Just like with all businesses, there are always risks attached. This article includes various significant risks you may encounter when recapitalizing. Among these will be tax repercussions, lender problems, and debtholder liabilities. Despite the challenges you may encounter with them, they serve their own purpose and reading this article will help you be more aware of them.
Significant risks in real estate recapitalization
Whenever a sponsor refinances a project they already own, they are said to be recapitalizing it. It frequently involves bringing in new investors to contribute extra equity.
The sponsor’s historical expertise in the structure and its operational performance provides a clear benefit in this circumstance by reducing risk.
Investors in such recapitalizations must be mindful of three main risks: liability, lender difficulties, and tax ramifications.
Tax repercussions
Tax repercussions related to the idea of the partnership’s “base” should be investors’ top priority.
Here is how it functions.
Your basis in a property you purchase for $100 will be $100 at the time of acquisition.
Your new basis will be $200 if you have a recap with a stepped-up basis and value it at $200.
The sponsor and previous partners may be subject to capital gains responsibilities as a result, and new partners will not be able to benefit from certain tax advantages that would otherwise apply to the original owners.
A partnership may wish to think about filing a 754 election with the IRS to help alleviate these problems.
In case of a stepped-up capital raising, 754 elections stipulate that your partnership basis should satisfy the inside to outside bases. In non-accounting speak, the partners’ interest is to ensure they benefit from any devaluation and appreciation in the worth of property on time, without waiting until the asset gets sold.
Investors could ask the agreement sponsor if they plan to make a 754 election that details any specific repercussions to the transaction because this is a decision made at the partnership level.
Lender Problems
Lenders’ dislike of recaps is the second significant problem with them.
In closing, lenders will require to who they have lent money, whoever the debtors’ principal are.
Tons of loan documentation will forbid transfers, including many forms of recapitalization not needing the lender’s approval.
It is due to a few factors.
AML (anti-money laundering), KYC (know your customer – anti-corruption), and OFAC (Office of Foreign Assets Control – counter-terrorism) are some that are related to compliance rules.
Banks must ensure that no violations of these laws will result from their loans.
Even though prohibitions against recaps are in loan documents, they aren’t adhered to until there are additional circumstances that would cause a default, most often failing to make the agreed-upon payments.
Investors should take note of this since this may be a breach of the loan documentation if a sponsor recapitalized without the lender’s approval.
Predatory investors would buy pools of notes during the 2008–2009 recession in search of these types of defaults, and they would foreclose even though the borrower was making their payments on time.
If an investment is likely too technically default due to loan documents, investors won’t want to invest in the business.
Investors, however, likely get the chance to review loan documentation to ensure everything is in order.
The simplest method to reduce this issue is to ensure that the sponsor guarantees in the memorandum of understanding that investors won’t cause any loan provisions to default simply by joining the partnership.
Existing Debtholders’ Liabilities
Liability is the third significant problem to consider.
Investors must confirm that no pre-existing obligations exist that shouldn’t be in a straightforward transaction.
It is to validate that any losses that weren’t there after the investors entered the project won’t be held against them when they invest during the recap.
Negotiating complete indemnity from the sponsors for any activities or anything that happened before an investor came in throughout the recap is the best approach to achieve this sort of guarantee.
If you are unable to negotiate or willing to accept the sponsor’s conditions at the original expense as you would on a real estate crowdfund. Check if the sponsor has enough insurance to protect against the loss, particularly those that arise due to actions that occurred before investors entered the deal through recap is one way to mitigate risk.
As an illustration, consider the following scenario: If the review is on a partnership and the property in question is the asset, any remedy against the collaboration can negatively affect the property’s value.
Investors are safe from such losses by requesting indemnity from a sponsor one level above the partnership, as compensation from the firm would likely be useless if all the collaboration held a single property.
Recaps have a purpose.
Due to the heritage sponsor’s extensive operational and asset management knowledge, they offer continuity and can lower the dangers of the unknown. However, investors must be aware of the dangers associated with recapitalizations and the type of financing they offer before making a financial investment in one.
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