What to expect when you’re expecting (to remove your GP): a real estate investor’s checklist

 
Presented with the choice between selling assets and moving on versus a messy divorce, many would select the former. Unfortunately, a lack of liquidity in the market and dramatically fluctuating valuations have made property sales much more difficult, and to preserve value many investors are being forced to choose the path of most resistance by pursuing a removal and replacement of their sponsor. While most partnership agreements prescribe an orderly method for the removal of a GP, there are a number of practical challenges to effect that removal outside the four corners of the agreement that investors should consider as they pursue this course.

Real estate investor checklist for removing a GP

1. Replacement sponsor negotiations

Unless investors have in-house management teams (including those with sector expertise, if necessary) that can take over the assets right away, the first thing an investor will need to do if they plan to remove their sponsor is to begin negotiations with replacements. These negotiations can take many months, involving settling new partnership arrangements, management agreements and potentially new financing. These negotiations may also involve a (painful) resetting of the economics of the partnership and asset valuations. Investors would be wise to approach these discussions with up-to-date appraisals and a sense of the most recent market trends.

2. Financing matters

Financing arrangements for individual assets are frequently driven by the sponsor, with sponsor individuals or funds serving as guarantors under those financings. Typically, those loan agreements provide that a “change of control” of the borrower requires the consent of the lender. As such, sponsor removal and replacement will include the involvement of the lender because they will likely have to consent to either or both the change of control and a replacement guarantor.

Some of these headaches can be managed at the time of entry into the financing arrangement by investors negotiating firmly over criteria for the removal and replacement of the sponsor and/or guarantor. Whether it is a “white list” of pre-approved transferees or a list of criteria such as AUM, number of square feet under management, net worth, etc., the presence of objective criteria can eliminate lender discretion where that discretion would give them significant leverage over the future of the project (be wary of a list of objective criteria that concludes with “…and is otherwise acceptable to lender in its [reasonable/sole] discretion”). Investors can have themselves pre-approved as replacement guarantors at the outset so they can manage a quick transition if necessary. Further, lender KYC searches for replacement control parties or guarantors can eat up valuable time and investors should be prepared to wait out that process, requiring careful management of transaction timelines.

It is likely that a replacement GP will have their own banking relationships and may want to reset the financing at the property in connection with their entry into the structure. If this is the case, investors can consider whether to negotiate a short-term extension of the existing financing or put up the capital (by loaning the money to the borrower entity) to pay off the loan and get repaid with new loan proceeds.

3. Transition arrangements

Sponsors (or their affiliates) often serve the project in multiple management capacities, such as property manager, asset manager and/or development manager. A removal and replacement of the sponsor at the partnership level will almost always automatically terminate the affiliated managers in those capacities as well. Management agreements typically provide for a “transition period”, where the manager will continue to serve following the termination for a defined period of time provided that fees continue to get paid at the property owner’s election. A simultaneous removal and transition is practically challenging, therefore the most prudent course is to plan to send notices electing a transition period along with any notices terminating the applicable management agreement.

4. Tax matters

Many investors (especially foreign investors) participate in the U.S. real estate market through tax-efficient structures. Some of these structures require that the investor not hold more than 50% of the indirect ownership interests in the asset or that the investor not “control” the property owner or investment vehicle. Investors should consider the tax implications of different courses of conduct as they pertain to these requirements, including whether it is worth temporarily ignoring the tax implications given that the assets may be in a loss position, with a view toward reverting to the desired tax structure once the new sponsor arrangements are stabilized.