Representations and warranty insurance (RWI), once a relatively niche product, has become an ordinary course part of private M&A transactions. While RWI is more commonly associated with the acquisition of the classic “widget” company that is engaged in the sale of goods or services, the product has gained significant traction in the real estate sector.
RWI, as offered in real estate transactions, has important distinctions from that which is offered in the context of the acquisition of operational businesses, and which reflects significant differences in the key transaction documents of such deals. By their nature, real estate deals demand a less thorough set of representations and warranties given that real estate assets lack operational elements such as employees, IP, and IT (to name a few), and thus the coverage asked of an issuer of RWI is likewise narrower. As a result, pricing and, especially, retention, are often significantly lower than that which could be obtained in a non-real estate context.
Real estate RWI coverage can generally be obtained at a significant discount (currently in the range of 15-25%, accounting for today’s soft market – with spreads increasing further in harder markets) from that which might otherwise be expected to be obtained in other M&A transactions. Significantly, retentions are often dramatically lower – with initial retentions often in the range of 0.25% – 0.1% of the total enterprise value.
One key factor underwriters will often be particular attuned to is whether the transaction agreement includes any representations to the condition of the real estate target’s assets. Traditionally, real estate deals have been effected on a “your watch, my watch” system, which included a due diligence period (akin to a standard deal’s interim period) during which the buyer would be entitled to conduct such on-site diligence and, should material defects be found, allowed to walk away without penalty.
REIT transactions
Where differences can arise in the structure of RWI coverage for real estate transactions is when the acquiror is a real estate investment trust (REIT). In particular, buyers are concerned with a target losing its REIT status, which has massive tax implications. REIT testing is notoriously complex and situation specific – which, when coupled with the high potential quantum of loss, spells the perfect use case for RWI.
Growing the RWI pot
The growth in interest in RWI cover for real estate transactions is playing out against a backdrop of shifting fortunes in the real estate market, and increased appetite among private equity firms for investing in the space. Growing interest from PE money across various real estate sectors also brings the prospect of an accompanying growth in RWI business. As such, investors increasingly view the coverage as essential to the transaction process.
While occupancy levels currently remain high on average across all real estate sectors, this state of play is obviously highly dependent on the economic cycle.
As a recent BlackRock report notes, the real estate market is going through a period of adjustment, with shifting drivers of tenant demand persuading investors to adjust portfolio allocations accordingly.
The rate of occupancy for office space is still exposed to a high degree of uncertainty post-COVID, as hybrid and home working trends have slowed the rate at which workers have returned to the office. However, with even Zoom – the company arguably most closely associated with remote working – having joined Google, Amazon and others in enforcing a minimum onsite requirement for employees, it seems that in the corporate world at least, fully remote working is set to become a thing of the past.
As such, the status quo of renting or acquiring office buildings in downtown locations looks set to remain, with office attendance in metropolitan areas having rebounded from record lows during the pandemic. However, there is still some way to go before it reaches pre-COVID levels, with attendance having stabilized at around 30 percent below previous norms, according to a recent report from McKinsey.
Occupancy in the retail sector remains a concern, with retailers continuing to face challenges from the compound effect of the shift away from shopping at brick-and-mortar stores to online purchasing, slowing consumer spending amid a challenging economic environment, and reduced footfall in urban centers due to hybrid/remote working, which has had a notable impact on the food and hospitality sectors.
Seeking value in specialty areas
On the flipside, other commercial and non-commercial properties are proving attractive to private equity buyers, as investors look for value outside bread-and-butter real estate options.
The logistics sector, having endured through the pandemic, remains strong, particularly given the surge in online shopping and home delivery services. And with substantial growth in frozen food sales post-COVID, cold storage space has become another attractive investment opportunity – although with a relatively small number of facilities available, demand has threatened to outstrip supply, according to recent news reports.
In the residential space, multi-unit buildings remain an attractive investment, continuing to offer consistent income, while specialty sectors such as student housing have been attracting an increasing level of interest.
As a recent New York Times article indicates, the single family home space is becoming a more attractive asset class for PE, due to funds’ ability to make cash purchases and their relative immunity from the impact of high interest rates on the cost of borrowing.
However, increased media scrutiny is also generating some resistance to PE involvement in the housing market that may ultimately impact the risk profile of some acquisitions, making RWI an increasingly compelling protection against transactional risk.
LINKS:
2023 Private Markets Outlook: A new era for investors | BlackRock
The impact of the pandemic on real estate | McKinsey
https://www.mckinsey.com/mgi/our-research/empty-spaces-and-hybrid-places
A Private Equity Firm Might Be Your Next Landlord | The New York Times
https://www.nytimes.com/2023/08/15/nyregion/private-equity-apartments-nyc.html
People Are Organizing to Fight the Private Equity Firms Who Own Their Homes | Vice
Surging frozen food demand may stress critical cold storage supply chains | CNBC
