Real Estate Finance

Finance for construction in most cases, cannot be completely arranged from builders own funds. It is necessary to raise funds from other sources, such as banks or private parties.

Types of Borrowers

1. Property developers require finance to construct residential or commercial developments. Developers sell apartments, shops & office space to individual buyers. The finance has to be fully repaid upon sale of property
2. Individuals & firms require funds to purchase an undeveloped land and construct residential, commercial or industrial development, purchase a finished development, renovate/redevelop an existing development. Owners either occupy the property or let/lease it to a tenant. Finance is repaid in installments over long term.
3. Government require finance for developments. Public developments such as roads and bridges are usually owned by the government, and sometimes tolls are collected from users. Residential, commercial, industrial developments of government are either held by public sector organizations or sold to individual buyers.
4. Owners of existing developed property require finance for other purposes. This can be raised against the property by mortgage or lease, in which borrower may or may not occupy the property. Interest has to be paid regularly and capital is repaid at the end of mortgage or lease term

Borrower Behaviour

1. Profitability over and above interest on loans. Developers can achieve profit only if they earn a margin in sale more than outstanding interest payment with the bank. Developers are keen to keep the construction, interest and holding cost before sale as low as possible. For this reason, developers tend to consider one or more of following options: - Reduce amount of high interest loans and maximize use of low interest funds - Raise finance by direct equity funding i.e. on profit sharing basis such as joint ventures - Construct using own funds and mortgage the property to banks during the holding period before sales - Seek longer term finance from financial institutions allowing some equity partnerships.
2. Limited funding by banks. Limitation of bank funds to 60-80% of total project cost makes it difficult to small entrepreneurs, who would be advised to limit to smaller projects. They can take up ambitious projects only after establishing sufficient credentials.Larger firms on the other hand can offer collateral security with other properties and collective returns from various assets can repay the borrowed loans. A loan that calls upon other assets of the developer than the current project is called a recourse loan.
3. Selling and holding property as investments. Since short term finance is expensive, a developer starts construction as soon as the site is acquired and get the building completed quickly. Thereafter, he starts selling the development or holding it as an investment.Property trading companies realizes profits as soon as construction completion by selling. Ideally, the company would sell during construction period.However, successful developers retain some better developments or a share in them as investment. This offers returns on the development, serves as a hedge against inflation and also helps to provide collateral security to further developments

Development Finance

Property developers require finance to construct residential or commercial developments. Developers sell apartments, shops & office space to individual buyers. Finance for this purpose is arranged by following methods:

1. Short term loans from private parties or banks that can be repaid after sale of the property.
2. Raising equity from company share holders
3. Raising equity loans from institutions by assuring minimum priority returns
4. Entering into joint venture with individuals such as land owners or other firms for a share in the return.

Short-term Loans

Short term finance is like working capital of industries, to cover the production period until finished good is sold. The sale of the finished construction or developed property is the sole means of repayment of such loans. In order to control risks on lending, banks take risk factors into consideration whereas developer trying to maximize the benefit of the loan and minimize costs, take particular measures in this regard.

Loans can be either overdraft loans or term loans. Overdraft loans allow an account holder of the bank to draw a specific percentage of funds more than available balance. Overdrafts are usually cheaper than term loans. Term loans are predetermined funds advanced for predetermined term. Term loans give more security to the developer because, it can be fixed for the whole period of the loan enabling developing costs to be forecast accurately.

As most occupiers purchase completed property with long term funding from financial institutions, in one way, institutions are the ultimate purchasers as far as the lending banks are concerned. While institutions base security on the completed and occupied property, banks rely on the project assessment and knowledge of the developer. Banks account for this high risk by considering following factors.

