Residential property construction financing: lending and opportunities for diversification

The pace of development of each real estate market depends, among other things, on the economic situation in the country, the phase of the economic cycle, the political environment, legislation, the size of the local capital market, as well as on the production potential and financial resources of companies implementing key projects in the field of residential property construction.

The desire to make a profit above average with the minimum possible participation of equity capital encourages developers to use the effect of financial leverage to a greater extent than companies from other sectors of the economy.

This requires a professional approach to choosing a financial model for each investment project.

Residential property construction financing can be carried out using internal or external capital raised from various sources.

Examples of internal financing are depreciation, retained earnings, or asset sales.

The traditional financing model is predominantly based on loans, bond placements, or hybrid instruments such as mezzanine finance.

Bank financing continues to be a popular form of housing financing.

However, the economic downturn caused by the COVID-19 pandemic shows how risky it is for developers to rely on a single instrument to fund their investments. The current difficulties in obtaining large loans are prompting businesses to seek new sources of financing and diversify them.

GCAM Investment Group, a financial company, has brought together a highly qualified team of experts ready to help developers with residential property construction financing.

We offer large development loans for up to 20 years, and we also support the implementation of housing projects at the international level, providing professional consulting services.

Residential property construction financing using corporate bonds

For construction development companies, issuing corporate bonds is just one of the ways to obtain additional funds for the implementation of capital-intensive projects.

This solution has many advantages and is often viewed as an alternative to a bank loan.

This method of financing housing construction is based on the issue and placement of corporate bonds of construction development companies. Interest in this tool is growing every year, especially after the financial crisis of 2008-2009. The attractiveness of bonds can be explained by the flexibility and high efficiency of the use of financial resources.

The favorable situation in the capital market makes it possible to partially abandon the issue of bonds secured by real estate, therefore developers choose unsecured bonds. Investors attach more importance to the financial condition of the issuers, rather than the terms of the bond.

Corporate bonds or bank loans?

Due to the improvement in the sector, investors perceive corporate bonds of construction development companies as an attractive and safe investment vehicle.

Conversely, during periods of crisis in housing construction, the attractiveness of this tool drops sharply.

Real estate is the main asset of the developer, thanks to which bondholders can count on debt repayment, even if the issuer faces difficulties.

This is a common form of long-term financing for large developers, especially joint stock companies. The amount of funds raised in this case can significantly exceed the maximum bank loan, which can be explained by formal banking restrictions, for example, in relation to the debt concentration limit.

Bonds of companies with a good financial condition are now considered a safe investment. Their interest rate usually exceeds the yield on deposits offered by banks. Investors regularly receive their interest, and in the event of bankruptcy of the enterprise, bondholders can receive various benefits to satisfy their financial interests.

The table below summarizes the main differences between a corporate bond and a bank loan for residential property construction financing.

Corporate bonds	Bank loans
Debt to multiple creditors.	One creditor (bank).
The debt is repaid at the end of the agreement.	The bank loan is regularly repaid throughout the entire period of the loan agreement, requiring constant strain on the borrower's financial resources.
The purpose of the bond issue is usually not specified.	The purpose of the loan must be stated.
In many cases, the borrower does not need to provide collateral for the repayment of the borrowed funds.	The developer usually has to provide collateral.
The bond issuer independently determines the structure of the issue, adapting it to the needs of the project.	The terms of the loan are determined by the bank.

The developer's collateral assets can be freely used for several years and even transferred between several projects, which is impossible in the case of a bank loan.

The funds from the placement of bonds are effectively used to finance priority investment projects specified in the terms of the issuance of the corresponding corporate bonds.

The placement of corporate bonds is an ideal example of bridge financing. They can be an excellent source of financing in addition to a loan, including providing the down payment required by banks. Debt securities can also be converted into company shares.

As a classic example of bridge financing, corporate bonds from construction development companies are especially useful in risky investment projects where banks require a significant initial investment.

For example, a bank loan for the construction of a hotel may require the down payment at approximately 30-50% of the total project cost.

Benefits of issuing bonds

Developers often choose this form of financing because it allows them to acquire land plot for construction and start work without prior sale of assets.

Corporate bond issuance is a promising solution with many advantages over a loan.

For development companies, bonds represent a very convenient and quick way to raise funds in the capital market, taking into account specific goals. This type of securities has been known for a long time, but now it is becoming popular not only among institutional, but also among private investors.

There are a number of reasons for this.

