Principal forms of investment finance and their sources

Question 1

Why is commercial property financed?

Answer 1

Not having the required level of capital to pay for an investment

Borrowing can provide exposure to leverage = can increase potential return from investment

Access to several finance types: traditional bank lending / insurance funds / ‘platforms’ that can offer various types of products

Question 2

What is Debt Finance?

Answer 2

Where an investor / company (the borrower) takes out a loan OR issues a bond to raise capital for an asset/portfolio/project/business

Lender receives a regular interest rate payment for providing the loan

Like residential mortgage for fixed amount from a bank (the lender) to buy a house but usually for a shorter fixed period (circa 5 years) at agreed interest rate

Question 3

What are some examples of private property finance vehicles?

Answer 3

Banks

Insurance companies (not so common)

Debt funds (i.e. junior / mezz)

Hedge funds (will use some sort of derivative)

Crowdfunding

Peer to peer

Question 4

What are some examples of public property finance vehicles?

Answer 4

Commercial mortgage-backed security (CMBS)

Government Bonds

Question 5

What is Equity Financing?

Answer 5

Involves an investor /asset owner / company giving shares in the ownership in exchange for capital

No promise to repay the investment like in a loan arrangement, nor is there an interest component

Both parties share in the upside and downside risk of the investment

Question 6

What are the types of finance used in real property transactions?

Answer 6

Equity

Commercial mortgage

Unsecured loans

Secured debt

Floating charges

Property development finance

Bridging finance

Mezzanine finance

Portfolio finance or revolving credit facility

Sharia finance

Joint ventures (JV)

Securitisation and bonds

Question 7

What is equity finance?

Answer 7

Raising of capital through sale of shares / equity in the company / asset

Question 8

What is commercial mortgage finance?

Answer 8

Debt finance

Most common type of lending used

Secured against underlying property whereby the lender lends a certain % of property value for fixed period of time

Rate will be quoted as x% over base rate / LIBOR (London Inter-bank Offered Rate) = interest-rate avg calculated from estimates submitted by London leading banks

When rate = not fixed = variable rate mortgage

Borrower pays lender back with a predetermined set of payments over a specified period

Question 9

What is secured debt finance?

Answer 9

Debt finance

Secured debt uses collateral from another asset such as a house / business / car as security

This is usually for a lower amount than required for a commercial mortgage

Question 10

What is floating charges finance?

Answer 10

Is a security interest / lien over a group of non-constant assets that change in quantity and value

A floating charge is used as a means to secure a loan for a company

The assets used in a floating charge = usually short-term current assets that the company consumes within 1 year

Question 11

What is property development finance?

Answer 11

Debt finance

Usually in the form of a short-term loan that’s used for development of a new building project/refurbishment of existing property

Interest rates tend to be higher than commercial mortgages to reflect uncertainty / risk

Question 12

What is bridging finance?

Answer 12

Short-term finance solution favoured by property developers and investors

Provides quick way to finance purchase of a property

Lender will take a first charge on your property, and will seek an exit once the loan has come to term

Question 13

What is mezzanine finance?

Answer 13

More complex and hybrid type of finance

Combines elements of debt AND equity - secured against the property

Gives lender right to convert to equity interest in company in case of default, after venture capital companies and other senior lenders are paid

Helps property developers reduce their cash flow requirement, enabling them to finance projects that would normally require a larger capital share

One of highest-risk forms of debt.

Subordinate to pure equity but senior to pure debt

Some of highest returns compared to other debt types, with rates between 12-20% per year, sometimes as high as 30%

Question 14

What is portfolio finance / revolving credit facility finance?

Answer 14

Debt finance

Whereby a variable amount = available as a loan that can be drawn as required

Long-term business loan

Usually offered to large corporate property owners such as REITS

Lender offers ability to consolidate borrowing into 1 loan

Question 15

What is sharia finance?

Answer 15

Islamic finance / Sharia finance = how corporations in the Muslim world, including banks and other lending institutions, raise capital in accordance with Sharia / Islamic law

Also refers to types of investments that are permissible under this form of law

Question 16

What is joint venture (JV) finance?

Answer 16

A business entity created by 2 or more parties, generally characterised by shared ownership, shared returns and risks, and shared governance

Question 17

What is securitisation and bond finance?