• Liquidity of the property. If there is a fall in the property market, money of the bank gets locked.
• Successful project and marketing management of the developer. Project should manage to be saleable. Hence, history of the developer is an important consideration.Besides, funds are released by the bank only in stages of construction, to give the borrower sufficient flexibility and exercise a measure of control over the project.Banks also monitor the time of completion of the project. A loan for an industrial godown would be for a shorter period period than for an office block as latter takes longer time to complete.Banks also limit loans to about 60-80% of the project cost as determined by its own valuer for same security reasons.
• Increase in short term interests given by banks to small investors.If there is an increase in short term interest rates offered by the bank to small investors in response to government or bank policies.

Equity
Equity capital consists of funds that are to be given a share of the profit after sale of the construction.
As against loans, it is not a liability and interest payments may not be made.
Equity capital is obtained by ploughing back profits, selling shares or by joint ventures. Normally, except for well established companies, profits are not large enough to purchase capital property. Raising equity shares is open only to public companies, with minimum raising limitations.

Equity financing has two main disadvantages: First, the cost of equity finance depends on popularity of the company at the Stock Exchange. Second, issue of shares could mean the control of the company passes out of the hands of the original owners.

Besides, the property companies are more suited to loan finance than equity finance because, income is based on regular rents and capital gains by appreciation. Hence, payment of fixed interest offers less botheration than dividends. Moreover, the property itself can be provided as security for the loan.

In real estate, certain types of financial arrangements which combine the advantages of equity and loans are useful. Equity loans are based on paying returns on priority basis to lender. Equity can also be ploughed in by two or more firms to construct joint venture.

Equity Loans

Since short term financing is difficult for major developments such as shopping complexes or office blocks, many developers seek long-term finance during development stage itself. This mode of borrowing is based on equity participation by the lender i.e. lender directly seeks returns from the project rather than interest. Many financial institutions may be interested in this arrangement as security in prime property developments allows participation in returns from the land as well as in appreciation. Sometimes private investors may also be involved. Such finance may be arranged in various manners enumerated in increasing order of equity participation as:

• Priority Returns Basis: Long term finance institution agrees a minimum return with the developer. Thus, developer can keep the costs minimum, let the project complete as quickly as possible and seek profits.
• Sale and Leaseback Arrangement: The property is sold to a financial institution which then advances the development costs at a fixed rate of interest. If the development is not let out within a fixed period after project completion, developer receives the balancing payment or can enter into fresh leaseback or rental agreement. The agreement is terminated when letting to an occupational tenant is achieved.
• Profit Erosion Basis: This is a special type of lease back arrangement in which the base rent is adjusted against the balancing payment if the property is not let out. If the balancing payment gets exhausted, developer ceases to have interest in the property and institution takes over full letting out responsibility.
• Institution Occupation: With developers having successful record, institutions advance entire development costs at a fixed rate of interest and after completion occupies the premises at a rent agreed with the developer.
• Joint Venture: The development and usually a private investor such as land owner undertakes the project as a joint venture, wherein the profits are shared according to agreed proportions. However as dividends and shares cannot be deduced from assessing corporate tax, this scheme represents a tax disadvantage to the joint company.
• Direct Development by Institution: Institution develops the entire project, by employing the developer as a project management consultant at an agreed fee structure fixed as a percentage of construction cost.

Economics of Finance

Following factors may affect any arrangement of development finance:

1. Usually, finance industry consists of a few monopoly lenders such as banks or financial institutions with more or less same conditions for loan. Advantage of competitive lenders may not be present.
2. When banks are required to limit their lending by government policy, property developers turn to small merchant banks, foreign banks and even hire purchase finance companies.
3. When there is more than one owner for a shared property, arrangement of finance may reflect relative bargaining strength of each principal in bilateral negotiations.
4. Exemptions from income tax offer advantages in lease-holds and security-mortgages whereas capital gain tax and corporation tax schemes discourage leasehold and mortgage arrangements and prefer sharing of returns.
5. Sources of capital also alter as the requirement of lenders change. Insurance companies seek equity shares when they introduce profitable policies to its policy holders or as an inflation hedge

These factors underline that a developer should organize facilities with three or four alternative sources.