Every managed asset should have a written business plan, and most do not. What exists instead is a model, which is not the same thing. A model calculates outcomes from assumptions; a business plan explains why those assumptions are the right ones, what has to be done to achieve them, who will do it, and what happens if it does not work. The model is the arithmetic. The plan is the argument.
The thesis has to be stated in one paragraph
A business plan opens by saying what will make this asset worth more at the end than at the beginning. Not a general statement about the market, a specific mechanism: the leases are below market and roll within three years; the building has unused floor area that planning permits; the tenant mix is wrong and can be repositioned; the asset is mismanaged and the cost base is inflated. If the thesis cannot be stated in a paragraph, it is not a thesis.
The thesis also decides what the rest of the plan has to measure. A lease roll thesis depends on the dates on which leases expire or can be broken and on the evidence for the new rent; a planning thesis depends on the consent; a repositioning thesis depends on the capital and the time needed before the new tenants pay. Stating the mechanism is what allows every later section to be tested against it. It is also what places the asset in a strategy, and the labels the market uses describe the plan rather than the building, as we explain in our note on core, core-plus and value-add.
The capital plan is where plans fail
The single most common defect in a real asset plan is capital expenditure that is understated, undated or both. A credible plan sets out what will be spent, on what, in which quarter, and who has priced it. It distinguishes between capital that must be spent to keep the asset functioning and capital that is discretionary and expected to generate a return, and it holds a contingency that reflects the age and condition of the building rather than a conventional percentage.
Plans rarely fail because the rent came in below forecast. They fail because the capital expenditure came in above it, later, and had to be funded when funding was expensive.
The plan should also say where each part of the capital comes from and when it becomes available. Capital held back from the equity, capital drawn from a capex line in the facility and capital expected from the asset’s own cash flow arrive on different timetables and under different conditions, and a plan that relies on future income to pay for the works that are supposed to create that income is circular. A bank lender reads the capital plan in the same way. The European Banking Authority’s Guidelines on loan origination and monitoring, discussed further below, ask it to assess, where relevant, the necessary capital expenditure on the property throughout the term of the loan (paragraph 171), and to take capital expenditure risk into account, as applicable, in its sensitivity analysis (paragraph 174).
Leasing assumptions have to be defensible
The plan will assume rents, letting periods, incentives and vacancy. Each of those is a market judgement and each should be supported: what has actually been achieved in comparable buildings recently, how long units genuinely took to let, what incentives were given. A plan assuming a rent nobody has achieved and a letting period nobody has matched is a plan whose downside has not been considered.
The same evidence is what a bank looks for. In assessing the prospects of reletting a property, the EBA guidelines ask the lender to account for tenants’ demand for that property, having regard to the supply of comparable properties, the conditions and specifications of the property, its location and its proximity to relevant infrastructure (paragraph 172). Where the lender has material concerns about the reliability of the borrower’s financial projections, paragraph 151 tells it to make its own and, when relevant, to use them to challenge the borrower’s. A leasing assumption the manager cannot support invites the lender to substitute its own.
The downside is the part that matters
A serious plan runs the case where things go slowly: letting takes twice as long, the capital budget overruns, the exit yield moves out. The purpose is not pessimism, it is to identify at what point the plan needs more money, and to secure that money in advance rather than in the middle of a difficulty. This connects directly to the financing structure, since the facility has to be sized and dated for the downside case, as we set out in our note on exit and refinance.
Lenders run their own version of this exercise. The EBA guidelines ask for a single-factor or multifactor sensitivity analysis of the borrower’s repayment capacity under adverse conditions that may occur during the loan (paragraph 156), and for commercial real estate they add, among other criteria, reletting, the risks and delays associated with refinancing, and capital expenditure risk (paragraph 174). Among the market events that paragraph 158 asks the lender to consider, where they are relevant to the borrower, is a severe but plausible increase in the cost of funding, which the guidelines illustrate with an interest rate rise of 200 basis points on all of the borrower’s credit facilities.
What a lender reads in the plan
For a commercial real estate loan, the business plan is part of the credit file. The EBA’s Guidelines on loan origination and monitoring (EBA/GL/2020/06) apply to the banks and other institutions within their scope, which must make every effort to comply with them. Paragraphs 9 and 19 determine to which borrowers and loans their section on loan origination procedures applies. In that section, they list business plans supported by financial projections among the information a lender should have and use when it assesses the creditworthiness of an enterprise borrower (paragraph 86), and they ask it to assess the feasibility of the business plan and the associated financial projections in line with the specificities of the sector in which the borrower operates (paragraph 161).
