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.

Long Term & Housing Finance in Construction

Finance to construct, purchase or renovate a development repayable over long term -
The borrower is usually a person intending either to occupy the development or let/lease it to a tenant. Loan is issued based on the income of the borrower, and developed property is mortgaged to lender. Borrower cannot sell the property until the loan is settled.

As, these loans are repaid in installments over very long span of time say, 10-20 years and they are called long-term loans. For example ordinary housing finance is a long term loan. Long-term loans are usually given by financial institutions which can hold the loan for long term. This includes insurance companies, provident fund or specialized housing finance institutions. Large banks which can hold funds for long term may also provide long-term finance.

Difference between long term finance, short term finance and mortgage loans
The difference between long-term and short-term finance is that former are secured on completed buildings whereas the latter are issued before construction. Hence capital is much safer, although not liquid. Profit to occupant is contained by the difference in interest payable and the rental income.
The difference between long-term and mortgage hold is that former are repaid in installments consisting of interest payments plus capital repayments on a regular basis. In mortgage hold, borrower is required to pay only the interest until the end of loan period and pay back the capital at the end. Other modes of repayment also exist for long term loans.
Types of long term finance are based on the kind of development that is involved. Accordingly, long term finance takes form of housing loans, industrial loans and commercial loans.

Long term finance includes:

1. Finance to purchase undeveloped land and construct property. Both land and proposed property is security in mortgage. Loan is issued in stages of construction and repayment starts after the construction period, agreed upon between the lender and borrower.


2. Finance to purchase a finished property. Depreciation at the time of purchase may be an important factor in the quantum of loan. Repayment starts immediately after occupation.


3. Finance to renovate a property. Usually existing construction is security in this case. Loan is issued in stages of renovation work and repayment starts after the development period,that is agreed upon by the lender and borrower.

Housing Finance
Housing finance is a long term loan where land use is residential. Being a long term loan, housing loans are issued by banks or private lenders who support long term lending or more predominantly by financial institutions. The general term housing finance includes and encompasses following types of loans.

1. Purchase of land


2. Construction of house


3. Expansion or renovation of house


4. Purchase of house or apartment


5. Refinance of completed loans by mortgage

Features of Housing Loans
Housing finance industry predominantly consists of two types of service providers.
First and more common, the financial institutions such as HDFC, LIC etc. They procure money from small investors by insurance schemes, provident funds, family welfare schemes, gratuity funds etc. These funds are not reimbursed to the small investors in principal or interest until a maturity period. Hence, institutions have the benefit of long term holding of funds. So they are capable of investing on long term assets such as real property and securities, whence they are called Institutional Investors (FII).
Second types of players in the housing finance industry are banks, mutual/benefit funds and private lenders. In most cases, these lenders are unable to hold loans for long periods. However, some companies supported by long standing fixed deposit and savings schemes from small investors do provide long term loan facilities.

Common features of housing loans are enumerated as follows.

1. All housing loans are mortgage loans i.e. the banks remain in possession of the title deeds of the property and execute a first mortgage agreement with the owner entitling the banks to sell the property to recover the loan in case of default.


2. Housing loans are repaid by the borrower from his personal income such as salary or profit of business. Hence, lenders of housing loans require evidences of income of the borrower in addition to security. In most cases, it is possible to include the collective income of spouse or other joint applicants of loan.


3. Occasionally, banks may also require additional security such as guarantor and/or life insurance policies. Sometimes additional or collateral security may also be asked for. Government promissory notes, securities and fixed deposits are also accepted by few banks


4. Usually most lenders issue housing loans up to 85% of cost of the house. The other 15% (called seed money) needs to be provided by the borrower himself. The loans are disbursed in stages: upon identification of property, execution of legal documents and/or various stages of construction.


5. Normal rates of interest on housing loans vary from 5-15%. Interest rates may vary according to rules and sops introduced by the government and special offers given by companies towards marketing finance. Many banks offer fixed rate of interest that do not change with fluctuations in the market, whereas others offer floating rates of interest that changes with market conditions.


6. The repayment period may be varied at convenience between 5-20 years. The term usually does not extend beyond retirement age or 65 years age of the borrower whichever is earlier.


7. Housing loans are repaid by the borrower in monthly installments along with principal and interest. There are different types of installment schemes. Most banks offer Equal Monthly Installment (EMI) mode of repayment. Housing finance companies are entitled to collect post dated cheques towards EMIs over the repayment period.


8. The EMI comprises of both principal and interest and its value for a particular amount of loan over particular repayment period at a given interest rate depends on the period of interest calculation. Interests may be calculated on annually, monthly or daily basis. When there is a delay between commencement of EMI and disbursement of loans, the borrower may be required to pay the interest alone on the outstanding balance as pre-EMI interest.


9. Both principal as well as interest paid on housing loans involve tax benefits to the borrower. Tax deduction amounts to 15-20% of principal and interest payments can accommodated as outgoings before tax.


10. Most institutions charge a processing and/or documentation fees while processing and sanctioning the application apart from the interest. Processing fees are usually a fixed sum or sometimes a percentage of the loan amount.


11. Most institutions charge a penalty of 1-2% of outstanding due for closing a loan by paying back the principal before completion of the repayment period. This is called pre-payment penalty. Some institutions also charge a commitment fees for non-utilization of a sanctioned loan within a specified period.


12. For legal requirements, issue of housing loans require in addition to documents pertaining to the property, documents concerning identity, age and address of the borrower, credentials with bank accounts and documents relating to income and tax standing of borrower.

