Flashcards in week 4 - financing Deck (28)
explain project valuation - how to value a project
o A ‘for sale’ project: Will generate equal to its net sales value after marketing costs. The value of the for sale project results from its total units multiplied by the net sale price per unit
o Retail, apartments, and most office and industrial projects primarly generate annual income in the form of ren from tenants (build to rent). The valuation of an income producing project depends on the application of a capitalisation rate
o Sometimes a project has a mix of uses or income types.
For instance, a mixed-use project with residential and retail generates value from both the sale of the residential units and the leasing of the retail space. In this case we need to use more than one type of valuation
8 sources of capital
banks and building societies
property companies and stock market
explain financial institutions source of capital
o used in the property and real estate industry to describe pension or superannuation funds, insurance companies, life assurance companies, investment trusts and unit trusts.
o 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.
explain banks and building societies source of capital
o 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’ (large scale commercial) property.
o Due to exposure to bad debts in market downturns though, they became understandably cautious about investing in speculative developments and the trend is for most banks to restrict lending to high-risk borrowers and so to reduce their overall level of bad debts.
o Most banks now adopt a ‘hands on’ approach to understanding the property development industry and are assisted by their own in-house valuers and property-research teams.
o 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. (Compare property to ‘Bitcoin’.)
explain property companies and the stock market source of capital
o Property companies vary from small private firms to large publicly quoted (listed) companies. Some specialise in a particular geographical location such as a (legal or telco) quadrant in a city, while others hold large portfolios of a cross-section of property types in both domestic and international markets.
o 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. (Think of REITs.)
Shares can be liquidated quickly.
explain REIT source of capital
o Have been a successful vehicle for the securitisation of property or real estate in many countries including the US, UK, Australia and Singapore.
o 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 (and quick transaction times compared with actual property)
slides extra info
explain private individuals source of capital
o The majority of private investors purchase property investments at the lower (transaction size) end of the market, with a large proportion being ‘mum & dad’ investors.
o 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. (ie: they don’t allow for risk.)
o 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.
explain joint venture source of capital
o 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.
o A partnership may involve any combination of sharing the risks and rewards of a scheme via many different contractual and company arrangements.
o 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.
o Share expertise, capital and risk.
explain gov assistance source of capital
o Government may offer specific grants or subsidies for specific projects
what is 'debt financing;
o Debt financing receives a return based on fees and an interest rate, either fixed or variable.
o Debt will usually fund from 50-80% of project costs or value, with equity paying for the remainder
o Unlike investors, lenders are not looking for an upside; they just want to make sure that the project will pay principal and interest on time and that it has enough value to cover the loan balance from the proceeds if they need to foreclose
A higher debt percentage means higher “leverage”.
o Lower financing costs on a greater percentage of project costs produces higher returns to the developer and requires smaller amounts of capital from equity investors.
o developers and equity investors (generally) seek high leverage; however, this also raises the risk for the investors, because lenders protect their position (LTV, LTC, lien on assets, foreclosure.)
o Lenders are actually in a senior position in the financing “capital stack,” because their interest in the project is senior to the interest of the equity investor (and is secured by the underlying real estate).
debt has 2 stages
Different stages and have different needs. Interest rate will typically reflect risk:
1. Construction loans - “acquisition, development, and construction” loans, or ADC—are short-term; they are usually adjustable rate loans tied to the prime rate and often require developer guarantees that are secured by recourse to the developer’s assets (usually based on a percentage of project value/costs).
2. A permanent loan repays the outstanding construction loan based on the lender’s underwriting criteria for adequate debt coverage and/or the LTV percentage. Permanent loans are generally nonrecourse, so the lender looks only to the property value as security for the loan
explain permeant funding
o Usually after there is a demonstrated cash flow. Permanent lenders on most income-producing projects usually require a significant portion of the project to be leased as a condition of funding.
o developers may purchase “forward commitments” for a permanent loan, including commitments on funding amount and rate.
o Pre-leasing commitments are needed to ensure that the conditions necessary for a permanent loan are
o Equity investors receive their return from the project revenues available after paying operational costs and debt service—in other words, from profits. Equity investment is repaid from OCF (operating cash flow).
o (usually), equity funding pays its share of the project costs first, before the construction loan starts funding. (ensuring the lender does not fund the project to a higher share of project value than the lending criteria allow).
o profits are usually distributed hierarchically in a “waterfall” to a series of equity investor “pools,” each of which has a different rate of return
and position in the capital stack
explain who gets paid first
what is meant by mezzanine or subordinated debt
, “performing debt,” “gap financing,” “subordinated debt,” “junior debt,” or “mezzanine debt.” This financing funds a gap that neither the primary debt nor equity covers.
