By Douglas Gibbs

Counsel | Corporate & Finance

The last decade of growth in fund finance has been driven most notably by private equity. But real estate investment funds ("REIFs") are another important part of the funds market. REIFs have traditionally relied on asset-level secured financing (on individual properties or portfolios). Yet here in the Netherlands (and around Europe), major REIFs are increasingly using fund-level finance structures. These raise unique structuring and commercial considerations that we explore in this article.

Like private equity firms, REIFs may borrow at fund and asset level. At fund level, they may attract NAV facilities, subscription lines, hybrid facilities or general liquidity facilities. At asset level, REIFs typically incur non-recourse property financing with a full security package over a propco's shares, property, bank accounts, leases and insurances. As fund-level borrowing becomes more sophisticated, the interaction between these layers of debt must be carefully structured.

Characteristics of Real Estate Investment Funds

Several characteristics of REIFs raise unique questions compared with other fund borrowers:

• Asset finance – asset-level financing is near-ubiquitous for REIFs and is structured differently from corporate financing. Strict LTV and DSCR controls, which can be triggered by third-party valuations (see below), may lead to earlier enforcement in distress than for a typical corporate.
• Security package – in a PE NAV deal, security is typically via shares in holdcos and distribution accounts. In real estate, it is more typical for a lender to look through at the underlying properties and, in many circumstances, take direct security from propcos in the group.
• Enforcement risk – enforcement considerations can be more complex, with change of control provisions for key tenants, real estate transfer taxes/stamp duties, land registry issues and so on. Multi-jurisdictional portfolios will be significantly more complex in this regard.
• Cash flow profile – recurring rental income gives REIFs a steady cash flow against which fund financing can be underwritten. However, third-party asset-level lenders can restrict or block that cash flow if the relevant asset is under stress.
• Valuation – real estate valuations are based on third-party (or sometimes in-house) appraisals, which are more standardised and verifiable than PE marks but can lag the market. An asset with a long-term lease may appear valuable and produce reliable income, for example, then achieve a lower value in the market if the tenant leaves or becomes insolvent. Some assets, such as shopping centres, are highly sensitive to market and consumer trends, yet valuations may not reflect this until well into a downturn. Concentration risk can also be significant unless a REIF is large and diversified across asset classes and locations.
• Fund structure and life cycle – unlike PE funds, REIFs are often open-ended, so their liquidity needs are more varied and include redemption requests. With a changing investor pool and no fixed investment period, subscription lines are also less common.
• Regulation – regulatory considerations for real estate differ substantially from those of trading corporates. Environmental legislation, energy performance standards, insurance and zoning are core to the business and require close monitoring. Funds may also be subject to regulatory leverage restrictions.
• Development assets – most REIFs will at some point hold assets that are (1) under construction or (2) inoperative during renovation. Such properties have limited enforcement value and generate no cash flow until completion.

Products

We have seen real estate investors using several types of fund-level finance:

NAV facilities – popular with established funds with a broad asset base, NAV facilities are a good long-term leverage option for REIFs, but must be tailored to the individual fund, as the security perimeter and borrowing base calculation will vary significantly.

General liquidity facilities – we have seen REIFs use general fund-level RCFs, either secured (often with a borrowing base tied to fund-wide LTV) or unsecured (with covenants requiring a pool of unencumbered assets to remain in the group). These provide liquidity for, among other things: (1) redemption requests; (2) acquisitions with short bidding processes; and (3) capex or emergency equity needs at propco level, without being tied to security over specific assets.

Subscription lines – these suit some REIFs, but not all institutional investors will accept security over the fund's right to call capital, and not all fund documents permit it. Open-ended funds will find sub lines harder to obtain given their shifting investor pool.

Hybrid facilities – newer funds could use the sub line portion for early acquisitions, converting to a NAV facility once established, although we have seen fewer of these in real estate.

Bond issuances and private placements – while outside the scope of this article, several larger REIFs use notes alongside private debt for long-term, competitively priced fund-level leverage.

Structuring Considerations

Structural subordination and security

Much as LBO investors finance their portfolio companies, REIFs frequently use non-recourse asset-level financing secured on the property, receivables, insurances and other assets of the relevant propco/opco. In distress, asset-level lenders can enforce and remove those assets from under fund-level creditors, potentially leaving them without sufficient credit support.

Fund finance providers must therefore ensure that either they have their own security package with sufficient coverage to satisfy the debt upon enforcement; or there are sufficient unencumbered assets in the group (and other indebtedness is sufficiently limited) to satisfy the group's debt upon enforcement.

