Riassunto di Real estate finance

ANALYSIS OF THE TRANSACTION AND TERM SHEET

The information exchanged between the bank and the borrower during the initial stages are:

• Description of the project’s sponsors

• Illustration of the structure of the company applying for the loan

• The project business plan

If the sponsor is assisted by a financial advisor, an information memorandum will be presented: it’s a

document setting out the details of the project + the project’s sponsors + working proposal for its capital

structure

If more banks are involved in the project, the sponsor will ask the bank to draw up this document in order

to carry out a preliminary review of the bankability of the project

When disbursing a structured loan, the bank carries out an analysis similar to the one carried out by an

equity investor

In the first meeting with the bank, the borrower will present the project and the amount of the loan

requested. Sometimes he also asks the bank to draw up a term sheet, the document setting out the terms

and conditions of the loan 7

The term sheet is used to conduct negotiations on the terms and conditions; it’s updated during the

negotiations and when the real estate project is finalized. The term sheet specifies, for example:

• The parties involved

• The amount and term of the loan

• The guarantees to be provided

• The property description

• The procedures regulating the repayment of the loan

• The interest rate and fees

• The interest period

• The covenants

• The events of default

The term sheet is so detailed to be a pre-contractual act establishing a pre-contractual liability

It “crystallizes” the preliminary agreements reached facilitating the conclusion of the overall agreement

The parties usually wish to specify that the term sheet does not have the status of “preliminary agreement”



by including explicit clauses to that effect the efficacy of the term sheet is conditional upon the approval

of the conditions contained in it by the credit committee of the parties

In this way the terms sheet is not considered an offer and the bank does not have to allocate equity

This does not apply if the borrower requests a binding commitment (irrevocable proposal by the bank),

that is usually requested when the loan has been negotiated with various banks in competition with each

other

The term sheet may be drawn up during different stages of the negotiations:

• 

Preliminary stage if the borrower requests an offer from more than 1 bank

• 

Advanced stage in this case the bank may request the up-front payment of the costs of the due

diligence, regardless of whether it grants the loan

The term sheet facilitates the negotiations but its signature is not essential to conclude a financing

agreement

REAL ESTATE VALUATION

The valuation has the purpose to estimate the value of the real estate asset that will be provided as

collateral. The bank will ask an external surveyor to value the real estate asset determining:

• 

Open Market Value (OMV) amount that could be obtained for a property at the date of

valuation between independent parties

• 

Mortgage Lending Value (MLV) value determined by a prudent assessment of the future

marketability of the property taking into consideration market conditions, long-term sustainable

aspects, current and alternative uses of the property (NO speculative elements)

These values are very similar, but the MLV introduces additional parameters to market trends (long-term

sustainable aspects). This is made by:

• Adapting the rental income to a stable obtainable rent level

• Adjusting the capitalization rates to the long-term development of the market

• Customizing the administration and management costs

Usually OMV > MLV, but in stable markets OMV = MLV

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The MLV provides a long-term sustainable value limit, which guides internal banking decisions in the credit

decision process or in risk management

It facilitates the assessment of the suitability of a property as a security for a mortgage loan

The MLV does not pursue the market cycle OMV

MLV

Time

BASICS OF PROPERTY APPRAISAL

There are 3 methodologies to value a property:

• 

Comparison methodologies sales comparison approach + hedonic models

• Cost methodology

• 

Income methodologies direct capitalization approach + DCF analysis models



Comparison methodologies the value is obtained on the basis of the prices for comparable transactions

Assumption: nobody will be willing to pay a price > cost of buying similar assets with the same utility



Cost methodology the value is obtained on the basis of the value of the land, the construction costs and

the adjustment factors to take into consideration the depreciation due to time and obsolescence

Assumption: nobody will be willing to pay a property at a price > cost of land + cost of building a property

with comparable characteristics, after taking into consideration the loss in value due to the ageing of the

building

It’s a residual approach used to value assets for which there is no rental market and no sale market



Income methodologies the value is obtained on the basis of an economic benefit and a time coefficient

Assumption: nobody will be willing to pay a price > NPV of the economic benefits generated by the asset

