Bumper real estate M&A year – lessons learnt from the top

Commercial real estate in Australia continues to attract high premiums from domestic and foreign investors seeking to deploy capital and seek stable returns. Our market leading M&A and real estate team led by David Wilkie and Kylie de Oliveira worked on 3 of the top 5 AFR property deals in 2021. Their team of rising stars – Ben Cosentino, Francis Yuan and Gina Yeung – share some of the key legal and commercial dynamics they have witnessed over the last 12 months. 

We saw hot competition for premium commercial property assets in 2021, including hotels, commercial office buildings and industrial property. What assets are likely to be top picks for prospective investors in 2022?

The demand for well-located large industrial prime assets is likely to continue, with the COVID-19 pandemic transforming consumer buying habits and driving the sharp uptick in e-commerce. Even with geopolitical risks worsening, we expect this to continue well into 2022 as demand for e-commerce is not showing any signs of slowing down, particularly as businesses pivot from just-in-time inventory to just-in-case inventory to combat supply chain disruptions.

With COVID-19 restrictions loosening in Australia as well as around the world, we are again seeing a greater interest in the hotel markets after occupancy levels dropped to an all-time low in 2020 and 2021. Transaction volumes will continue to rise as owners look to reduce debt and purchasers seek to secure investments whilst interest rates remain low. 

We expect the healthcare sector and interest in healthcare property to continue to grow in 2022 as investors look for ways to diversify traditional real estate portfolios. Investors are looking at already existing offices and industrial spaces to be repurposed for healthcare tenants.

We are also seeing investors showing a greater interest in the build-to-rent sector, particularly as border restrictions are loosened and removed and rental markets recover from the recent pandemic low. As for the retail property sector, we are seeing investors focussing on properties anchored by tenants whose businesses supply 'essential goods and services' and performed resiliently during the pandemic.

Competition for these tightly-held blue chip assets is expected to remain strong in 2022, which is motivating some investors to consider fund through transactions as an alternative way to adding blue chip assets to their portfolio.

What are the common elements of deals in the top end of the market?

Nimble buyers win

With many sellers looking to realise value in investments whilst interest rates remain low and yields are compressed, we have seen an increase in the use of multi-stage auctions to drive sale prices. These auctions may have shorter or longer timeframes for bidder engagement, but a consistent theme is that bidders who are willing to move more quickly and prove their interest in closing the assets have a significant advantage. Bidders should be willing to conduct diligence, mark-up sale documents and organise debt and credit comfort letters extremely early in the auction process, even if this is not within the guidance/rules set by the seller for the process.

Early FIRB engagement

Now that the FIRB lodgement fee regime has been overhauled, it has become much less expensive for many buyers of small – medium size assets to make FIRB notifications. This has led to a surge in bidders making notifications early in competitive processes and gaining a meaningful advantage over other foreign bidders. The new passive Foreign Government Investor Exemption Certificate is also assisting many fund managers which were previously deemed to be foreign government investors streamline their investments, especially small – medium size assets without requiring FIRB approval.

Due Diligence

Due to current market demand for blue chip assets, sellers have typically been able to force extremely limited warranty packages on buyers, emphasising the need for buyers to rely on their own due diligence.

Companies' ESG credentials are increasingly under scrutiny by regulators and stakeholders. How do you see this factoring into deal activity and influencing buyer appetite for particular assets?

The trend in Australia and also globally is that investors are embedding ESG considerations into the property lifecycle from due diligence to acquisitions to asset management. Transactions that involve hard assets already have ESG considerations built into the investment mandates and taxation rates (e.g. tax breaks for green assets).

On the buyer side, sovereign wealth funds and super funds are looking for buildings and infrastructure that have the highest level of green credentials as they become more accountable to their own investors.

As seen with the devastating floods on the East Coast of Australia, many significant risks facing buildings are climate related. Investors and owners need to consider property insurance premiums to ensure their real estate portfolios can sustain the costs involved with physical damage from natural disasters.

