Real estate project finance: funding options and general features
Over the past few decades, developed countries have used a new method of financing of real estate projects and risky development projects
This method is called project finance (PF).
This concept is usually characterized as leveraged financing of a project with limited recourse by raising funds through a specially created independent company.
Thus, project finance differs from traditional construction finance in at least two ways.
First, lenders share some of the business risks with the project company.
Secondly, the project finance is provided against the future cash flow generated by the project.
A very important feature of the projects implemented in this way is the sharing the risk between the participants. Each PF initiative is assessed by the participants mainly in accordance with its ability to generate cash flows, which become the main guarantee of debt repayment and return on equity.
Project finance is a flexible combination of financial products / services that makes it possible to finance projects in the field of residential or commercial construction against a guarantee of expected future cash flows.
In order to obtain a safe environment for invested funds, the generated cash flows must be isolated from any other property of the participants.
This is achieved through the establishment of a special purpose vehicle (SPV / SPE). Thanks to a formally independent company, in the event of a project failure, creditors can only seek to satisfy their claims within the assets of the project company. Accordingly, the initiators risk only those funds that were invested in this company.
Conversely, in the event of shareholder insolvency, the SPV / SPE will continue to operate under all circumstances.
This guarantees the completion of the development project regardless of the financial health of the initiating companies.
Real estate project finance
Currently, there is a wide range of instruments for financing of real estate projects of various types.
Usually, developers use financing from internal sources and attract external financial resources by issuing shares or borrowing (loans, leasing, bonds).
The world financial literature gives more than fifty methods of real estate financing, classified according to many criteria.
The dilemma of every developer at the stage of preparing to secure financing of real estate projects is the choice of the most appropriate source of funds and the organizational form of the project.
CP Finance UK has recruited a multidisciplinary finance team with solid experience in financing development projects around the world.
We are ready to offer a large bank loan of 10 million euros or more with a maturity of up to 20 years for a Financing of real estate projects.
If you are looking for a reliable source of funds for the construction of large properties or refinancing loans, contact us.
Financial engineering in project finance
All residential and commercial real estate projects are characterized by a complex planning stage and a long period of operation of finished objects.
Another important characteristic of such projects is the irreversibility of investments.
At the initial stage, the project involves high capital costs, and at a later stage, the maintenance of buildings and residential complexes implies significantly lower operating costs. The revenues / benefits from such a project increase over time, but the costs are stable and predictable.
The implementation of a large development project usually involves a significant proportion of borrowed funds (high debt burden). Moreover, the bulk of the required resources must be provided within the first 1-2 years of construction.
Financial engineering in real estate project finance applies to the selection of funding sources and capital structure.
It assumes, in particular, the following actions:
• Calculation of the weighted average cost of capital (WACC).
• Determination of the optimal capital structure and external financing mechanisms.
• Assessment of the project’s creditworthiness and search for optimal sources of funds.
• Financial planning of cash flows after tax.
• Securitization of future financial flows.
• Identification and assessment of project risks.
• Preparation of a hedging strategy to reduce / eliminate risks using derivatives.
• Refinancing of asset-backed securities.
The preparation and implementation of a large development project depends on the impact of other sectors, therefore it is extremely vulnerable to changes in the macroeconomic situation, legislative changes, and so on.
This is clearly demonstrated by projects for the construction of hotels, shopping centers or entertainment complexes, which have suffered as a result of the pandemic and severe restrictive measures.
For this reason, financing of real estate projects requires a professional approach to project risk assessment.
PF assumes a rational distribution of risks between participants, depending on their ability to control these risks.
Financing of real estate projects looks complex, requiring a combination of various financial instruments, including complex derivatives.
It is very difficult, therefore projects according to this formula in many developing countries of the world with a weak financial market are not being implemented.
When modeling financial cash flows, classical discounting methods are used. The finance team needs to calculate whether a given project has a positive or negative value, or calculate the rate of return. Of course, a detailed analysis of the financial projections is necessary.
If you need real estate project finance services, please contact CP Finance UK.
Bank loans for commercial real estate projects
Currently, bank financing of real estate is most often carried out according to the project finance formula (PF).
