RE Funding

Question 1

What ownership structures are there?

Answer 1

unit trusts, unincorporated joint ventures, companies, partnerships

Question 2

what commercial issues lead a financier/property owner towards an ownership structure decision?

Answer 2

taxation, stamp duty, liquidity and legal liability, and qualitative components ( control, acceleration rights, events of default, rights and obligations following a default, security)

Question 3

Why is it important that risks are assessed correctly when funding a re investment?

Answer 3

Financing cost is positively linked to assessment/perceived risks (lower the risk assumed, lower the cost of finance generally), hence why it is important that risks are assessed correctly as the fees/costs are charged accordingly for accepting these risks.

Question 4

As a financier always seeks to balance likely Rs with the risks of providing finance, what does the debt financier typically assess?

Answer 4

• debt servicing ability - you ask the question if rental income or other income service interest and capital payments
• security ratios - i.e. prop val relative to level of finance
• ability to sell the asset (liquidity)or refinance

Question 5

how did the GFC affect provision of debt finance and equity finance?

Answer 5

both debt and equity finance became more inert, more expensive and more onerous, there still remains waves of overhaning debt fears and investor confidence remains highly reactive. smaller/second tier banks acquired or merged with big banks as they struggled to attract capital to lend, hence big 4 banks dominate the lending sector. Equity investment in prop is now less driven by investment banks and more by HNW investors/family offices/super funds.

Question 6

Explain what ‘above the line’ and ‘below the line’ is in terms of cash flow analysis.

Answer 6

Below the line means property finance does not impact on prop’s overall profitability other than cost of finance like interests. ‘below the line’ refers to how each period’s net cash flows are financed. represented by the equation: Overall net cash flow = Net cash flow from debt + Net cash flow from equity.

‘Above the line’ refers to the transaction net cash flow that is not geared, and is represented by the equation: Cash inflows - Cash outflows = Overall net cash flow

Question 6

Explain what ‘above the line’ and ‘below the line’ is in terms of cash flow analysis.

Answer 6

Below the line means property finance does not impact on prop’s overall profitability other than cost of finance like interests. ‘below the line’ refers to how each period’s net cash flows are financed. represented by the equation: Overall net cash flow = Net cash flow from debt + Net cash flow from equity.

‘Above the line’ refers to the transaction net cash flow that is not geared, and is represented by the equation: Cash inflows - Cash outflows = Overall net cash flow

Question 7

Cost of RE finance no doubt has an impact on the prop val, what other important factors have an impact on prop R and val?

Answer 7

• Availability of prop finance (debt and equity) - if this availability is reduced (even more so for debt finance given that banks typically lend the lesser of the purchase price and 3rd party verified val) , then investor’s ability to acquire props is also reduced and the # of participants in the mkt is also reduced, which then affects price achievable for the prop. The opposite is true in boom conditions.
• Availability of debt capital directly affects R on equity - if more equity than debt in the finance, then less cost efficient as equity finance is more expensive, hence less gearing, less cost efficient capital structuring is

hence why asset/prop prices recalibrate in accordance with prevailing capital conditions i.e. when face with reduced availability of debt capital and knowing that equity capital is more expensive to obtain, asset/prop may have to be repriced in order to attract equity investment

Question 8

what factors influence the progressive normalisation of re finance mkts?

Answer 8

* re values resetting
* historic low cash rates and bond ylds
* debt providers increasing their appetite for risk and providing more abundant funding
* equity providers reducing their cost of funding as wider economic risks subside
* banks being able to securitise their loan books , hence freeing up their balance sheet for new lending . note that bank funding can dry up for a number of reasons: shortage of wholesale deposits, low retail savings rates, impairment of their own credit ratings (could be because of falling asset prices/poor economy), enforced regulatory changes. That’s why re industry largely depends on strong banking system (for supply of debt finance)

Question 9

What are the factors that determine the optimum level of gearing (debt)?

Answer 9

quality of income ( which is linked to creditworthiness of tenants

lease terms

future rental increases/tenant’s ability through any clause to cease rental payments

property category e.g. if it’s a hotel then business performance affects the rental income causing volatility)

financial strength and mgmt/development experience of the borrower

interest rate management strategy used by the borrower

security avail for the financier

fees and margins

time horizon

banking appetite/availibility of debt

Question 10

Discuss term debt finance vs construction debt.

Answer 10

debt finance for income-producing prop (one that does not involve construction) is called term debt finance; whereas finance for development of a project is called construction debt.

Question 11

What components typically make up cost of finance?

Answer 11

the interest rate being charged by the financier = margin + an agreed benchmark (e.g. 90day bank bill rate).