Selection of Housing Finance Parameters
Following observations are useful in determination of housing loan parameters on EMI basis.

1. For given loan amount, repayment period and rate of interest, EMI is lower for monthly balance schemes than annual balance schemes and is even lower for daily balance schemes. This is unless the savings in interest is offset by increased processing fees or other service charges.


2. For a given loan amount at a given rate of interest and calculation period, EMI reduces with increase in repayment period. The reduction is drastic from 5 to 15 years of repayment. Beyond this period, the reduction is slow.


3. For a given loan amount at a given rate of interest and calculation period, total amount repaid increases with increase in repayment period. The increase is gradual from 5 to 15 years, thereafter there may be drastic increase.


4. It is advantageous for the borrower to avail floating rate of interests when there is possibility of reduction of retail prime lending rates (PLR) in future. But when interest rates are likely to go up, fixed rate of interests are more beneficial to the borrower.


5. When a fixed rate of interest has been availed by a borrower in uncertainty of future market lending rates, it is advisable to avail a balance transfer facility with another bank offering an interest lower than the current rate, prepayment penalty and new processing charges put together.

Selection of Bank
Housing finance is an active sector in the finance industry even in the worst of times. With the entry of (subsidiaries of) multinational financial institutions and the growth of Indian institutions to international standards have contributed in various ways to the housing finance segment.
In general, while choosing financial institutions for procuring housing loans, borrowers look for following aspects.

1. Criterion of eligibility: Enhanced value of housing loans can be claimed from lending institutions by considering age, qualifications, spouses income, number of dependants, assets and liabilities, savings history and credit repayment as eligibility criterion in addition to income.


2. Processing time: Formalities of processing, paperwork involved etc. have come down considerably with improved systems of automation. In ideal cases, processing time should be less than 15 days. Most banks can sanction loan in matter of hours with proper documents. Many banks may also offer sanction the loan even before identification of the property.


3. Rates of interest: The lending rate war among companies are constantly bringing down the rates until, they may reach the minimum stipulations specified by the central bank of the country. It is advantageous to avail floating rate of interests in which interest rate responds dynamically to the sops introduced by government and market competition. But when retail prime lending rates (PLR) are likely to go up, fixed rate of interests are more beneficial to the borrower. When bank interest rates do not change while market rates changes, it is possible to arrange balance transfer facility with another bank. By balance transfer, the outstanding dues to bank charging higher interest are transferred to another bank that charges lower interest.


4. Reducing Principal: Almost all banks offer equal monthly installment based repayment, where the equated installment pays back both principal and interest steadily. While calculating reducing balance it is advantageous for the borrower to keep the calculating period to be lesser. Daily reducing schemes are more preferable than monthly reducing schemes, which are in turn better than annual reducing schemes.


5. Accessibility features: Availability of ATM, phone and net banking facilities make services of lenders more attractive


6. Benefits and incentives: Additional benefits such as free accident and property insurance to the extent of loan outstanding, discounts of interest and waiver of processing fees, prepayment penalty, commitment fees etc. are decisive factors in selection of institution.


7. Flexibility of schemes: Finance schemes should offer flexibility of schemes in terms of interest rates and repayment period. Many banks allow payment of outstanding dues ahead of repayment period with an intention to save interest. The facility to close account before repayment period and amount of prepayment penalty are decisive factors in selection of banks. Daily balance schemes make repayment more flexible, as an occasionally large deposit can be adjusted against outstanding balance to reduce interest costs.

Eligibility Criterion
Housing loans are repaid by the borrower from his personal income such as salary or profit of business. Hence, lenders of housing loans calculate eligible loans based on the income certificates. However, banks can be negotiated for higher values based on following considerations.

1. Age and qualification of the borrower: Younger the age and higher the qualifications, future earning prospects are brighter. As a result, higher estimates of eligible loans can be permissible.


2. Income of spouse or other family members: Income of spouse or other family members may be cited to enhance loan amounts, provided the joint applicants permit such arrangement.


3. No. of dependants: Lesser number of dependants may be used to advantage in calculating possible repayment of EMI.


4. Assets and Liabilities: Existing assets such as cars, stocks, shares and consumer durables increase confidence of lender on the applicant


5. Savings history: If applicant has remarkable savings history, this can be reliable evidence for credit worthiness. Many banks have innovative schemes where savings deposited in bank is considered against principal outstanding, so that interest may reduce. These savings deposits can also be withdrawn on requirement, so that interest is recalculated again on outstanding principal.


6. Credit repayment history: Banks where borrowers have a previous history of successful credit repayment, such as by credit cards, vehicle loans or personal loans support initiatives of the borrowers better.

Installment Schemes
Usually, during initial stages after development, projects fetch lesser revenue and revenue increases later either through increased demand or through inflation. Hence, the occupant pays installments more than incoming cash flow during the initial stages, whereas returns become more than outgoing installments at a later stage.
The arrangement of installments vary from institution to institution. Two extremes can be identified.

In Diminishing Monthly Installments, borrower pays constant installments of capital repayment every month, so that the interest on outstanding capital diminishes continuously. According to this scheme, borrower has to pay larger amounts during initial stages when the revenue from development is not fully matured.

In Equal Monthly Installments, borrower pays constant installments every month so that interest payments are larger initially and capital payments are larger towards the end. The EMI scheme appears convenient because it delays large payments until returns from development can be fully realized.