Moreover, the use of a long-term bank loan is becoming an integral part of the process of buying / building commercial real estate in modern realities.
In the project finance formula, the borrower considers the proceeds from the project as the main source of debt repayment. This type of financing is entirely based on the future cash flows expected to be received under commercial lease contracts, both already signed and ready to sign.
In the case of a PF, the borrower is usually an independent special purpose vehicle (SPV or SPE – Special Purpose Vehicle / Special Purpose Entity), which deals only with the construction and management of real estate.
Thanks to this structure, the project debt does not burden the financial statements of the initiators.
Assets are not used as collateral for debt, and the provider of capital (usually a large bank) issues a loan against future cash flows.
Before the 2020 pandemic, project financing was widely used for the construction of large tourist facilities, hotels, shopping and entertainment centers around the world. Many capital intensive projects in the French Riviera, Barcelona and other tourist destinations in Europe have been built using this mechanism.
But even today, when investors have redefined their attitude towards commercial real estate projects, there are ample opportunities for project finance in various areas.
Banks’ requirements for borrowers and development projects:
Before an investor goes to the bank with his project, he must answer a few questions.
First of all, does the project meet the basic requirements of the bank, necessary for the consideration of a loan application?
Below is a list of banks’ requirements for commercial real estate projects:
• Formal legal requirements. A reliable investment project must have an orderly legal status of real estate. In addition, banks pay attention to the presence or willingness of participants to create an SPV / SPE, the presence of building conditions or a building permit.
• Technical requirements of the bank. To finance the project, a positive assessment of the project and a conclusion on the technical feasibility of the project are required. The initial document confirming this possibility is an architectural project, and then a building permit. In addition, the experience of an investor in commercial real estate or the ability to provide expert services is important for most banks.
• Financial requirements. To negotiate with the bank, a potential borrower is required to provide a ready-made financial model with a business plan. Typically, the project initiator must provide 10 to 40% of the investment costs. The documentation must confirm compliance with the DSCR (Debt Service Coverage Ratio) standards.
• Marketing requirements. The Bank requires a positive result of market research, confirming the possibility of leasing retail space or selling real estate on favorable terms.
The choice of the financing bank should not be random.
Financing a construction investment project is a long process.
When deciding to cooperate with a bank, an investor should be aware that for several years he will have to interact with this lender and depend on him.
Ineffective collaboration can negatively impact project implementation. During the construction of real estate, the real estate project can change greatly, so the investor must not only assess the financial conditions, but also analyze the bank’s policy.
Alternative sources of financing for real estate projects
However, the pandemic and economic downturn are forcing banks to treat borrowers more selectively, and development companies have become cautious with lending funds.
The greatest difficulties in obtaining loans are experienced by hotel and commercial real estate. Banks are still open to finance investments in warehouses, offices and residential premises, but financing conditions are more conservative.
Funding for commercial real estate after 2020 is still limited to the best projects.
Moreover, todaylarge construction projectsare supported only by a few banks, and it is almost impossible to obtain credit funds for hotels.
Banks have also tightened their funding criteria and are now offering lower LTV and LTC options, expecting higher levels of pre-lease retail space and sales for residential properties.
Experts point out that this could be an impetus for investors to search for alternative financing methods, the availability of which is still limited in many countries of the world. However, the current situation shows that dependence on one form and lack of diversification of sources of financing for commercial real estate is a critical issue that threatens the survival of the business.
Regardless of the choice of funding sources, companies need to properly prepare for real estate investments.
A business plan, project documentation and financial analysis are the minimum that can become a prologue to serious negotiations on financing real estate construction.
Banks also often condition the decision to grant a loan on the value of the LTC ratio.
So, financing of real estate projects and the construction of the facility through a long-term loan is still the most popular solution among investors.
Almost all institutions on the market offer loans for real estate construction. However, investors are frustrated by the increasingly restrictive approach of banks to assessing a potential borrower.
The pandemic that led to the economic downturn is making it difficult to finance some retail, hotel and sports facilities around the world.
Of course, this situation does not exclude the possibility of concluding a loan agreement, but the proposals of banks may be far from your expectations.
If you are looking for attractive sources of financing for commercial real estate projects, contact the CP Finance UK for advice.
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