• that **margin** would reflect the lender’s assessment of risk that has to be taken on for investing in prop loan, risk that is in addition to the risk free rate
• up till the credit crisis in 2007/2008, banking competition drove margin compression, the GFC was a wake up call for those who had incorrectly priced risk in the past. Credit crisis impact: margins increased well above LT averages to compensate for higher perceived economic and credit risks, banks themselves being perceived as higher credit risks, tightness of wholesale debt markets.

Question 12

What is the most common form of loan security?

Answer 12

most common form of security is mortgage (note that a prop can have multiple registered mortgages, registered meaning the lender’s interest in the prop is registered on the cert of title; multiple mortgages can happen if a very high % of prop val is borrowed, or the prop already with one or more registered mortgages is used as security for loan for something else)
* but second and subsequent mortgagees also rank behind the prior ranking mortgages in the event of default (manaing sale of prop and accessing prop income for proceeds towards debt. )
* common for a prop with multiple mortgages to have deed of priority or inter-creditor deed that dictates the rights of each mortgagee.
* note that security duty is known as stamp duty in some states, and is calc as a % of the amt of loan secured.

Question 13

Discuss what negative pledge lending is.

Answer 13

lender accepting an agreement of negative pledge (i.e. borrowing agreeing **NOT to do certain things**). if borrower is a corporation, the negative pledge can mean the borrower is NOT to take on further debt that may jeopardize ability to make payments towards existing debt; NOT to create/grant security interest over borrower’s assets in favour of parties other than lender; NOT to manage sale the prop that deal with proceeds in ways unpermitted by agreement.
it all sounds good in theory, but reality is that many borrowers still didn’t abide by their negative pledge agreement… there is no specific security other than a promise made in a negative pledge, so if the borrower breaks it, the lender loses access to the borrower’s assets, the entire loan is in default…

Question 14

What is fixed and floating charge?

Answer 14

most prop debt financiers require fixed and/or floating charge in addition to mortgage security. a floating charge generally gives financier security over all borrower’s assets (attaches to assets newly acquired and relases those sold); floating charge is very commonly used by developers in financing as they usually only hold prop for a short period.

Question 15

Name circumstances where put options may be used?

Answer 15

• used as a guaranteed take-out for construction financiers
• enable borrower of poor credit rating to borrow a high (up to100%) percentage of a prop’s val.
• used in limited recourse financing (lender unable to sue borrower in the event of default but the put option gives lender security over the prop and any other specific security agreed to at the time loan was entered into)
• real estate securitisation

Question 16

Explain what put options are in the context of refinance.

Answer 16

Put options are usually exercised if cannot be refinanced/value has fallen below the put option strike price. contract where property owner sells to grantee the right for the grantor/financier to sell a prop to the grantee. put options **mostly used as a form of security in debt financing** or viewed by debt financiers as a **risk mitigation technique (particularly in light of credit crunch and corporate failures)** as it involves a party guaranteeing to buy the prop hence provide equity finance (if required to do so) .

Question 17

Why is construction finance considered more complex and specialised than fixed term debt finance?

Answer 17

It is because lender in construction finance must assess a broader range of risks e.g. ability of the builder to complete consutrction, so their experience in similar projects (size and nature) would need to be assessed, construction delays, potential cost escalation, the leasing mkt i.e. ability to find tenants on acceptable terms, provision of take-out finance

all these risks can be heightened under stressed economic conditions e.g. the 2007/08 credit crunch

generally, construction finance exposes the financier to greater risk than term debt finance, the greater risk due to not knowing if the project will be completed on time for the agreed costs, what it will look like. Hence why financier needs a broad range of inputs from sundry consultants (lawyers, quantity surveyors, re valuers, credit analysts, and even specialist consultants if the specific nature of a development requires so) . hence fees and margins would generally be higher.

Question 18

How may a borrower mitigate some of the risks that are assessed in a construction finance application?

Answer 18

arrange a take-out finance and the financier may be willing to accept a lower margin. but note that the **reliability of the take-out finance** is ruled by developer’s ability to complete the project (take-out financier only able to refinance for completed project) and the take-out financier’s financial standing to take-out the project. So the construction financier needs to be confident about both prior to providing the construction finance

Question 18

How may a borrower mitigate some of the risks that are assessed in a construction finance application?

Answer 18

arrange a take-out finance and the financier may be willing to accept a lower margin. but note that the **reliability of the take-out finance** is ruled by developer’s ability to complete the project (take-out financier only able to refinance for completed project) and the take-out financier’s financial standing to take-out the project. So the construction financier needs to be confident about both prior to providing the construction finance

Question 19

Explain how take-out finance works?