Answer 17

Securitisation = process where issuer creates a financial instrument by combining other financial assets and then marketing different tiers of the repackaged instruments to investors

This process can encompass any type of financial asset and promotes liquidity in the marketplace

Question 18

What are the risks in debt finance?

Answer 18

For the borrower and lender:

• Non-payment of the interest payment
• Potential of capital depreciation of the asset
• When borrowing, the higher LTV /debt the more expensive it is
• This LTV along with the interest rate = 2 key factors when modelling the performance of a property / portfolio
• Higher level of debt = higher interest that needs to be paid back and as part of the lender’s underwriting they need to be comfortable that the rent being paid is sufficient to cover the interest payments

Question 19

What are some recent innovations and events in property finance?

Answer 19

Significant transaction in the UK by British Land in 1999

The purchase of 20 St Marys Axe (Gherkin) in 2006

Question 20

What happened during the significant transaction in the UK by British Land in 1999?

Answer 20

£1.5bn securitisation (issuer creates a financial instrument by combining other financial assets and then marketing different tiers of the repackaged instruments to investors) of their Broadgate Estate Asset

BL issued asset-backed bonds for period of time = an income coupon was paid to purchasers of the bond

As a result, BL raised / received £1.5bn to grow and develop their existing portfolio

The sheer size and scale of this make it a stand out transaction

Question 21

What happened during the purchase of 20 St Marys Axe (Gherkin) in 2006?

Answer 21

Gherkin was purchased by German fund manager IVG Private Funds + London-based private equity firm Evans Randall from Swiss Re for £600m

Financing was provided by several banks / via a syndication

As part of borrowing, IVG took out its share in Swiss Francs as cheaper to borrow than in sterling

To protect themselves from currency risk, agreement was made with occupier Swiss Re to pay part of rent in Swiss Francs = creating a hedge

Not all rent was covered by the hedge and appreciation in the Swiss Franc against sterling caused IVG’s borrowing cost to rise by circa 60% or £100m

Borrowers also took out interest rate swaps to protect them from interest rate rises but during this time interest rates fell

Created a double whammy of a £100m rise in borrowings + circa £140m in swaps debt, which wiped out the equity put in by borrowers

Property values in London also fell

By 2009, Gherkin’s value had dropped to £480m and the building’s owners breached their LTV covenants and defaulted on their loans

Question 22

What is a syndication?

Answer 22

A partnership between several investors - they combine their skills, resources, and capital to purchase and manage a property they otherwise couldn’t afford

Question 23

What are the FOUR quadrants of capital markets?

Answer 23

Private equity
Private debt
Public equity
Public debt

Question 24

What is private equity?

Answer 24

Requires a broker

Buy / sell property direct investment / act as a developer / private equity fund

Unlisted fund

Core, value-added and opportunistic properties

Question 25

What is private debt?

Answer 25

Commercial, mortgages, bridge and mezzanine loans.

Question 26

What is public equity?

Answer 26

Publicly traded on stock exchange

REIT, prop cos, legislation for REITs = not taxed twice and have to distribute 90% profits

Question 27

What is public debt?

Answer 27

Commercial mortgaged-backed securities

Corporate bond

Question 28

What are the TWO types of income on property?

Answer 28

Capital appreciation = generally higher standard deviation therefore more volatile

Rental income = generally secure and stable = lower standard deviation

Question 29

What are property derivatives?

Answer 29

Financial instruments which allow the investor to take a position in property / hedge a position without actually buying or selling properties

They receive / pay a return based on the performance of the MSCI IPD (in the UK) or NCREIF (in the US) or any other established property index

Question 30

What is a common share (equity)?

Answer 30

Common share = RIGHT to vote in a company and a % of profit = a dividend

This equity normally has fewer rights associated with it than preferred equity and can be offered to employees at the company

Paid dividends after preferred share holders

Question 31

What is a preferred share (equity)?

Answer 31

Preferred share = NO voting rights.

But fixed income / dividend and paid priority over common share

Question 32

What are corporate bonds (debt in company)?

Answer 32

A loan to a company for a predetermined period

In return, company agrees to pay interest and then repay face value of the bond once it matures

Question 33

What is the main difference between common share (equity), preferred share (equity) and corporate bonds (debt in company)?

Answer 33

Differences = priority of payments

If company goes bankrupt, priority =

1. bond debt holders
2. then preferred
3. then common hold

But shares have higher risk than bonds