Chapter 4 Development Finance Property Development ( 6 th Edition)

1. Chapter 4 Development Finance Property Development(6th Edition) Publisher: Routledgewww.routledge.com Authors: Professor R.G. Reed and Dr S. Sims

2. 4.1 INTRODUCTION • The majority of property developments can only be undertaken with the assistance of funding from an external third party source as a developer does not normally have 100% of the cash required for all development costs incurred during the lifetime of the development. • This loan fills the financial difference between the developer’s available equity, or cash equivalent, and the total cost of the project including all associated expenses over the development period until completion. • There are two forms of finance that are required for property development: short-term finance to pay for the initial development costs (i.e. purchase of land, construction costs, professional fees and promotion costs), and long-term finance to enable developers to repay their short-term borrowing/loan and either realise their profit via selling or retain the property as an investment with tenants.

3. 4.2 SOURCES OF FINANCE 4.2.1 Historical Perspective • The role of the development financier varies depending on factors such as the position of both the business and property development cycle at any particular time in relation to the credit cycle. • Many decades ago the roles of the short-term financiers (i.e. predominantly banks) and the long-term financiers (mainly insurance companies then) were quite separate and developers usually retained their completed developments as long­-term property investments. • Many property markets are generally cyclical in nature, also being increasingly globally inter-connected partly due to technological advances and the instant availability of information about other markets including financial details. • Whilst the global information age may offer an enormous selection of financiers who are not necessarily even based in the same country, it is important for the borrower to be fully aware of the conditions attached to any loan.

4. Discussion point: What is the effect of a market upturn or downturn to the amount of finance available to real estate developers?

5. 4.2 SOURCES OF FINANCE 4.2.2 Financial Institutions • A financial institution or financier are general terms used in the property and real estate industry to describe pension or superannuation funds, insurance companies, life assurance companies, investment trusts and unit trusts. • The underlying primary goal of these financial institutions is to maximise returns to their shareholders at the same time as minimising exposure to risk and adopting a conservative approach with every investment. • The integration of property into wider multi-asset investment policy is an accepted means of diversifying to reduce exposure to risk and a typical portfolio may include equities, cash and a substantial property holding. • As well as purchasing completed and partially/fully let developments as an investment, many institutions also carry out their own developments or provide development finance. • Involvement in development, whether directly or indirectly, will depend largely on a particular institution’s attitude to risk and their perception of the development cycle at any one point in time.

6. 4.2 SOURCES OF FINANCE 4.2.3 Banks and Building Societies • Banks participate in the funding of property developments due to the potential for growth in capital and rental values and the fact that property offers a relatively secure and low risk investment, especially when it is ‘prime’ property. • Due to exposure to bad debts in market downturns they became understandably cautious about investing in speculative developments and the trend is for most banks to restrict lending to high-risk borrowers and reduce their overall level of bad debts. • Most banks now adopt a ‘hands on’ approach to understanding the property development industry and are assisted by their own in-house valuers and research teams. • Property is attractive as security for banks as it is a large identifiable asset with a resale value, but importantly it cannot be sold unless it has a clear unencumbered title of ownership.

7. 4.2 SOURCES OF FINANCE 4.2.4 Property Companies and the Stock Market • Property companies vary from small private firms to large publicly quoted companies. Some specialise in a particular geographical location such as a quadrant in a city, while others hold large portfolios of a cross-section of property types in international markets. • The shareholders of property companies are a combination of financial institutions and private individuals. Financial institutions invest in property company shares instead of or in addition to their direct property investments. 4.2.5 Real Estate Investment Trusts (REITs) • Have been a successful vehicle for the securitisation of property or real estate in many countries including the US, UK, Australia and Singapore. • Increased popularity of REITs is linked to many advantages including taxation incentives, availability of up-to-date information about the REIT and being traded on the central stock market. • Many property developers have grown from relative small developments and are now large enough to be listed as a global REIT (e.g. Multiplex, Westfield).

8. 4.2 SOURCES OF FINANCE 4.2.6 Overseas Investors • The property market now operates within a global economy and in today’s real estate market, overseas investors have become significant participants in the property investment market. • A property development may be located in a particular region. however some of the relevant stakeholders (e.g. lender, architect) may be located anywhere in the world. 4.2.7 Private Individuals • The majority of private investors purchase property investments at the lower end of the market, with a large proportion being ‘mum’ and ‘dad’ investors. • Unfortunately many private investors often place too much emphasis on the relationship between return and capital outlay, therefore making a direct but false comparison with the return from a standard bank deposit. • Many investors are not fully conversant with the risk reflected in the yield rate where a higher yield equates to a higher risk, not lower as per a standard cash deposit in a bank.