Answer 19

* can be provided by either the construction financier (in which case, the construction finance facility gets converted to term debt finance facility) or a separate financier
* it is used only following the **completion of the project**
* it can include: an off the plan sale (contract to sell to an investor or occupier on completion), **put option (exercised if cannot be refinanced/value has fallen below the put option strike price)**, or term debt finance.

Question 20

What is a common method lenders can use to mitigate refinance risk?

Answer 20

common for lenders to provide the **whole construction funding package** (i.e. refinance term debt and acquisition debt) but the amount of loan facility will usually have to meet 2 LVRs: 1. **LDCR** (loan development cost ratio or loan to cost ratio i.e. whole debt facility as a % of the total cost of the project which is the cost of constrution incl. land acquisition cost). Max LDCR is usually 70-80% (although it varies from lender to lender, from project to project) 2. **LVR** (loan to value ratio **upon completion**) again this differs for each lender and project. but for many senior debt lenders, max LVR is 60-65%

Question 21

What forms the **facility limit**?

Answer 21

usually **all costs of the project** (provisioned for and held back till equity contribution has been made by the borrower), **contingency amount** to assist with project cost overruns, provision of an a**mount to cover capitalised interest** to fund the interest bill throughout the course of the construction.

Question 22

while the debt facility might have been approved, drawn down will not be allowed until the construction financier is satisfied that __________ are met?

Answer 22

all key conditions precedent i.e. completion of all key expert reports, security documentation, construction contract with an appropriate builder, equity contribution made by the borrower, lenduer due dilligence on contracts and project documentation, minimum pre-sales/pre-commitment hurdles

Question 23

What is off balance sheet finance?

Answer 23

neither the prop value(asset) nor the liabilituy (amount borrowed) is shown on the company’s balance sheet - reasons why the coy does off balance sheet financing ? under market pressure to present a less leveraged position, or they have made a negative pledge arrangement (to not take on further debt). Either way, the risk is underrepresented, which is why credit analysts nowadays heightened scrutiny in measuring financial risk and benefit rather than only looking at the balance sheeti.e. **substance over form**.
many banks still include all ‘satellite debts’ when assessing a company’a aggregate debt exposure.

Question 24

what explains the somewhat limited issurance of debt instruments?

Answer 24

fear of corporate collapse and severe losses made by investors in debt instruments in recent years, particularly during the GFC.
turbulence in global debt mkts brought enhanced scrutiny on previously accepted debt deal characteristics (pricing of risk, role of ratings agencies, lending practices)

Question 25

name 2 main types of debt capial mkt instruments

Answer 25

CP (commercial paper, 30, 60, 90, 180 days) and MTN (medium-term notes, 3-5 yrs). issuance of these generally require a credit rating by an independent rating agency.

Question 26

debt finance structure based round the CF commitment of **a triple net lease covenant** from a high credit quality corporate tenant. What is a triple net lease?

Answer 26

Triple net lease means the tenant is responsible for all outgoings, capex, maintenance and all structural repairs, and usually no avenue for abatement or termination of the lease; note though it is usually very difficult to obtain a triple net lease, hence in many cases, financier may have to **put in enhancements to structure a triple or strong double net lease**:

• include inherent defects insurance to cover structural risk
• include a contract with a service provider of a high credit standing to underwrite the rental in the event of a service failure to cover loss of income due to abatement

Question 27

In general terms, what is a credit rating process?

Answer 27

agencies undertake risk analysis (as in risk of investors not receiving expected interest and principal repayments) , determine credit rating based on ability of the collateral (i.e. corporate, property asset or triple net lease) to deliver the expected income during the term of the transaction.

**essentially, the rating process is about assessing risks associated with value and income growth of the security the borrower is presenting** . and to assess, you will need undertake a detailed property review by looking at : macro (economy) and micro (re mkt) conditions, supply and demand, buiding quality, age, condition and effective life considerations), mktability, location factors and attributes, tenancy schedule (esp. lease expiry profile, and vacancy allowances), tenant credit quality, lease covenants, mgmt expertise.

upon reviewing the above for prop assets, you then **produce a stabilised net CF projection** (net of vacancy, capex, leasing commissions, tenant improvements and non-recoverable outgoings), then capitlise the derived NET CF by an appropriate cap rate to arrive at the MV.

Question 28

CCR (corporate credit risk rating) - what is being assessed?

Answer 28

ability and willingness of a corporate to meet its obligations, which comes from the entity’s **business risk** and **financial risk** in the context of its market and global peer group.

Question 29

How is a corporate’s financial risk profile examined?