Secured deals

The first approach is self-explanatory. However, even a fund-level secured lender to a REIF will often expect security over specific assets, not just holdcos and collection accounts as is typical in other fund financing. This offers:

1. A variety of enforcement options, giving flexibility to manage tax or regulatory impacts;
2. (For bank lenders) potentially favourable regulatory capital treatment for loans secured by property mortgages (and therefore better pricing for borrowers); and
3. A direct first ranking proprietary claim against the assets, which gives priority against third parties.

This pool of secured assets often forms the borrowing base for a NAV facility and/or fund-level RCF, with covenants ensuring sufficient headroom between outstanding debt and the value of the secured properties.

Unsecured deals

Where security is unnecessary or restricted (for example, by negative pledges in other financings), some REIFs obtain unsecured fund-level financing. Without direct recourse to group assets, lenders must structure carefully against structural subordination and enforcement risk, and will often require some combination of:

1. Negative pledge on all assets of the group (though often with an exception for ring-fenced propcos which can incur security in non-recourse standalone financing structures);
2. A cap on the secured debt that can be incurred within those non-recourse subsidiaries, and/or a general cap on the debt that can be incurred by all subsidiaries of the REIF;
3. A minimum unsecured assets test, to ensure there is sufficient headroom between outstanding debt of the group and the value of its unsecured asset base; and
4. Fund-wide LTV covenant, to cap debt incurrence above a certain percentage of asset value.

If opting to permit the use of ring-fenced propcos, credit support (e.g. guarantees) from the rest of the group should ideally be prohibited or capped, so that the asset-level secured lenders cannot gain recourse to other members' unsecured assets.

Financial covenants and valuations

REIF covenants often resemble asset-level real estate more than other fund finance. LTV covenants, unencumbered assets tests and caps on secured assets are typical (as already mentioned above).

A debt service or interest cover ratio is also common, measuring cash flow from the assets to the fund. Given a healthy REIF's regular cash flow, DSCR/ICR provides a helpful early warning if its assets are struggling.

Most covenants rely on asset valuations, making them central to credit monitoring. Best practice is independent third-party valuations, but these become expensive across many assets. Some REIFs and lenders therefore combine less frequent independent valuations with more frequent internal ones, depending on the relationship and the REIF's nature and capacity. Real estate bankers will have established views on valuation frequency and content, and most of these deals are delivered jointly by real estate and fund finance teams.

Development assets

As noted above, development assets generate no cash flow and are worth less on enforcement. Lenders should consider their treatment in covenants and valuations, and whether to limit them – depending on whether the REIF invests mainly in existing assets or has more appetite for construction and renovation. Development assets are often excluded from LTV and borrowing base calculations, or heavily discounted.

Cross defaults and intercreditor issues

Since REIFs often have other asset or fund-level financing, cross default provisions should ensure that, when other lenders can accelerate, fund-level lenders can too (preserving a "seat at the table").

Borrowers, however, will be wary that a default under a financing with stricter covenants can cascade via cross default into their other financings with looser covenants.

REIF borrowers therefore focus on aligning key terms across their documentation – especially financial covenants, negative pledges and debt incurrence permissions. Lenders should explore tailored solutions that balance this need for alignment with their credit protection, and be mindful of the fact that a borrower will typically (and often, reasonably) seek cross-acceleration instead of cross-default.

ESG

Finally, many REIFs already track ESG KPIs such as ergonomic and environmental certifications, energy efficiency and emissions reduction, and could benefit from a sustainability-linked loan tied to their portfolio's ESG performance.

Final Thoughts

Fund-level financing offers REIFs valuable flexibility, but their asset-level debt, valuation dynamics and open-ended structures mean that a standard fund finance approach will rarely fit. Lenders and borrowers that map the existing capital structure carefully, align key terms across financings and combine real estate and fund finance expertise will be well placed to structure facilities that support growth while protecting credit. As REIFs continue to embrace these products, we expect the market to become increasingly sophisticated.

In closing, here are four practical considerations when approaching these transactions:

1. Involve a real estate team, particularly to advise on the REIF's jurisdictions, enforcement risks, asset strength, diversification, likely security package, and the approach to valuations.
2. Map out existing debt and security with great care, and game out the possible enforcement scenarios.
3. Make sure that you understand the key terms of the REIF's existing financings – particularly financial covenants and cross defaults – to ensure other lenders won't be advantageously positioned ahead of you when things go south.
4. Consider sustainability-linked loan options.