From a legal team's perspective, what are the most critical factors in getting a deal over the line?

For sellers, preparation. Making all information relevant to due diligence available to buyers at the start of the due diligence period and responding to RFIs as soon as possible is crucial. This will allow the parties to identify key risks earlier and therefore address those risks in the transaction documents within the transaction timetable. If Warranty & Indemnity (W&I) insurance will be used, engage with W&I insurers early in the transaction so that they can get across the key risks and how they have been addressed within the time required under the transaction timetable. If FIRB approval is required, consider giving FIRB advance notice on the transaction before buyers start making notifications.

For buyers, creativity. Try to get ahead of the proposed transaction process. Be prepared to accelerate engagement with the seller ahead of the timetable set for the auction. The willingness to outlay diligence and FIRB notification costs early in the process is key. Sellers are increasingly looking for ease of doing business with potential bidders, particularly for larger assets where certainty of funding and minimising execution risk is key. Be willing not to make amendments to an auction draft contract during the competitive process – this is a strong demonstration to the seller that the deal can be closed efficiently if your bid is ultimately selected.

In general, experience. You need at least one person on the team who's seen everything before as well as the ability to leverage specialists and commercial litigators when needed, especially in anticipating any issues that might arise post transaction.

What do bidders and sellers need to consider in evaluating asset purchases from a legal perspective?  

FIRB traps can be a nightmare, particularly in real estate acquisitions. Make sure that all elements of an asset which could trigger a requirement to make a FIRB notification are determined immediately via the RFI process. In particular, ascertain whether any public infrastructure, stored communications, electricity substations or government tenants are present at the relevant asset.

Vendor due diligence (VDD) is important, but should be supplemented with adequate buy-side diligence. VDD reports are increasingly limited in their scope, now typically covering only issues which are required to be addressed to facilitate the transaction (e.g., ROFRs, defects in title, discharge of existing debt securities etc.). VDD reports will not typically address pricing or risk issues which a buyer may wish to negotiate or have covered by the seller or an insurer.

Understand the circumstances of the seller and the bidders for the relevant asset. Knowing the various timelines for capital raising and fund-windup for the seller and various bidders will provide a useful map of the price elasticity which those parties are willing to accept. This will in turn inform how to mark-up documents and engage with the seller/preferred bidders.

Are we seeing any innovations in the way that deals are being structured or delivered that could open up further opportunities?

The recent uptick in take-private transactions is likely to continue, with many investors searching for management discounts which may be priced into REITs or REIT equivalent corporates.

What are the considerations for international investors entering the Australian market?

Despite the reduced levels of international bidders in the past 24 months, relative to historic levels, the commercial real estate market will see heightened bids from foreign investors due to Australia's stable economy.

• The most critical consideration for international investors is to factor in the Foreign Investment Review Board's (FIRB) timeframe to approve a transaction. The changes to the foreign investment review framework, which commenced on 1 January 2021, and more recently to the Security of Critical Infrastructure Act 2018 (Cth), meant that certain offshore M&A transactions that were previously only subject to a voluntary notification regime are now mandatorily notifiable.
  • For instance, if a foreign entity acquires a substantial interest (20% or more) in an offshore entity and the entity has a subsequent interest in an Australian entity classed as a "national security business" (regardless of value), the transaction will require mandatory notification. FIRB considerations will also be of particular relevance in the upcoming Australian federal election. Noting also that FIRB does not make any decisions during the caretaker period, foreign investors will also need to factor in delays to transaction timetables.
• In addition, international investors should know what form of credit support they are willing to offer if their purchasing entity will be a special purpose vehicle (e.g. a guarantee).
• No doubt investors will need to consider macroeconomic influences throughout the rest of 2022 including rising interest rates, increasing geopolitical uncertainty and its effect on supply chains, along with changes to government policy arising from the federal election in Australia. Each of these will challenge the commercial real estate market’s capacity to maintain the heightened activity levels of 2021.