Answer 29

**financial policies** (e.g. gearing and interest cover targets, interest rate hedging policies), **profitability** (rating agencies’ expectations as well as the corporate’s own projection of its performance relative to its peer group), **cash flow protection** (stability of operating CFS relative to the debt level it services), **capital structure** , **financial flexibility** (ability to cope with expected and unexpected changes in economic and property mkt conditions incl. access to alternative sources of liquidity, ability to wind back discretionary capex and ability to sell assets)

Question 30

How is a corporate’s business position relative to its peers evaluated?

Answer 30

market position (assess the entity’s mkt share relative to its own mkt segment and how that influences future performance), **asset quality**(higher the quality more stable the future CFs business generates throughout various economic cycles), **operating stability** (identify entity’s geographic, asset and tenant diversity to check if there’s concentration of risk that may impact stability of entity’s CFs e.g. may wanna check lease expiry profile), **operating strategy and management experience** (skill, integrity and experience of the mgmt team determine if strategic objectives will be achieved and pf mged within acceptable risk parameters)

Question 31

when issuing various debt tranches, each tranche level (e.g. AAA, AA, A or BBB) is determined by LVR and debt service coverage ratio based on the prop’s ability to meet debt service obligations for the term of the transaction. How can these levels be enhanced?

Answer 31

liquidity reserves, hedging strategy, income support mechanisms

Question 32

Discuss the effect of the Credit Crisis on Mkt Participants /main traditional acquirers of direct domestic real estate i.e. HNW investors, REITs, investment banks/fund ma nagers, superannuation/pension funds (which can be further divided: corporate, govt, industry, international/sovereign wealth funds)

Answer 32

* HNW: well-capitalised and able to transaction post credit crisis, yet remain slow and cautious about new acquisition on a case by case basis
* REITs: sector is re-emerging post GFC, higher quality mgers recapitalised balance sheets and refinanced debt with longer dated maturities (duress was experienced during GFC due to high gearing and expansion beyond core geographies)
* IBs/fund mgers: many were damaged during the GFC (e.g Lehman Brothers permanenlty, and Macquarie significantly), very few post-GFC were adequately capitalised to transaction in any meaningful way. the ones that survived well are able to create investments for HNW clients
* super/pension/soverign funds: domestic super funds continue to play an important part in australia’s direct re ownership, as they did pre GFC. Compulsory SGC ensures super funds continue to provide flow of capital to the re sector.

Question 33

Name types of equity finance?

Answer 33

listed re inv trusts/coys, joint venture finance/participating mortgages, head contractors, mandatory convertible notes/converting pref securities, unlisted re syndicates and funds, unlisted wholesale prop funds, mezzanine finance/subordinated finance

Question 34

equity comes at a higher cost, reflecting the relative scarcity of capital and relatively higher perceived risk. What risk ?

Answer 34

* risk

Question 35

Describe characteristics that describe A-REITs today.

Answer 35

* access to large pf of re,

* greater diversity of re type (retail, office, industrial) and location (domestic AND international)

* professional, highly experienced mgmt

* greater liquidity than direct inv in re mkt.

Question 36

what made many REITs become riskier inv than traditional REITs?

Answer 36

expanded operations via stapled entities, increased level of gearing (either on or off balance sheet)

Question 37

What are the equity raising alternatives?

Answer 37

* placements (::almost all made to pro investors,:: PDS only a must to retail investors but too costly and time consuming so rarely offered to retail investors; in any 1 yr, 15% is the limit to the proportion of an entity’s capital that can be issued by a placement)
* rights issues aka entitlement issues (::unpopular due to process being time-consuming and costly::) - oppo for all existing unit/share holders to subscribe for additional capital in proportion to their existing investment.
* DRPs (easier and cheaper to recapture existing corporate capital earmarked to be paid as dividends vs raising new capital in the mkt place, DRPs allow for a steady flow of capital, guaranteeing part/all of the distribution is reinvested) , offered at a modest discount, no brokerage/transaction costs.
* UPPs / SPPs (unit or share purchase plans) - trust mgers can issue (without a PDS) up to $5000 of units per year to each unitholder. No brokerage payable. have become more popular with retail investors

Question 38

In equity capital, what are **Head contractors** - what do they do? what is the advantage of using a head contractor for a project sponsor ?

Answer 38

Head contractors are equity capital investors (while not necessarily a form of equity finance, but certainly a form of risk mitigation) with strong balance sheets, advantage to the project sponsor is that if subcontractors are unable to complete the prop development project on time for agreed costs (i.e. time and interest overruns), head contractors step in the make good any loss and/or complete the project.