Riassunto di Real estate finance

Introduction to property financing

Debt

Debt financing involves an explicit cost defined under contract with no link between its cost and the return of the investment. Tax deductibility enhances the equity's return. Debt financing continues to be used even where there are no tax benefits, such as:

• Capital rationing (lack of equity capital)
• Risk diversification
• Increase in projected earnings (in return for a greater risk)
• Greater control over management; the need to service the debt limits management's discretion.

Real estate investments involve a significant debt-financing element because of their large size. Most operators don’t have access to all the capital they need to implement the projects with NPV > 0. Many investors use debt financing because they want to distribute their equity capital over several investments (to reduce the overall risk).

Opportunistic funds seeking a high return add financial risk to the operating risk. The higher return (higher FCFE) is counterbalanced by a higher risk (higher discount rate). Properties are well suited to be financed with high amounts of debt because they can be provided as security (they can’t be concealed + their value is quantifiable quite precisely). The value of a property is less influenced by the owner; the bankruptcy costs are lower than in other sectors.

However, complexity may increase even in the real estate sector, particularly in development projects (higher bankruptcy costs when the developer’s role is fundamental for the successful completion of the operation). The possibility to guarantee the debt by mortgaging the property reduces the lenders’ exposure to the risks. However, the value of guarantees is influenced by the legislative regime and the time-scales for enforcement procedures.

Lenders play a significant role in promoting the use of more advanced techniques (e.g., mezzanine, private equity financing) instead of traditional bank financing instruments. Financing methodologies can be divided into two categories:

• Financing instruments identifying a specific contractual form (e.g., mortgage loans, ordinary shares)
• Financing techniques made up of several instruments (e.g., mezzanine)

Equity

Equity refers to all forms of capital contributed by shareholders and any money concerning such contributions (paid-in capital + retained earnings). It has an implicit opportunity cost. Remuneration depends on actual economic performance and is payable after all other investors. There is no tax deductibility and no maturity date for repayment, and no obligation to repay.

The expected remuneration depends on the overall risk perceived (operational risk + financial risk).

A different approach to property financing

A different way to conceptualize financing is to consider the two partners: the shareholder (equity) and the bank (debt). They contribute capital to the same investment in different ways:

• The shareholder's equity contribution will grant entitlement to control/manage the transaction and to a residual remuneration.
• The bank has less control (or even indirect control through covenants and guarantees) but has priority in the payment.

The weight of capital provided by the two partners has a different effect on the net result. The partner which brings capital has to assess the sustainability of the capital structure. In any case, the shareholder's aims and the bank's aims should be aligned with each other. The techniques to analyze the investment should be the same for both the shareholder and the bank.

Corporate finance and project finance

Real estate financing is characterized by the procurement of financial resources from the value of the property provided as security, hence from its projected cash flows. Real estate assets may be financed using highly complex structures and techniques, whilst in the past they were financed using just a few instruments (mainly mortgage loans because they make it possible to tie in the borrower for a long period of time while keeping a contained level of risk thanks to the guarantee).

Today banks privilege project finance solutions, in which the transaction is assessed from the same perspective as that of the equity investor; the focus of analysis is the project, not the borrower. An investment project secures sources of finance (through debt or equity) according to its future capacity to generate cash flows to make payments.

You can adopt a specific approach on the basis of the object of the loan:

• Corporate finance: The object is the loans disbursed to a party (e.g., companies).
• Asset based: The object is a specific asset (e.g., mortgage loan, financial lease).
• Cash flow based: The object is the project (e.g., real estate developments).

The guarantees requested by the lender (and the risk profile) differ depending on which approach is adopted:

• Corporate finance: The lender has to assess the corporate situation.
• Asset based: The collateral value of the guarantee will predominate.
• Cash flow based: The quality and volatility of the project’s cash flow will predominate.

The corporate finance approach (accompanied by guarantees on properties) is often reserved for larger real estate companies or funds. Asset-based and cash flow-based approaches are becoming predominant for real estate financing when there are no guarantees external to the project. From a company finance perspective, the lender will assess the economic and financial equilibrium of the company and the company’s future performance (internal and external factors).

