Commercial real estate buyers and sellers, hoping to bridge the gap between bid and ask prices, are using so-called "hope" certificates in sales contracts. Hope certificates were more prominently used during the downturn in the early 1990s and, like their name implies, allow a seller reluctant to unload at a depressed price the opportunity to participate in potential post-sale appreciation. "Everybody is trying to find a way to bridge the bid-ask gap," said Gil Tenzer, partner at Contrarian Capital Management.
Andrew Stark, executive managing director at Cantor Real Estate, said that the firm is using hope certificates to close deals and noted that they have helped to increase deal flow. "It's going to be the way deals need to get done going forward," he said.
Here's an example of how hope certificates work. Say a seller is shopping a bond with a $100 million face value and a coupon of 5%. The buyer negotiates a 50% discount to face value and a 15% preferred return, with any additional upside negotiated as a 50/50 split. The bond matures in two years, during which time the buyer receives $10 million in interest payments, leaving a $5 million shortfall on the preferred return. If the recovery on the bond is 75%, then the first $55 million goes to the buyer--a $50 million investment plus the $5 million catch up on the preferred return. The remainder would be split, with the seller receiving $10 million of the $20 million balance.
Hope certificates tend to be used more with whole loans than structured debt. They're also used on sales of equity positions. "Once we get our investment and our return back, we want [developers] to share in the deal," Stark said. "They may even get a lion's share, depending on the deal."
One debt investor said his firm is thinking about using hope certificates in a situation where a borrower is struggling to repay a construction loan. He added, however, that it is important to remember that a hope certificate is exactly what its name implies. "Real estate developers are the most optimistic people in the world. If you give them the possibility of some upside in the future, they'll cling to it and that doesn't mean it will happen," he said.
Another caveat is that the use of hope certificates may raise the eyebrows of regulators. Sellers may want to value bonds or loans at the full amount of their potential gains. If the gains don't materialize, this would result in writedowns. Tenzer, however, believes that regulators will likely require sellers to value certificates at reduced values.
Tenzer acknowledged that most buyers would prefer to close deals without the use of hope certificates. "[But] everyone's getting a little bit of battle fatigue," he said. --Sarika Gangar
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