Bet the Ranch or Save the Farm

by Susan L. Stupin, Managing Director, The Prescott Group, LLC.

September 15, 2011 - For those interested in broad stroke investing, the underlying capital structure can be a neglected consideration. The capital underpinning of a bold sector move may seem less than critical. But it could be argued that the underlying capital structure is one of the most important aspects of a successful property investment. Let's not forget that risky investment strategies can be hedged, mitigated, or supported by more conservative capital structures. Conversely, investment risk can be compounded by leverage. And true enough, leverage can also amplify returns. Just look at John Paulsonís breathtaking investment multiple on his sub-prime mortgage bet.

Investors dazzled by an investment strategy should look at underlying risk factors integral to capital structures and ask themselves a few questions. Can the underlying capitalization support the cash and loan-to-value requirements of the investment strategy? Is the capital structure thoughtfully matched to the future capital needs of the investment? What is the risk tolerance in a market meltdown? Is there any flexibility if a restructuring is ever needed? If all of these factors had been considered and addressed in the last few years, the CMBS special servicers would be begging for business instead of swaggering and collecting fees at the expense of bondholders; owners would have not lost as much equity; and the real estate market overall would likely be much healthier. But, unlearned lessons create value creation opportunities and a chance for investors to perhaps be more rational in the future.