In recent years, there has been a rise in the number of financial technology (Fintech) companies looking to apply technological innovations to improve aspects of the residential real estate market. These innovations include (i) using technology to streamline the process of buying and selling real estate, (ii) utilizing digital platforms to better predict real estate values, (iii) creating programs to better align tenants’ housing needs with desired rental properties and (iv) creating unique ownership structures to allow second home ownership. One obstacle faced by Fintech companies which acquire real property as part of their business model is that acquiring and maintaining such real property requires a sizeable capital investment in order to efficiently operate, commercialize technology and grow their business. Like other startups and early stage companies, Fintech companies generally obtain capital initially from traditional Fintech company venture capital sources, which include venture capital funds, working capital lines of credit, general corporate debt, or preferred equity issuances, before moving onto the established asset-based financing and securitization markets for financing. These traditional Fintech company funding sources can be expensive, and restrict growth by requiring significant concessions in control rights, including consent rights over obtaining new debt, creating new subsidiaries, and/or the creation of all assets liens. Given the foregoing, real estate focused Fintech companies would be well advised to consider whether their business model lends itself to utilizing asset-based financings, similar to non- real estate focused Fintech companies, to leverage their real estate assets to access more efficient and cost effective forms of capital, in lieu of solely relying on traditional venture capital sources.
Traditional Capital Sources for Startups
Early-stage Fintech companies typically rely on traditional venture capital sources, such as venture capital funds, working capital lines of credit, general corporate debt and preferred equity issuances.
Obtaining capital from traditional venture capital sources is important for startup companies, and has the potential to provide several key benefits. In addition to providing needed capital, providers of venture capital may confer “credibility” through their investment, assist in attracting talent and help with networking in relevant industries, among other benefits. However, these benefits can come at a steep cost. Traditional venture capital funding sources often only provide capital in exchange for an equity stake in the company and a variety of other concessions, giving providers significant control of the company, such as a board seat or veto rights over actions of the company. Providers of venture capital frequently structure their investments in the form of preferred equity or discounted convertible debt, which allows such capital providers to receive proceeds (and often a preferred return) prior to the holders of common shares, pro rata rights in order to maintain their ownership percentage, veto rights over certain company actions, rights of first refusal or the option to sell their shares at the same time as the founders, and strong anti-dilution rights, among other privileges. Other capital options for startups include working capital lines of credit, incurring general corporate debt, and preferred equity issuances. However, these options typically come with terms that may restrict growth of such Fintech companies, such as high interest rates on debt, and usually require an all assets lien on the company’s assets (which may include intellectual property), as well as consent rights over new lines of credit and the creation of new subsidiaries.
While traditional venture capital sources are a critical part of any startup, Fintech companies—whose business models involve acquiring and owning real property and related assets—have tangible assets easily valued in the market which non-venture capital providers, including banks, are generally comfortable financing. As a result of their ownership of such assets, these Fintech companies have a unique opportunity to diversify their capital sources in order to finance the acquisition and maintenance of real property and related assets, like non-Fintech companies, rather than solely relying on traditional venture capital sources.
Forms of Asset-Based Financing
Asset-based facilities are financings where the lender will lend to a bankruptcy remote special purpose vehicle (SPV) that owns certain collateral, while the lender will have limited or no recourse to the related parent operating company. Typically, the advance rates provided in asset-based facilities are higher than with respect to a loan made directly to the operating company, because such financings are structured with the intent of isolating the collateral from the credit quality and bankruptcy risk of the operating company. Unlike venture capital funding sources, asset-based financing sources generally do not place restrictions on the ability of the parent or affiliates of the SPV to incur debt or conduct their business, nor do asset-based financing sources typically require an equity stake in the parent as a condition of the asset-based financing; however, they do rely heavily on the value and condition of the assets they finance. The following subsections highlight two forms of asset-based financing well suited to financing real property and related assets: asset-based credit facilities and securitizations.
Asset-Based Credit Facilities
Under an asset-based credit facility, an SPV, or a series of SPVs, will enter into a loan agreement with a bank or other lender and pledge its interest in the collateral to the lender. An advantage of an asset-based credit facility is that it is usually less document intensive, and easier to amend over time, than the securitization structures described below. Generally, these facilities include eligibility requirements for the characteristics, sometimes including the value, of the real estate that can be pledged to the facility and concentration limits that restrict real estate with certain characteristics, an example of such are geographical restrictions. In addition, the availability under the facility is typically tied to a borrowing base, which is a calculation of the value of eligible real estate multiplied by the applicable advance rate, and the borrower is required to maintain sufficient collateral pledged to the facility to satisfy the borrowing base. In addition, most facilities have performance related triggers and events of defaults that are negotiated between the borrower and the lenders.
While securitization structures are generally more document intensive and more difficult to amend than the asset-based credit facility structures described above, there are advantages.1 The investor base that purchase securities issued under a securitization may be a separate set of institutions from those that enter into asset-based credit facilities described above. This is significant because, unlike obtaining financing from a bank or other financing provider—each of which likely have limits on the aggregate amount that can be lent to a company—securitizations are limited by market appetite and the amount of assets owned by the SPV. In addition, a securitization would provide a Fintech company with term financing for the expected life of the asset as compared to an asset-based credit facility, which typically does not provide funding for the asset’s entire term, which can create liquidity issues for borrowers if a facility is not extended.