Section 5.2.7 then adds criteria specific to commercial real estate lending, other than for property the borrower occupies for its own business. The lender assesses and verifies the borrower’s experience with the type, size and geographical location of the property, and where the borrower is a special purpose vehicle sponsored by another entity, the sponsor’s experience (paragraph 169). It assesses the income-producing capacity of the property and the prospect of refinancing, over the committed term of the loan (paragraph 170), and, where relevant, matters that include the sustainability of the cash flow, the quality of the tenants and their lease terms, the reletting prospects and the necessary capital expenditure (paragraph 171). Read together, those paragraphs describe the contents of a business plan.
The exit belongs in the plan from day one
Who buys this asset at the end, and what will they be looking at. A core buyer wants durable income and will pay for lease length and covenant strength; a developer wants the site; another value-add investor wants the next gap. The plan should be executed with the eventual buyer in mind, because the work that maximizes value for one buyer is not always the work that maximizes it for another.
The exit and the financing rest on the same assumption. Because the lender assesses the prospect of refinancing over the committed term of the loan, a plan that assumes a sale in year five on a facility that matures in year three carries the kind of gap that assessment exists to find. Where the plan assumes a sale, it should also say how the buyer it has in mind will value the asset, since the same building can carry different values depending on the approach used and on who is asking, as we set out in our note on how a European asset is actually valued. The preparation for the sale itself, from the choice of route to the data room, is covered in our note on exiting a European real asset.
When the plan is a regulatory document
For some managers a business plan is a legal requirement as well as good practice. Article 19 of Commission Delegated Regulation (EU) No 231/2013, which supplements the Alternative Investment Fund Managers Directive, applies where a manager invests in assets of limited liquidity and the investment is preceded by a negotiation phase. In relation to that negotiation phase, and in addition to the general due diligence duties of Article 18, the manager must set out and regularly update a business plan consistent with the duration of the fund and market conditions, and then work through the steps the article lists, from selecting transactions consistent with that plan to monitoring the fund’s performance against it. Among the matters it must weigh when assessing a selected transaction are strategies, including exit strategies, which is the regulatory form of the point made above. Article 19(2) requires records of those activities to be retained for at least five years.
Whether Article 19 reaches a given manager depends first on whether the Directive does. Article 3(2) of the Directive provides that, without prejudice to Article 46, only paragraphs 3 and 4 of Article 3 apply to managers whose assets under management do not exceed the thresholds, and meet the conditions, that it sets. Article 3(3) requires Member States to ensure that, at a minimum, such a manager is subject to registration with the competent authorities of its home Member State, provides them with information at registration and regularly afterwards, and notifies them if it no longer qualifies under Article 3(2). Such a manager can also opt in to the Directive as a whole, must apply for authorisation within 30 calendar days if it ceases to qualify under Article 3(2), and remains subject to any stricter rules that Member States adopt for such managers. Where that line falls for a particular arrangement is the subject of our note on when you become a fund manager.
Governance and reporting around the plan
A plan that is written once and filed is decoration. The plan is a live document, against which performance is measured quarterly, and variances are explained rather than absorbed. That is the reporting discipline we describe in our note on reporting and governance for investors in a managed asset, and it is what turns a plan from a fundraising document into a management tool.
For a manager within the Directive, part of that discipline is also an obligation. Article 15(3)(b) of the Directive requires it to ensure that the risks associated with each investment position of the fund, and their overall effect on the portfolio, can be properly identified, measured, managed and monitored on an ongoing basis, including through appropriate stress testing procedures, and Article 22 requires an annual report for each financial year of each EU fund it manages and each fund it markets in the Union, with content that includes a report on the activities of that year.
The lender watches the same variances. Among the credit quality deterioration signals the EBA guidelines ask institutions to consider in their ongoing monitoring is a significant deviation in actual earnings from the forecast or a significant delay in the business plan of a project or an investment (paragraph 274), and, where applicable, the borrower’s adherence to its covenants is to be used as an early warning tool (paragraph 267). A plan that the manager has stopped tracking is still being read by a bank that lends against it, and a variance the manager explains first is a different conversation from one the lender discovers.
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This article is informational and does not constitute investment, tax or legal advice. Asset management and investment advice are regulated activities and the treatment of any transaction depends on its facts. Each engagement is subject to scope and applicable regulation.