What is financial engineering? And is it really necessary?
To summarize, It is when you utilize mathematical techniques and equations in order to solve financial difficulties. Financial engineers play an important role to various fields in investment strategies, risk management and many more.
In this article, we will be talking more about how what happened in 2007-2008, what are the most common traps in this industry and some notes from our experts on how to avoid them.
Financial Engineering
Financial engineering, the process of using borrowing and covert reporting to ostensibly increase a transaction’s profitability has been the norm in private equity, and is closely tied to commercial real estate investments. The financial crisis of 2007-2008 taught us that financial engineering may be used in various circumstances and isn’t always for the benefit of shareholders. Given how intricate today’s real estate and property agreements are, investor due diligence is more important than ever.
Fundamentally, financial engineering involves using a lot of leverage or shortening the time an investment is held to maximize the internal rate of return (IRR). In the underwriting process for managing real estate assets, we look for and assesses risk variables using forecasting and pricing methods. However, debt financing arrangements that have the potential to backfire on investors are also subject to financial engineering. Examples include the holding company debt that caused Remington, a manufacturer of firearms, to file for bankruptcy and the collateralized debt obligations that sparked the current financial crisis.
In conclusion, debt financing exposes investors to greater risk than they would realize. These risk concerns may not be disclosed or be unclear to real estate asset managers. Due diligence procedures to identify the possibly deceptive use of financial leverage are outlined below along with the top 5 financial engineering mistakes we regularly see that aren’t always obvious or mentioned in the transaction documentation.
- Manipulation of Property Investment Timing. Within 2 – 3 years, several companies that manage real estate assets sell their interests. Although it’s usually too early to generate high returns, selling the property will result in a high IRR that will appear great to an unsuspecting investor. IRRs are larger over shorter timeframes, but money is not created. This strategy may be hazardous as well as deceiving. If interest rates increase and a sale is not possible, a transaction with tons of short-term, unsecured financing built on prospects for a fast sale may go south. Due diligence: Real estate asset managers should justify early sales if the original business strategy has altered. Additionally, rather than focusing just on the IRR, investors should hold management accountable for the projected equity multiple, or the overall return to the investor. “You can’t spend IRR.” and “it doesn’t create money.”
- Misuse of subscription credit lines. The capital commitments of investors are often used as collateral for loans in private equity real estate. This kind of bridging loan must be repaid by the property asset management a few days after a capital call. If the subscription line is extended for 180 to a year, the investor is supplying collateral without receiving interest in exchange. Additionally, it is another method of boosting IRR, which ignores the lengthy period when investors’ money is pledged but not yet used. Due diligence: Investors should enquire about subscription lines’ use patterns and typical borrowing terms from real estate fund managers. Abusing subscription lines will also reduce the equity multiple because the additional profit from the loan is zero.
- Increasing Financial Leverage. Loan-to-value (LTV) ratios of 85 percent or 90 percent need less investor equity and have a higher return on equity. However, if the company’s idea faces obstacles, returns might disappear swiftly. Fully leased commercial or multifamily real estate may appear to be a secure investment, but depending on its classification or conditions, it may not give the borrower much room to generate additional income for loan repayment. When an economic crisis happens, lenders may be forced to sell the asset even if real estate market circumstances worsen. Due Diligence: Investors need to know what type of returns are necessary to support the degree of risk they are taking. Concerning leverage, they can quantify what the return should be to support the risk thanks to the WACC (Weighted Average Cost of Capital) calculation. They should be mindful of LTV ratios exceeding 75% and ensure that the rate of return rewards them adequately for the risk of incurring a higher cost of equity.
- Funding a Management Team Through Refinancing. The ability to increase rents, have the property reappraised, and refinance with a larger loan is all possibilities once real estate asset management adds value to a property through renovation. The investor is left with nothing except the higher risk of increased debt if the manager’s compensation is paid entirely out of the higher loan profits. Additionally, plenty of managers are compensated through IRR-based obstacles, which encourages them to refinance more quickly and with bigger loans. All of this increases the investor’s risk. Due Diligence: Refinancing should be advantageous to the manager and investors alike. Investors should search for securities with structures that include 3 to 5 years’ worth of refinancing lockouts.
- Covering up ground leases. Some commercial real estate owners sell the structure while keeping the land it stands on, but the buyer is still responsible for paying the ground lease. Lease payments are essentially another type of debt financing. Investors risk losing their investment if the lease payment isn’t paid since the building is pledged as security. A bargain like this should be more affordable. Due Diligence: An investor would need to be informed that a ground lease would be a significant risk element in a private equity real estate acquisition. The lease must be accounted for in the capital cost. Keep an eye out for ground leases with short lease terms, in particular those with 50 years or less, since they come with increased risk because lenders find it challenging to finance them.
It is significantly harder to utilize financial engineering unethically because of stricter rules like the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. However, it is still simple for an asset manager to conceal transaction realities that enhance risk or for a prospectus to deceive shareholders. Investors must thoroughly comprehend the risks involved, estimate their projected returns, and decide if the gains outweigh the increased risk. Furthermore, asset managers for real estate must be open and honest about the details of every transaction.
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