Real Estate Project Finance

Long-term financing of stand-alone capital investment, such as real estate.

Residential, commercial, industrial, special purpose and land are the five types of real estate. These categories include all sorts of real estate, as well as immovable property.

Real estate project finance

It is referred to as real property because it is immovable from its current position, as opposed to personal property, which can be readily transferred, such as vehicles, jewelry, or art.

Real estate is a major economic driver and the source of the majority of households around the world.

In general, real estate refers to the physical surface of the ground, as well as what is above and below it, what is permanently linked to it, and all ownership rights. Such as the right to acquire, sell, and lease it. 

Personal property differs from real estate. Personal property has the significant feature of being transportable. Vehicles, boats, furniture, clothing, and cell phones are all examples.

Real estate may improve an investor's risk-and-return profile by providing competitive risk-adjusted returns. Compared to stocks and bonds, the real estate market has a low level of volatility.

Compared to other traditional income sources, real estate is very appealing. This asset class often trades at a yield premium to US Treasuries, making it particularly attractive in a low-rate environment.

What is Project Finance (PF)?

Project finance is the long-term financing of stand-alone capital investment, such as a project with identifiable cash flows and assets. Using a financial framework that is non-recourse or has limited recourse.

Project finance

The loans and equity used to fund the project are repaid from the cash flow created by the project; therefore, repayment is largely based on the cash flow generated by the project, with the project's assets, rights, and interests serving as secondary collateral.

Project financing appeals to the private sector because it allows corporations to fund large projects off-balance sheets.

A famous example is real estate project financing. Mining, oil and gas, and structures and constructions are all instances of project financing.

What is Due Diligence in Project Finance?

Proposals are provided in the form of appraisal notes to either the credit committee or a senior management committee, depending on which sanctioning authority is suitable. 

In project finance, due diligence entails properly analyzing all offers included in a transaction.

The background of the company, its management, shareholding pattern, and physical and financial performance

The purpose of the project being funded, details of costs involved and means of financing, the market for the company's products, future prospects and profitability projections, risk analysis, and the terms and conditions of sanction should all be included in an appraisal note.

Loans with Recourse vs. Loans with No Recourse

Only the borrower is accountable and liable in a recourse debt, unlike non-recourse debt.

Even after taking collateral, such as home or credit cards, recourse loans permit lenders to recover what is owed for the obligation. To collect what is due, lenders have the authority to garnish earnings or levy accounts.

The lender cannot pursue anything other than the collateral in a non-recourse debt (loan).

If a borrower fails on a non-recourse house loan, the bank has little choice except to foreclose on the property. In most cases, the bank will not be capable of pursuing any legal action to collect the money owing on the loan.

To illustrate, financial institutions can take various measures against each borrower if they want to buy a major asset, such as a house, and one gets a recourse loan while the other receives a non-recourse loan.

The residences might be used as collateral in both situations, meaning they could be confiscated if either borrower defaults. When debtors default, banking institutions might try to recuperate expenses by selling the property and using the proceeds to pay down the loan.

The banking institution may only pursue the debtor with the recourse loan if the properties sell for less than the amount owing. Beyond the seizure, the debtor with the non-recourse loan cannot be pursued for any extra payment.

Off-balance Sheet Projects

Typically, project debt is kept in a sufficiently small minority company that is not recorded on the balance sheets of the individual owners. This lowers the cost of the project's existing debt and debt capacity. 

The owner's debt capacity might be used for various purposes.

To some extent, the government might use project finance to keep project debt and obligations off the balance sheet, freeing up budgetary headroom. 

The amount of money the government may spend in addition to what it already spends on public services like health, welfare, and education is referred to as fiscal space.

Businesses also understand that a better-looking balance sheet will attract more investors and that banks will charge heavily leveraged companies higher interest rates to borrow money since they are thought to be more likely to default on payments.

Operating leases have become one of the most popular off-balance-sheet financing options. To avoid purchasing equipment or property entirely, a business might rent or lease it and then repurchase it at a discounted price at the conclusion of the lease time. 

Using this strategy, the corporation can keep track of the rental cost. As a result of treating it as an operational expenditure on their income statement, their obligations on their balance sheet are reduced.

Understanding Real Estate Project Finance (REPF)

Several financing mechanisms are available today for various residential and commercial real estate projects. Typically, developers employ internal funds and seek outside funding by issuing stock or borrowing money (loans, leasing, bonds). 

More than fifty real estate financing techniques are described in the international financial literature ESFC, and they are divided into categories based on various factors. 

Leveraged finance of a project with limited recourse is generally described as obtaining capital through a specifically formed separate business. 

As a result, project finance is distinct from standard real estate and construction financing in that lenders share part of the project company's commercial risks. In addition, the project funding is secured by the project's future cash flow.

Real estate finance

The numerous means through which individuals expect to acquire a home, piece of land, or other sorts of property are described, explained, and encompassed under real estate financing. 

The great majority of Americans, predictably, require loans to purchase a home. For homeowners, these loans and the stipulations that come with them can be daunting and perplexing.

Workers

As a result, they'll almost certainly seek assistance from their agent. When qualifying for loans, several factors come into play, including credit reports, asset, and income verification, appraisals, and titles. 

With that stated, each client with whom you do business will probably have a unique circumstance to deal with.