Mezzanine finance might require the developer to forego a portion of equity in the project, or take out mortgage indemnity insurance.
explain project finance and 'sponsor' for large developments
How well the project will work – less concerned with the actual developer:
Project finance is the long-term financing of developments based on the projected cash flows of the project rather than the balance sheets of its sponsors. Usually, a project financing structure involves a number of equity investors, known as 'sponsors', a 'syndicate' of banks or other lending institutions that provide loans to the operation. They may be non-recourse loans secured by the project assets and paid entirely from project cash flow, rather than from the general assets or creditworthiness of the project sponsors. The financing is typically secured by all of the project assets, including the revenue-producing contracts. Project lenders are given a lien on all of these assets and are able to assume control of a project if the project company has difficulties complying with the loan terms.
Generally, a special purpose entity is created for each project, thereby shielding other assets owned by a project sponsor from the detrimental effects of project failure. As a special purpose entity, the project company has no assets other than the project. Capital contribution commitments by the owners of the project company are sometimes necessary to ensure that the project is financially sound or to assure the lenders of the sponsors' commitment. Project finance is often more complicated than alternative financing methods.
explain risk identification
Risk identification and allocation is a key component of project finance. A project may be subject to a number of technical, environmental, economic and political risks, and project sponsors may conclude that the risks inherent in project development and operation are unacceptable. The financing of these projects must be distributed among multiple parties, so as to distribute the risk associated with the project while simultaneously ensuring profits for each party involved
A riskier or more expensive project may require limited recourse financing secured by a surety from sponsors. A complex project finance structure may incorporate different types of collateral enhancement to mitigate unallocated risk.
types of risks affecting finance
Risk: there are interrelated types of risk to consider here: (1) Credit risk and (2) Real-Estate risk:
what are the 5 C's of risk analysis of the borrower - past exam question
o Capacity – ability to pay back loans
o Capital available
o Collateral: Debt/equity
o Conditions: the terms and conditions
see nots for more info
explain the 4 factors of risk analysis
3 elements of financial sponsors:
factor 2: project risks:
factor 3 (project) delivery risk - on time successful
gator 4 - payback risks is payback risks - is payback likely, on time, assured
what is capital
What is capital?
o Borrowed sums or equity which the firms assets are acquired and it’s operation are funded
Describe the 3 main sources of capital that a developer might access?
Developers own capital and asset resources
Developers own capital and asset resources – funding all or part of the development, including recourse provisions for loans
External equity sources – co-investors, forward funding arrangements, owners)
A lending source – (e.g. debt issued by bank or other sources of loan funds, perhaphs secured by lien on developer’s assets)
What metric underlies the basic viability of a real estate project?
How its value compares to its costs (and hopefully then gives a profit.)
o The financial viability of a real estate project is based on how its value compares with its costs
Why is debt financing generally cheaper than equity financing, and what is the difference?
The cost of debt is usually 4% to 8% while the cost of equity is usually 25% or higher.
Debt is a lot safer than equity because there is a lot to fall back on if the company does not do well. Therefore, in many ways debt is a lot cheaper than equity.
How do providers of debt financing protect their positions?
through security (mortgages), back-ground checks, feasibility studies of proposed developments, staggered drawdowns etc.
Who is paid first – debt or equity?
• After a project is built, if it is a for-sale project, the debt and equity capital used for building is repaid from sales proceeds, with debt repaid first and equity investors receiving a distribution of the remaining sales proceeds
which cash flow is equity paid from
• For an income-producing project, the permanent loan replaces the construction loan and is usually repaid in monthly instalments. Equity investors receive their return from the revenues that are available after paying these instalments and operating costs.
Describe the usual features of a construction loan and a permanent loan
• Construction loans - “acquisition, development, and construction” loans, or ADC—are short-term; they are usually adjustable rate loans tied to the prime rate and often require developer guarantees that are secured by recourse to the developer’s assets (usually based on a percentage of project value/costs).
• A permanent loan repays the outstanding construction loan based on the lender’s underwriting criteria for adequate debt coverage and/or the LTV percentage. Permanent loans are generally nonrecourse, so the lender looks only to the property value as security for the loan.