Many reports have recently appeared in the media about downward revaluations of real estate portfolios. Although it is not exactly clear how big the decline in value has been, there seems to be a consensus in the market that the value of real estate has decreased considerably since autumn 2008. As a result, real estate investors have seen the value of their assets go down. This may also have far-reaching consequences for private, non-listed real estate funds. Because the financial crisis has now affected the economy as a whole, the risks have further increased. As commercial tenants are having more and more difficulty keeping their businesses going at the same level, rental income may be wiped out completely or in part. Real estate funds may have to endure a very rough period because of these developments. This may provide cause for financing banks to impose additional requirements on funds, under the threat of terminating credit or enforcing security interests.
Private real estate funds
Many private real estate funds in the Netherlands are structured in the form of a limited partnership. The acquired real estate is financed with the equity contributed by the participants (limited partners), supplemented with bank financing. Until the economic crisis, it was not uncommon for banks to finance 80% of the value of the real estate. For the fund to be transparent for tax purposes, participants may not transfer their participating interest without the consent of all the other partners. Private investment funds are also usually closed-ended, meaning that a participant cannot demand that the fund buy back their participating interest. For this reason, participants are generally obliged to hold on to their interest in the real estate fund for the duration of the fund – usually, five to seven years.
Loan-to-value ratio
Nearly every credit facility for financing real estate is furnished under conditions and requirements that are intended to limit the bank’s risk that it will not receive its interest and repayments. Besides having to provide mortgage security, the real estate fund must often maintain a certain Loan-to-Value ratio (LTV ratio). That is, the ratio between the loan and the value of the real estate must not fall below a certain value. The recent decline in the value of real estate has resulted in the LTV ratio going down for many funds and even falling below the contractual value for some funds. In the latter case, the bank will in principle be entitled to call in the loan, even if the rental income has not decreased. If repayment is not made, the bank will also be entitled to foreclose on the real estate through summary execution. The result is obviously a serious loss for the fund and its participants. They will therefore look for ways to avoid this worst-case scenario.
In principle a fund has various options available to restore the LTV ratio. Generally speaking, any choice will involve the incumbent participants having to take a certain loss. One logical option is selling the real estate (or a portion of it) and repaying the bank debt (in whole or in part). Because, however, the decline in the real estate’s value has caused the problems with the bank, an assessment will have to be made whether the proceeds will be sufficient to raise the LTV ratio to the required level. Another possibility is directly or indirectly converting part of the bank debt into a subordinated loan, one option being by issuing a negotiable debt instrument. Typically, the bank’s co-operation is required for this. Contribution of new capital by the incumbent or new participants may also provide a solution. This last option is discussed briefly below.
New capital or new participants
It makes sense for a fund manager to examine whether a new round of capital from the incumbent participants is feasible. If the incumbent participants pay additional amounts in proportion to their participating interests, a complex or other restructuring of the fund will be unnecessary. Unless otherwise agreed, however, each participant must consent to the additional payment. The basic rule is that participants are only liable up to the amount of their agreed contribution and are therefore not obliged to make an additional payment. If some of the participants are unable or unwilling to make an extra contribution, new participants may be recruited. In general, though, they will want to be compensated for the fact that they are joining a fund that is experiencing financial difficulties. Such compensation may, for example, take the form of the issue of new participating interests at a discount (thus, below the market value). The consent of the incumbent participants is normally required for such a restructuring, as an issue of this kind means that new participants become parties to the limited partnership agreement. Further, issue at a discount is impermissible without consent.
The incumbent participants’ interest will be diluted with the issue of new participating interests. Nevertheless, this may be an attractive option for them if it can prevent a greater loss. As noted, every incumbent participant must agree to the issue. It can be inferred from the case law that a minority objecting to a new issue can only be forced to give up its resistance in exceptional situations. The specific case decided upon involved the refinancing of a private limited company, in which the interest of a small, recalcitrant minority would only have been slightly diluted, while the company would very likely have gone into liquidation if the solution of last resort, the issue of new shares, were to have been thwarted.
Depending on the circumstances, the best choice for a restructuring will have to be made. Various alternatives and combinations are conceivable. Besides civil law aspects, tax-related issues and regulatory laws will have to be looked at to come up with the best solution.
By Berth Brouwer, corporate real estate lawyer, Boekel De Nerée. E-mail: This e-mail address is being protected from spambots. You need JavaScript enabled to view it .