From a project finance perspective, the lender will assess the economic and financial equilibrium of the project, legally and financially separated from other assets through the creation of an SPV (if the project is unsuccessful, the lender cannot seek satisfaction on the other assets); the assessment as to the convenience of the project may already be made with reference to a specific form of financing. The choice between corporate finance and project finance approaches depends upon various factors. Project finance arrangements may be more flexible (because they are arranged on the basis of the specific transaction) but they may have a more complex structure.

Bank financing

Bank financing can be classified under three headings depending on the borrower and the purpose of the loan:

• Property loans to private individuals intended to purchase a residential property or to provide liquidity to cover an expense or home refurbishment.
• Property financing granted to companies intended to cover the company’s financial requirements.
• Structured property financing granted to companies/real estate funds intended to finance the acquisition of an income-producing property or a trading portfolio of properties, or to finance the construction costs of properties to be leased/sold.

In the first two headings, the bank’s due diligence is focused on the capacity of the borrower to generate sufficient income to repay the loan (the property is only a guarantee). In the last heading, the bank’s due diligence is focused on the capacity of the property to repay the loan through the income generated from lease/sale.

Property loans to private individuals

The main guarantee requested by the banks is the establishment of a first-ranking mortgage on the property of the private individual. The bank verifies if the private individual can repay the loan on the basis of his income. If the private individual has an inadequate income, the loan may be granted only once a guarantee has been issued by a third party in receipt of sufficient income. The due diligence phase of the operation can be easily standardized. This kind of loan is offered by all commercial banks.

Property financing to cover financial requirements

The main guarantee requested by the banks is the establishment of a first-ranking mortgage on the property/ies of the company. The bank verifies if the company can repay the loan on the basis of a profitability indicator of the company (generally EBITDA). Sometimes a company, belonging to the same group as the borrower, provides a guarantee. The existence of a business group does not always constitute sufficient justification to permit a company to provide guarantees in favor of another one; sometimes, it is necessary that there are some benefits for the guarantor. The business plan justifying the provision of guarantees by one company for the debts of another one should be rigorously documented and agreed to by all the companies. This kind of loan is generally granted by banks carrying on corporate financing business.

Structured real estate financing

The project finance approach is generally directed at SPVs. The separation between the real estate project and the operations of the sponsors of the asset ensures that they are economically and financially isolated (ring-fenced financing). The parties involved in the due diligence process need a high degree of specialization in the real estate sector.

Fund raising, securitization, and syndication are systems through which banks collect money on the market. Syndication is a procedure through which the lending bank shares the loan with other banks. Securitization involves the conversion of various forms of assets into securities that can be traded on the market.

Traditional funding and securitization

In the traditional system, once the bank obtains the fund, it grants the borrower the loan, and the receivable remains due to the bank for the full term of the loan. The relationship between the bank and the borrower has the same duration as the loan, and any default on the loan will affect only the bank. Under the traditional system, the value of the loans was directly proportional to the bank’s assets, which have to guarantee the credit risk on loans granted.

Under a system based on securitization, the bank assigns the loan to a third party (not necessarily a bank) which issues stocks on the market to finance the operation. Any default on the loan will affect those who bought the stocks issued, and the amount loaned is potentially infinite because it’s not associated with the rigid capital requirements applicable to the banks. The securitization makes it possible to discount to the transaction date the present value of future cash flows which will be generated by the securitized asset.

In the securitization process (sale of the asset + issuing of the stocks), the cash flows resulting from the loan provide a guarantee for the stock issued. The asset is transferred from the originator to the transferee, which acquires it in return for payment of a fee.

Funding

The traditional fund raising systems are two:

• French system: No relationship between the funding activity and the lending activity.
• German system: Yes relationship between the funding activity and the lending activity. The link is established at the conclusion of the loan agreement and must be maintained for the full repayment term of the loan.

