In last week's Commercial Property supplement, Michele Jackson shared some insightful thoughts on the art of the deal in commercial property transactions. This week I would like to build on those foundations and look at the power of understanding the counterparty from a financing perspective.
There can be many reasons why an investor targets a specific property purchase, be that location, asset type or portfolio diversification. However, in terms of the decision to buy a commercial property in the general sense, the basic motivation is to achieve a higher return than could be achieved from alternative uses of the available funds.
Many different factors will have an impact on such an analysis, from yield to projected capital growth, from transaction costs to liquidity of the asset. However, one of the fundamental factors overarching all such considerations is how the proposed purchase is being financed. Is it a cash purchase? If debt is required, is it in place? What level of debt? What is its cost?
Understanding the financial position of the prospective purchasers can be a powerful tool for a vendor. It enables a vendor to understand the associated risks of each offer and may provide an ability to structure a deal to the optimal benefit of both sides, particularly when considering both the price being paid and the structure of the payments.
Geared return
Clearly, if debt is required then understanding the level of gearing typically achieved will help clarify the type of geared return required for the transaction to make sense, with a direct impact on yield and therefore price.
If the purchase is being backed by a fund then it is often the case that the internal rate of return required will exceed the cost of debt a bank-backed bidder faces.
This underlying difference in the cost of capital for each purchaser can translate to the price being achieved and therefore one needs to understand the cost of capital faced by all bidders. While there will not be full details, one can begin to understand the levers being applied.
Then, when considering the various offers the agent has secured, the execution risk needs to be considered. If the highest bid is chosen, this may be highly geared, with the finance perhaps at term-sheet stage, preceded by a plethora of conditions. This would present a large degree of risk, which might be acceptable based on the premium being achieved, but the extent of the risk needs to be understood to ascertain if the premium is correctly pitched.
Having a close understanding of the debt market is fundamental to considering this risk. It is necessary to understand which banks are active in each sector. What are the typical terms being negotiated for the type of asset being sold? What are the timelines involved with the different debt providers? Is there an active market for this asset among the “alternative funders”? Does the counterparty have a positive reputation in closing transactions?
Another aspect is the ability to structure a deal in a way that addresses the funding challenges faced by the potential purchaser. It may be the case that the property is being purchased for redevelopment purposes and this can throw up opportunities in the form of challenges.
Assuming planning is in place, the purchaser must buy the property, fund the development, source tenants and place the completed property on to an investment footing. This presents several funding challenges for the purchaser, and these risks will be priced into the bid.
One approach could be to stagger the payment of funds to better facilitate the sourcing of funds. The two key matters here would be to understand the funding markets that prevail and to then ensure the vendor is being suitably rewarded for risk-sharing in this way. This could be achieved through a carried interest or a pricing ratchet.
In summary, I would contend that funding – the amount of it, the cost of it and the certainty of it – are pivotal factors in the level a purchaser is willing to bid. Therefore, having an insight into the associated risks and how they can be appropriately mitigated and priced, can be a key tool in successful negotiations. Paul Kelly formerly worked at a senior level in commercial property finance at Ulster Bank and is now an independent consultant in the field