First, developers' corporate bonds are issued in strict accordance with the current legislation of the host country. This provides investors with high reliability and security, especially when it comes to developed countries in Europe or North America with a strong legal system. On the other hand, companies remain completely free to choose how to place bonds, targeting a wide pool of investors or only large private investors.

Secondly, the issuer of bonds is obliged to indicate the objectives of the issue and its financial indicators, which guarantees the transparency of both the offer and the issuer.

Third, the bonds of construction development companies are considered as securities with much higher yields than ordinary treasury or municipal bonds.

However, it should be noted that the successful issue and placement of bonds depends on trust in the developer. Therefore, this method of financing housing construction is chosen by well-known companies that have achieved significant success and work with recognizable business partners.

For many companies in the sector, finding the funds needed to finance large housing projects and business development is a major challenge. Residential property construction financing using external capital is associated with the fact that such projects are costly, and not all investors have sufficient funds at a certain point in time. The issuance and placement of corporate bonds can be the optimal solution for long-term financing leading to overcoming capital shortages.

If you are looking for financial advice or financial modeling for a major residential property construction project, please contact GCAM consultants.

Bank loans for housing construction

A developer loan is one of the most common ways to finance housing projects in developed countries.

Since the construction of residential complexes is an extremely expensive investment project, more than 90% of developers in RU countries use external financing, mainly choosing loans in various combinations.

These loans are provided by the bank for a specific purpose, that is, to finance investments in residential property construction and the expansion of related infrastructure. The high demand for new residential properties always contributes to the implementation of an increasing number of projects through debt financing.

A bank loan is a suitable form of financing real estate investment projects for sale and rent.

Its purpose can be the construction of residential and commercial premises, as well as the adaptation and renovation of existing facilities.

Loans can also be issued for the construction of residential complexes, apartment buildings, single-family houses, retail, office and mixed premises.

To obtain a development loan, as a rule, an initial payment is required, usually about 20% of the total cost of an investment project.

The borrower's own contribution to the project can be not only financial resources. Alternatively, it can be the land plot on which the project is being carried out, as well as other resources required for the project. The loan term covers a long period, from design and construction to the sale.

Requirements for obtaining development loans

A preliminary financial, legal and economic analysis is a prerequisite for applying for housing financing.

The preferred legal structure for lending is a special purpose vehicle (SPV / SPE), but this is not always required.

Banks, however, impose many other requirements on developers that must be met in order to obtain a loan on favorable terms.

The financial health of the construction development company is of key importance for the bank, as the current financial performance confirms the reliability of the potential borrower. As in situations with any other loan, the bank seeks to establish cooperation only with solvent customers.

Therefore, an important factor for a positive decision of the bank is the creditworthiness of the investor, regardless of whether he has fulfilled his obligations in the past. The bank pays close attention to the current state of assets.

As part of the application procedure, it is required to provide a detailed plan for financing the investment project. The chances of getting a loan increases when the LTC ratio is low, that is, the share of the loan in the total project cost is relatively small. Banks interpret LTC (Loan-to-Cost Ratio) as an indicator of the risk of a borrower's insolvency.

However, the bank is most interested in an investment project, so a good business plan is critical when applying for a loan to finance residential property construction. It must be highly profitable and stand out from the competitors.

The expected level of profitability varies depending on the market.

In general, the profitability of the project is one of the key factors affecting the approval of the application.

For some banks, it is important that the borrower has found a certain number of clients in advance for the pre-sale of apartments or the sale (lease) of commercial premises of a residential complex. If the developer does not comply with this requirement, the bank may refrain from providing financing.

The decision to finance the construction is also based on another important aspect, the location of the construction site. For many banks, this is one of the key criteria that are taken into account when evaluating an investment project.

Potential buyers carefully evaluate the location of an apartment building or commercial real estate.

Thus, a good location contributes to the success and profitability of the project.

When planning housing investments, developers should start by analyzing the specific location and finding attractive sites for potential home buyers.

First of all, the developer needs to pay attention to the potential of the area. It is worth adapting the construction site to the specific requirements of the project. In the case of commercial real estate, it is preferable to be located in the center of a large city, while residential complexes may not be a very good solution in the center of a noisy metropolitan area.

It is easy to see that residential complexes are more often built on the outskirts of cities, but in places with good transport links to the center. The cost and success of the project is also determined by the proximity of various kinds of infrastructure, green areas, clinics, schools and kindergartens.