Advantages & Disadvantages of Using Project Finance in The Real Estate Sector

Advantages

  1. Decrease in agency costs since investors will have more power and control over the cash flow.

  2. High financial leverage allows businesses to raise considerable funds with little risk to the borrower.

  3. Because the produced cash flows must be segregated from any other property of the participants, the construction of a special purpose vehicle (SPV / SPE) would be able to provide a safe environment for invested funds.

The project is run through a nominally independent company, and creditors can only attempt to fulfill their claims against the project firm's assets in the case of a project failure.

Disadvantages

  1. The necessity for government or major bank loan guarantees.

  2. Project funding is a difficult and expensive process that involves lots of research and preparations.

  3. Contracts between numerous project participants provide the basis of a multilateral funding framework.

Capital Stack 

The capital stack includes several considerations in funding real estate project finance, such as; 

  1. Using construction loans for financing

  2. Security and priority for various lenders in the capital stack

  3. Terms that correspond to the time it takes to develop and sell the project

  4. Interest rate trade-offs between fixed and floating

  5. Pricing around the equity.

Corporate Finance vs. Real Estate Project Finance

When a company makes a new investment, cash flows from other operations might be used to support the new venture. It can also borrow money and fund the project using its overall creditworthiness.

The company might potentially issue stock with an infinite maturity date.

The equity used to fund the project is generally reimbursed after a set time period in real estate project finance.

Alternative Real Estate Funding Sources

Bank financing is the most common and cost-effective option for commercial real estate projects. 

However, the epidemic and the economic crisis have forced banks to be more selective in their financing, and development corporations have grown more conservative in their lending. 

The hotel and commercial real estate industries have the most difficulty securing financing. Banks are still willing to lend money for warehouses, offices, and residential properties, but the terms are more stringent. 

After 2020, funding for commercial real estate will be confined to the top projects. 

Furthermore, significant development projects are now backed by just a few banks, and obtaining credit money for hotels is nearly difficult.

What is Real Estate Financial Modeling (REFM)?

REFM is the process of analyzing a property from the standpoint of an Equity Investor (owner) or a Debt Investor (lender) and determining whether or not the Equity or Debt Investor should invest based on the risks and possible rewards.

Real estate financial modelling

The specific steps vary depending on the type of financial model, but in general, they are as follows: 

  1. Create the transaction assumptions, which include those for the property size, the purchase price or construction expenses, and the exit strategy (i.e., how much you might sell the property for at the end).

  2. For a development model, project the construction period, generally on a monthly basis, and fund the construction with a combination of debt and equity over time - not all at once.

  3. Create the property's operating assumptions.

  4. Complete the proforma by bringing revenue and expenses, net operating income (NOI), adjusted NOI with capital costs, and debt service to compute cash flows to equity.

  5. Calculate the returns, including the initial investment and any further investments, the annual cash flows to equity, and the exit profits, which include debt repayment and transaction costs. The main considerations here are the internal rate of return (IRR) and cash-on-cash or money-on-money multiples.

  6. Make an investment decision based on your criteria as well as the model's output in various scenarios.

Major Relevant Types of Financial Modeling in RE 

  1. Acquire an existing property, make minor changes, and sell it using real estate acquisition modeling.

  2. Acquire an existing property, make significant changes, and sell it using real estate renovation modeling.

  3. Real Estate Development Modeling: Purchase land, pay for construction, find tenants, then sell after the property has stabilized.

Terms and Definitions in the Real Estate Project Finance Industry

Terms and Definitions

  • Amortization Period: The number of months or years it takes for a loan's principal repayments to be finished.

  • Term: The agreed-upon period of time for which the interest rate on a mortgage loan will be fixedly paid.

  • A general partner (GP): Is a limited-liability partnership owner who is generally a manager in the field who actively engages in the operations.

  • Limited Partner (LP): A passive investor with limited abilities dependent on the amount of money they have put into the project.

  • Land Loan: Financing is used to purchase a piece of land with no expected return on investment. The long-term value will be significantly lower than that of an income-generating property.

  • Loan To Value (LTV): The debt financing a lender will grant as a percentage of the real estate's market value.

  • Loan To Cost (LTC): The amount of debt finance a lender will grant as a proportion of a development's cost.

  • NOI (Net Operating Income): Taking the gross rental revenue and subtracting the operational expenditures (property taxes, insurance, maintenance, etc.).

  • Cap Rate: NOI divided by the property's value, stated as a percentage.

  • The floor space ratio (FSR) is a measurement used to quantify a structure's size and regulate the density of development on a piece of property.

  • Gross Building Area (GBA): The total of all building spaces from wall to wall is known as the gross building area.

  • Gross Leasable Area (GLA): The total of all enclosed habitable spaces.

  • Deductions: Public access zones, roads, lanes, and other sections of the gross site area that no properties can be built on.

  • Gross Site Area (GSA): The two-dimensional measurements of a site based on its property boundaries.

  • Net Site Area (NSA): Gross-site are minus any deductions.

  • The maximum gross building area is computed using the FSR.

  • GBA (gross building area) in construction: the gross building area calculated from construction blueprints.

  • Saleable Area: The gross building area, less all shared spaces and other non-saleable portions, is the saleable area.

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Researched and authored by Chadi Kattoua | LinkedIn

Reviewed and edited by Aditya Salunke | LinkedIn

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