Under one typical securitization structure, an SPV holds the collateral and issues notes backed by that collateral to investors. Income streams on the collateral, such as rental payments or proceeds from the sales of the real property, are used to make payments on the notes issued by the SPV issuer. Under another example of a securitization structure, a bank (lender), usually an affiliate of the lead underwriter for the securitization, will make an interest-only bullet maturity accommodation loan (loan) to an SPV that holds the collateral (borrower) secured by the borrower’s pledge of such collateral. The borrower generally uses rent payments or proceeds from sales of the collateral to pay interest and principal on the loan. The lender will not transfer any of its own funds to the borrower, but will sell its rights to the loan to a SPV (issuer). The issuer will issue notes backed by the borrower’s obligation to make payments under the loan, and the proceeds from the sale of the notes will be paid to the borrower as the proceeds of the loan.
SPV/SPEs and Guaranties
A key feature in the two proposed financing structures outlined above is the utilization of one or more SPVs to hold the relevant collateral. Lenders, investors and financing parties will often require the use of SPVs to further insulate the financed collateral from creditors of the parent operating company. An SPV is a direct or indirect, wholly owned subsidiary of the parent operating company—typically a limited liability company or a trust—that is formed by the parent operating company for the limited business purpose of holding the assets that are to be financed and which, through various restrictions on the SPV, is intended to be protected from any bankruptcy or insolvency of the parent operating company. From the perspective of a parent operating company this has the advantages of (i) generally limiting its exposure to the lender by isolating the assets subject to the lien of a lender from such parent operating company’s other assets (including its intellectual property), (ii) generally limiting the recourse of a lender to the assets of the SPV, and (iii) obtaining better financing terms. Lenders in these financing structures generally rely on the quality of the assets owned by the SPV and their ability to foreclose and take possession of those assets in a default scenario rather than primarily relying on the credit of the parent operating company.
Lenders will also typically request a limited guaranty from the parent operating company. Under a limited guaranty the parent operating company would only be obligated for losses suffered by the lender as a result of certain bad acts by the SPV (e.g., fraud or willful misconduct or bankruptcy of the SPV). These guaranties usually do not require the guarantor to post any collateral, but may have certain financial covenants the related guarantor is required to maintain.
Certain Considerations for Transfers of Real Property when Using Asset-Based Financings
To utilize forms of asset-based financing, the real property must be transferred by the parent operating company to an SPV or acquired directly by an SPV. There are costs associated with transferring real property to an SPV, particularly after it has been acquired by another affiliated entity, including costs related to changing title and related transfer fees and taxes. These costs increase when there are frequent transfers of assets between SPVs. The transfer process requires parent operating companies to prepare deeds for the related real property in the name of the applicable SPV. Some of these costs and expenses can be mitigated by using a tilting trust structure. A titling trust is a series trust created in accordance with the Delaware Statutory Trust Act (Act). Under this structure, assets can be transferred to the trust and allocated to different special units of beneficial interest (SUBIs) within the trust. There can be multiple SUBIs created in each trust and each SUBI, pursuant to the Act, is intended to be insulated from the liabilities of any other SUBIs created under the same trust. The advantage of using a titling trust structure is that the real property can be conveyed from one SUBI to another SUBI without having to be re-titled, and properties can be transferred between financing facilities with different lenders which finance different SUBIs. For a more in depth look at titling trusts and their advantages please see “Beyond Auto Leasing: The Use of Titling Trusts in Structured Finance Transactions”2
Certain Considerations for Fintech Companies when Using Asset-Based Financings
While the business model of any particular Fintech company may not lend itself to using asset-based financing, a real estate Fintech company would almost certainly be able to benefit from asset-based financing. In particular, while a real estate parent operating company may need to value its intellectual property rights for purposes of analyzing the creditworthiness of any limited guaranty, the real estate assets of a real estate Fintech company should be able to be valued by an independent third party, and therefore be isolated to provide meaningful security for the financing. As such, the asset composition of the real estate Fintech company may allow such Fintech company to leverage its real estate related assets in a more efficient and cost effective format and in a manner similar to non-Fintech companies. In addition, structuring such an asset-based financing so as to be eligible for investment by real estate investment trusts may permit an even greater investor base, thereby allowing for greater flexibility and efficiency.
Traditional venture capital sources are an important part of a startup’s early stage financing and have many advantages and disadvantages, but Fintech companies that own or plan to acquire real property may also be able to utilize asset-based financings to access more efficient and cost-effective forms of capital. As demonstrated above, there may be asset-based structured finance solutions available for Fintech companies looking to finance the acquisition or maintenance of real property and related assets. Fintech companies would be well advised to consider their business strategy, as well as their short- and long-term goals, in the context of the advantages and disadvantages of each asset-based finance product outlined above to determine the application to their business.
2 Van Gorp, Beyond Auto Leasing: the Use of Titling Trusts in Structured Finance Transactions, 25, The Journal of Structured Finance; (2020), https://eprints.pm-research.com/17511/25533/index.html?39880