The return on investment is directly related to the usable area. This indicator shows how much usable living space can be built on one square meter of land. Based on this indicator, investors predict land payments.

When calculating the usable area, it is necessary to multiply the building area by the number of floors of the planned residential complex.

Bank loan for SPV as a promising option

Lenders are more willing to cooperate with experienced developers who have already implemented similar projects.

Investors with a longer credit history are more likely to get a development loan. However, the bank's decision is determined not so much by the amount of the loan as by the prospects of a particular project.

It may turn out that a client who has completed one large and successful investment project will receive more trust than a developer with four smaller investments.

Is there a chance to get a large loan without experience?

Sure.

Every construction development company starts with its first project.

Banks do not trust her as a borrower, usually making higher demands and often refusing to provide financing. In such a situation, a loan for a special purpose vehicle (SPV / SPE) seems to be the most preferable.

To begin with, a special company is created, which is an independent business entity, whose activities are aimed only at the implementation of a specific investment project. Applying the project finance formula, SPV is responsible for the entire project and construction work with a very high percentage of leveraged capital.

A special project company is most often established in the form of a limited liability company. It attracts resources to finance residential property construction project. The shareholders of this company must have an impeccable credit history, which influences the decisions of the bank.

Although the bank prefers to finance experienced developers with a long financial history, the attractiveness of the investment project may be more important to it.

This requires the development of a highly reliable, professionally prepared business plan.

It is easy to make mistakes when planning an investment and applying for a development loan. Lack of assistance and support from an expert increases the risk of the bank rejecting the application.

Below we have listed some of the requirements for obtaining a loan for SPV / SPE:

• Comprehensive business plan with all information of value to the lender.

• Detailed analysis of the real estate market that demonstrates the market opportunities of a particular project, reveals potential obstacles and risks associated with competition.

• Adequate initial contribution of the borrower, which is at least 10%, but can reach much higher values for young companies and / or risky projects.

• Detailed project implementation schedule with clear milestones for each stage.

• Alternative options for the implementation of the project and a detailed plan of action in case of possible failure of the original investment plan, taking into account additional costs.

A loan for a special project company requires more participation in the preparation of the project than in the case of financing a developer with a rich credit history.

This is due to the high demands of the projects.

GCAM Investment Group offers large investment loans for the construction of residential complexes.

Our financial team is ready to develop an individual financial model for your project, providing comprehensive assistance in financing residential property construction around the world.

The role of leasing in residential property construction financing

Another form of housing financing is leasing.

Usually, the parties to leasing transactions (leasing entities) are the lessor, the lessee and the seller (supplier) of the leased item.

According to the lease agreement, the financial institution acquires real estate and transfers it to a partner for obtaining benefits. Under the contract, the company is obliged to make periodic payments over a certain period.

The main services provided to companies include finance lease-to-purchase, finance lease-to-buy, finance lease with full payment, operating lease, operating lease-to-buy, sale and leaseback.

A company that chooses to finance housing projects using leasing builds a house in order to then rent it out and make a profit.

After the expiration of the lease agreement, the entrepreneur can become the owner of the real estate. In order for the business to receive additional funding, companies usually sell the ownership rights to the leasing company upon entering into a contract that allows the original owner to operate the facility.

Key parameters that are determined by the lease agreement include the term, advance payment (determined depending on the transaction and the specific object), financing currency, the estimated value of the object, the type of property (residential, commercial, industrial), as well as the terms and conditions of repayment of lease payments (including the possibility of early payment of lease payments).

The parties also indicate any details that may affect the transaction, such as insurance.

Financial leasing and operating leasing

Financial experts classify leasing according to various criteria that reflect certain aspects of a particular operation.

When choosing sources for residential property construction financing, special attention is paid to the difference between financial and operational leasing.

Operational leasing provides for a short-term transfer of assets for use to the lessee, which means a shorter period of tax amortization. The property remains on the lessor's balance sheet, but is reflected in the off-balance sheet account of the lessee and cannot become the property of the latter after the expiration of the lease agreement, but is returned back to the lessor. In world practice, all transactions other than financial leasing fall under the category of operating leasing.

Financial leasing means that the lessor undertakes to purchase property from the seller in full compliance with the specifications established by the lessee and transfer it to the lessee for use for a specified period of at least 1 year.

Distinctive characteristics of the mentioned types of leasing are shown in the table below:


Also, the legislation of some countries may impose restrictions on property that is prohibited from leasing.