The economic benefit is the rental income net of operating expenses

These methodologies work well when:

• Ownership rights are not transferred frequently (es. commercial properties)

• There is a significant rental market

• The value of the property depends on its capacity to generate income, not on a physical measure

When the asset is complex it may be necessary to adopt jointly different methodologies

COMPARISON METHODOLOGIES

It’s necessary to have a sufficiently broad historical set of transactions relating to similar assets

Within the comparison methodologies there is the multiplier approach: it’s an easy and immediate method

used generally when determining the value of a business rather than a real estate asset



Sales Comparison Approach it estimates the value of a property on the basis of sale prices for

comparable properties by applying adjustments which take into consideration the specific features of each

property

It involves 3 steps: 9



1) Selection of comparable properties the comparable properties are similar in terms of location

and physical characteristics (es. age, quality, state of maintenance…); they have to be similar to the

property to be valued and they should have been sold recently (3-6 months) at normal market

conditions 

2) Normalization of the sale prices for comparable properties the sale price should be expressed in

terms of a unit of measurement (es. price per square metre, price per seat, price per room…)

The unit of measurement is specific for each different type of property

Value of the property = average price for unit of measurement * units of the property to be assessed



3) Adjustments the adjustments are necessary because the properties are never perfectly identical

Properties are not comparable if adjustment > 20% of the price per unit

COST METHODOLOGY

Under this approach, the buyer will have to choose between purchasing an existing property and building a

new one

Value of the property = value of the land + construction cost – property’s loss in value

The value of the land can be estimated through a comparison approach considering the recent sales of

plots located within a comparable area or by identifying its highest and best use; in this last case

value of the land = value of the property – construction cost – profit of the developer

Construction cost = average construction cost per square metre * number of square metres

As a property is made up of different parts with different construction costs, this operation has to be done

for every element (es. garage, residential units, commercial units…)

The property’s loss in value may occur because of:

• Wear and tear

• Functional obsolescence (es. energy inefficiency, absence of a lift…)

• Economic obsolescence (es. hotels located in a region which no longer attracts clients)

The measurement of the property’s loss in value is often difficult. The most common ways to do it are:

• By determining the useful life of the property and, hence, a depreciation rate (it may be better to

do it for each constituent part of the property)

• By determining the cost of renovation/refurbishment

INCOME METHODOLOGIES

These methodologies are often used to value properties generating regular cash flows (es. hotels, shopping

centres…). The capacity to generate revenues is the key element in determining the rent

The cash flows used under this approach refer to rents (sometimes also sale prices)

The income methodologies involve 2 different criteria:

• 

Direct Capitalization Approach it converts the expected income over 1 single year into an

indication of value, dividing the expected income by a capitalization rate (1 income, 1 rate)

• 

Financial Approach (DCF analysis models) it converts all future economic benefits into a present

value, discounting them at a discounting rate

Both the capitalization rate and the discount rate are expected measures of returns:

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• 

Capitalization rate it’s the expected yield, measure of income return

• 

Discount rate it’s the expected Internal Rate of Return (IRR), measure of income return and

capital gain returns

DUE DILIGENCE PROCESS

The real estate valuation should be followed by a due diligence process, aiming:

• To carry out an administrative check (es. obtaining all the permits)

• To review the compliance with the law (es. building regulations)

• To ensure that the documentation filed with the land registry is correct

• To carry out an environmental check, to ascertain if there are any sources of pollution

• To check the energy certification documents

LEGAL DUE DILIGENCE

Verification of full ownership of the property to be

mortgaged by the party offering the security

Verification that the property is not subject to any

other securities or chages

Verification of the legal capacity of all individuals

involved in the loan agreement

Verification of the lease agreements in which the

claims are granted to the lender

Corporate and tax due diligence

(for some transactions only)

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3 – LOAN AGREEMENT

OBJECT AND PURPOSE

Sometimes in the loan agreement there is a clause requiring the borrower to allocate the amount received

to the specific purpose of the loan

CONDITIONS PRECEDENT

The effectiveness of the loan agreement may be conditional upon the lender having received a set of

documents, by no later than the date of execution of t