the fund would have lost its equity in the problem property but would not need to repay the loan from equity remaining in its other investments. Losses on the problem investment would not spill over to other investments and the aggregate NAV of the portfolio investments would be higher under the non-recourse loan.

Beware the lender
Who the lender is can also make a tremendous difference to negotiations when times are tough. It can influence both the speed and likelihood of achieving a loan restructuring. Loans that were highly syndicated (across a number of banks) can be more complicated to restructure owing to the number of parties that need to be involved in a negotiation. Loans that formed part of a commercial mortgage-backed securities (CMBS) portfolio can be even more challenging owing to the level of risk stratification in the CMBS structure.

There is a trend at the moment for international lenders to retrench to their domestic markets. This means that even where there is only one lender, it is important to consider whether they will be looking to continue operating in the relevant market and will be willing to refinance the loans. Relationships with lenders are important when it comes to negotiations; however, even in a strong relationship, debt negotiations can take a long time, and the lender pulls most of the strings.

Leverage will also have a very important impact on a fund's distributions. In simplistic terms, debt is accretive to the income return where the net income return on property (after fees and costs) is greater than the cost of debt. In a falling market, however, the true net income on property can change as can the cost of debt. Higher loan amortisation payments following loan restructures, or ‘cash-sweeps', where income is diverted toward loan repayment, will act to reduce distributable cash flow. The cost of servicing debt will also depend upon the extent of interest rate hedging and the terms and type of derivative used.

Despite the complex risks associated with leveraged funds, many investors expect that today is one of the best times to apply leverage, and that a highly levered fund might be quick to recover value. However, assumptions are not always correct and it certainly pays to thoroughly inspect both sides of the balance sheet - both assets and liabilities.

Wendy Arntsen is director and head of multi-manager at DTZ Investment Management