For example, it is prohibited to transfer integral property complexes of enterprises and their structural divisions to financial leasing. On the other hand, it may be prohibited to transfer property complexes of state and utility companies into operational leasing. Organizational schemes for operating and financial leasing are also different.

GCAM Investment Group is ready to provide any services for the preparation of financial, legal and technical documentation for the financing of construction projects.

Contact us to find out more.

Benefits of leasing for housing financing

It makes sense to compare the advantages and disadvantages of leasing with bank lending, since they are alternative ways of financing residential development.

The demand for a particular financial instrument is determined by its characteristics and efficiency.

At its core, financial leasing resembles a secured loan. In case of non-fulfillment of contractual obligations, the leased property is returned to the lessor.

The cost of financing consists of the value of the property, bank commissions and interest. It is important to take into account the peculiarities of taxation and accounting of financial leasing (for example, lease payments are usually not subject to VAT, and the transferred property begins to appear on the lessee's balance sheet).

The advantages of leasing in comparison with other financing instruments are:

• Ample opportunities to maintain liquidity.

• Allocation of lease payments (depreciation and interest for the use of a lease loan) in the gross expenses of the company in order to optimize taxation.

• The terms of lease agreements usually do not require an urgent start of payments and are characterized by the greatest financing flexibility, which contributes to the development of convenient instruments with an individual payment schedule and a floating rate.

• Leasing operations do not require collateral (the leased asset belongs to the lessor during the term of the contract). This means savings in registration costs which is convenient for small businesses.

• Real estate transferred under a lease agreement is not subject to confiscation. In addition, these assets cannot be seized due to any action or omission of the lessee. This is due to the fact that the lessor is legally the owner of the property.

• Use of additional services that help to reduce the lessee's administrative costs (including fees for such services in lease payments allows them to be classified as gross expenses). In particular, leasing companies can offer lessors better insurance conditions than banks.

• Ease of registration of the transaction, saving time and effort on paperwork for the implementation of the operation (purchase and sale of real estate, land lease, insurance, mortgage). The lessor can take over the control of payments and the maintenance of accounting records, and the lessee pays a single payment.

Many of the benefits listed above can only be seen within a single theoretical model that is distinct from the real world of housing finance.

For example, the possibilities of accelerated depreciation of real estate in practice vary over a very wide range.

The lessor charges amortization, which significantly reduces the tax base for income tax. However, given that the minimum terms for using real estate in tax accounting often differ from the duration of lease agreements, the above advantage of leasing over bank lending in practice can be significantly reduced.

Financial leasing can create more attractive pricing conditions for financing the acquisition of a property by applying a low interest rate. But in the context of the dependence of leasing companies on medium-term bank lending and the absence of sources of “long-term money” for institutional investors, the interest on leasing agreements may turn out to be high.

Disadvantages of leasing

Despite the range of advantages, companies should be careful in setting lease terms and consider alternative financial instruments.

The disadvantages of leasing in comparison with other instruments for financing housing construction include the following:

• Legal restrictions on the use of financial leasing in relation to certain real estate objects. The legislation of some countries actually removes a significant class of real estate objects from the scope of leasing agreements from the scope of leasing. Particular difficulties with the use of financial leasing instruments arise in connection with the prohibition of leasing of land plots. Since ownership of a property is often directly linked to ownership of a land plot, this is a critical aspect.

• The difference in the effective terms of financing residential property construction and buying real estate on lease is up to 10-20 years, based on world practice and the long-term nature of this asset (leasing companies today work with medium-term sources and can often provide financing only for a period of 5-7 years).

• The possibility of imposing foreclosure on real estate for the obligations of the leasing company, as a result of which the object can be transferred in favor of creditors.

• Increased payment by the lessee for the registration of ownership (first, registration for the leasing company takes place, and after the expiration of the contract for the lessee).

• Lack of ownership of the object by the lessee at the time of the conclusion of the contract.

• The actual transfer of payments for insurance, utility bills, real estate tax and a number of other recurring costs to the lessee, since the corresponding costs are included in the amount of periodic lease payments.

The correct choice of residential property construction financing options depends on a professional analysis of the advantages and disadvantages of each available financial instrument in the context of a specific investment project. In particular, this includes the comparative assessment of such indicators of economic efficiency as net present value of assets (NPV), internal rate of return, equivalent annual annuity flows (EAA), as well as EPR and a number of others.