Banks are free to choose which system to use and should adopt measures to control and manage the risks associated with these activities (e.g., mismatching of balance sheet asset and liability maturity dates). The treasury department has to manage the following issues:

• Risk of interest rates (rise or fall)
• Risk that clients withdraw the funds from their accounts (bank run)
• Mismatching between the funding maturity and the loans’ maturity
• Definition of the level of current accounts that can be used to provide medium/long-term loans
• Funding activity and lending activity in different currencies

In the French system, banks usually raise funds on the interbank market. The cost depends on the market’s perception of the risk of the bank. Banks with a higher rating can offer better conditions to the clients.

In the German system, funds can be secured on an ad hoc basis; they are referred to as covered bonds. Differently from securitization, covered bonds guarantee a return on capital and interest since some assets are earmarked for their remuneration and repayment. Issuing covered bonds means that the bank will continue to bear the credit risk and it has to make the capital allocations in its accounts. Covered bonds offer more security than traditional bonds (because of the guarantee) higher rating and lower return. Banks issuing covered bonds can lend at lower rates. Covered bonds holders may enforce their rights against the assets set aside (other creditors cannot), that’s why they should accept a lower return.

Covered bonds’ characteristics:

• A guarantee relating to the cash flows generated by the receivables assigned to the vehicle that will be dedicated to satisfying the subscribers of the covered bonds
• Some guarantees of the bank relating to its assets and a self-standing commitment by the vehicle in the event of default by the bank

Syndication

When the banks can’t (or isn’t willing to) underwrite a loan in full, it can involve other banks. Syndication may occur:

• Upon conclusion of the loan agreement, the operation will be concluded in a pool with other banks (club deal), and the banks conclude an interbank agreement to regulate the relations between each other (specifying which bank is the agent bank). The agent bank has to coordinate the interaction between the banks and monitor the loan.
• After the loan agreement is concluded, the bank finances the transaction with a bridge loan (short to medium-term loan), then the bank or the client contacts the other banks before the bridge loan matures to make provision for the mortgage on a pooling basis with a medium to long-term loan. If the bank granting the bridge loan is not able to arrange the club deal before the bridge loan matures, there may be a default risk on the transaction.

In cases of construction financing (to be disbursed on the basis of a work in progress), the agent bank may underwrite the loan in full and start making the initial disbursements. Then, the bank will look for other banks that will sign a new financing agreement solely in respect of the part underwritten. The borrower will have to issue guarantees with the same ranking as those granted to the agent bank. Then, the agent bank will reduce its contractual commitment by an amount equivalent to that underwritten by the underwriting banks.

Structured real estate financing

In structured real estate finance, the bank accepts the cash flows generated by the property financed as collateral for the repayment of the debt. The cash flows refer to the revenues generated by the lease/sale of the property. The due diligence process involves an assessment of the economic and financial equilibrium of a specific real estate asset/project, legally and economically independent of the other initiatives of the sponsors. The real estate project will be implemented by its sponsors through an SPV, permitting the investment to be separated from the sponsors. The guarantees may be real (e.g., mortgage on the property) or contractual (e.g., contractual covenants).

These loans may be:

• Non-recourse: No right of recourse is provided against the sponsors or third parties. The capacity of the real estate project to generate cash flows is the main element to be assessed by the bank, but it will have to assess also the solvency of the sponsors’ shareholders because the sponsors may affect the real estate project.
• Limited recourse: Some rights of recourse are provided against the sponsors or third parties in some cases specified in the contract.

Debt financing is generally available for all kinds of real estate (e.g., offices, hotels, factory outlets). It may be intended:

• To pay the acquisition price
• To support construction costs; it’s necessary to provide an estimate of the costs of the project and of the cash flows. The capital structure of a real estate project may be made up of equity (≥ 20%) + debt + hybrid financing. The debt amount financed depends on:

• The reliability of the borrower
• The transaction and its operational risk
• The guarantees provided

Bank roles

In case of syndication, a bank will receive a mandate as syndicate manager from the borrower. After reaching an agreement with the other bank...