9. 4.2 SOURCES OF FINANCE 4.2.8 Joint Venture Partners • A development company may raise finance or secure the acquisition of land by forming a partnership or a joint venture (JV) company with a third party to carry out a specific development or a whole series of development projects. • A partnership may involve any combination of sharing the risks and rewards of a scheme via many different contractual and company arrangements. • Regardless of the reasons for forming a partnership to finance a scheme, it is essential for the developer to ensure the definition of the profit is clearly detailed and understood. 4.2.9 Government Assistance • At any given time various government grants are available. • In many cases the financial incentives would not be sufficient for the developer to undertake a viable project, although the government acknowledges there would be wider community benefits if a developer were to proceed with the project.

10. Discussion points: What are the main sources of finance which may be available for real estate development? What attributes of REITs appeal to property investors?

11. 4.3 METHODS OF DEVELOPMENT FINANCE 4.3.1 Forward-Funding with an Institution • Forward-funding is the term given to the method of development finance which involves a pension fund or insurance company agreeing to provide short-term development finance and to purchase the completed property as an investment. • The proposed development must fall into the ‘prime’ category if the developer is to be successful in securing forward-funding. • After a particular fund has agreed in principle to the forward-funding of the developer’s scheme, negotiations can then commence about the financial aspects of the agreement. • Depending on market conditions, the developer may be able to secure a profit on the value of the land if the value of the land at the time of the funding agreement is greater than the initial cost of acquisition.

12. 4.3 METHODS OF DEVELOPMENT FINANCE 4.3.2 Bank Loans • Banks have received increased competition due to the globalisation of the banking sector, as well as other types of lenders entering the market with hybrid products. • With the dramatic increase in bank lending in recent years and the wider acceptance of debt, various different methods of bank lending have been introduced, such as development companies seeking bank finance beyond the construction period up to the first rent review. • From the developer’s point of view, borrowing from a bank allows greater flexibility and enables the developer to benefit from all of the growth, unless some of the equity is given away. • Bank products include corporate loans, project loans, investment loans, mezzanine finance, syndicated project loans and products with a range of interest rate options.

13. 4.3 METHODS OF DEVELOPMENT FINANCE 4.3.3 Mortgages • Mortgages originally provided the most common form of long-term development finance, where amortgage is a loan secured on a property whereby the borrower has to repay the capital loan plus interest by a certain date. • Mortgages may normally be granted on a loan-to-value ratio (LVR) basis of between 60 and 80% depending on the risk involved. • Mortgage loans are normally for 20–25 years in line with the length of occupational leases, although this time period is open to negotiation. • Various methods have been developed to overcome the initial ‘deficit’ problem caused by the difference between rental income and interest repayments over the first 5 or 10 years, e.g. interest payments may be fixed for a certain period and then converted into a variable rate.

14. 4.3 METHODS OF DEVELOPMENT FINANCE 4.3.4 Corporate Finance • Equity finance – (i) new shares. Companies may raise money by selling shares to investors in a floatation on the stock market or the unlisted securities market. • Equity finance – (ii) rights issues. A company can raise additional capital by offering existing shareholders the right to purchase a number of additional shares in proportion to their existing shareholding at a lower price. • Equity finance – (iii) retained earnings. One source of finance is the company’s own resources generated by profits. • Debt finance – (i) bonds. Effectively is an ‘I owe you’ note, secured on a specific investment property or completed and let development owned by the company. • Debt finance – (ii) debentures. Can be traded on the stock market where the money is typically lent long-term at a fixed rate of interest and is secured upon the company’s property assets. • Debt finance – (iii) unsecured. Property companies may issue unsecured loan stock not secured on the assets of the company at a higher interest rate.

15. 4.4 FUTURE TRENDS • The property development industry is part of the larger real estate market, which is subject to changing supply and demand levels, resulting in often clearly defined property cycles. • Most lenders now take an active role in understanding the dynamics of the property market and the likelihood that the development will reach its full potential. • At any given time there will be a myriad of financially strong companies: new players embarking upon development schemes on the basis of pre-lets and, in some cases, speculative schemes. • Many vacant sites are testament to property developers waiting for the optimal time to initiate a proposal or re-approach a lender when the market is on the rise. • Property developers have a wide variety of lenders and associated products available to them, although the market is constantly changing and adjusting to its own supply and demand forces.

16. Chapter 4 Development Finance Property Development(6th Edition) Publisher: Routledgewww.routledge.com Authors: Professor R.G. Reed and Dr S. Sims