Mezzanine financing for residential property construction

Mezzanine finance refers to an intermediary instrument between debt financing (such as a bank loan) and equity financing (such as an equity issue in a construction development company).

Thus, the mezzanine housing financing structure contains some of the characteristic elements of debt and equity finance in various combinations.

Mezzanine financing emerged in Europe in the late 1980s and has since been very popular in developed economies.

However, it tends to be less popular in developing countries due to underdeveloped financial markets and an immature legal framework.

Hybrid mezzanine financing is a relatively modern way to raise additional funds for the implementation of investment projects. For this reason, the mezzanine is becoming more and more popular, especially among entrepreneurs, whose investment development plans significantly exceed the possibilities of obtaining a classic bank loan.

By combining the elements of debt and investment into a coherent whole, hybrid finance represents higher risk debt. Most often, the term for financing development projects is from 5 to 7 years. It is also worth remembering about the subordinated nature of financing. This means that first the company is obliged to repay bank loans (principal debt), and only at the next stage the mezzanine debt (subordinated debt) is paid off.

The most salient features of mezzanine financing are listed below:

• Unlike a bank loan, hybrid financing is repayable once and at the very end of the agreement. This solution saves the company from having to pay fees. All funds remain within the company, which definitely strengthens its position in the market.

• Mezzanine financing does not impair the development company's creditworthiness. Thus, the company can simultaneously use bank loans for other projects.

• Mezzanine capital is not secured by the borrower's assets. It is mainly secured by the pledge of the company's shares and cash flows that will be generated by the company in the future.

Important! The mezzanine is a way of financing, not a specific source of capital.

Therefore, depending on the method chosen, it can take the form of bonds, loans, or equity issues.

Sources of mezzanine capital

One of the most important characteristics of the mezzanine is the high level of risk of the investment project, which can be accepted by the capital provider (fund or bank).

However, in return, they require a share of the company's potential future profits at a lower level than the owner's share.

This feature largely predetermines the range of entities providing mezzanine capital.

Mezzanine financing is usually provided by specialized financial institutions such as venture capital funds, private equity funds (financing of high-risk projects), as well as many commercial banks and state-owned banks.

For example, private equity funds are willing to bear very high capital risk while expecting a higher return on investment. On the other hand, banks that provide loans admit an average level of risk, but require solid guarantees from the borrower.

The most commonly used mezzanine instruments include:

• Loan with the right to participate in profits. The lender is entitled to receive a portion of the profits from the project. Usually it is a percentage of the annual profit for a certain period.

• Loan with the right to participate in the capital. The company incurs costs in the form of interest. The rest of the costs are borne by the owner, but only if the project is successful.

• Bonds with zero coupon / discount. In this case, the issuer pays off all debt with interest payments at a time, when the maturity date of the bond comes.

• Convertible bonds. The issuer of the bond bears the interest coupon costs. In turn, the investor has the right to convert the bonds issued by the company into shares.

• Guarantee bonds. The company incurs financing costs in the form of an interest coupon on the bonds. The remaining costs are borne by the owner if the investment is successful.

• PIK (pay-in-kind). These are bonds or preferred shares, the interest on which will not be paid in cash, but, for example, in the form of new securities.

The choice of a source of mezzanine financing for housing construction is determined by the current economic situation and the state of the financial market, and also largely depends on the reputation of a particular development company and the prospects for implementing a particular investment project in the sector.

Benefits of mezzanine financing

Hybrid financing is used mainly by medium and large companies, as well as multinational giants with a turnover of billions of dollars.

Mezzanine finance can be seen in both emerging sectors and stable industries across all global markets.

However, this tool is most beneficial for companies that have an established position and generate stable financial flows. The mezzanine is readily used by companies with a solid market position, stable income, long history and proven management personnel.

An important feature of this type of financing is the ability to adjust the terms of the agreement to the needs of a specific development project. The mezzanine does not have a clearly defined framework or standard forms, which is required, for example, when applying for a bank loan. Each case is considered individually, and the financing itself is adjusted to the client.

Thanks to this, innovative and fast-growing market sectors that demonstrate high quality and efficiency in enterprise management also have a chance to receive mezzanine financing.

This type of financing is suitable for medium or large companies that are in good financial condition, but do not have sufficient creditworthiness to carry out all investment projects. It is an ideal business tool for businesses with stable cash flows, industry appeal, experienced management and growth potential.

Features that make the mezzanine attractive for residential property construction:

• The capital provider is willing to accept a higher level of risk than other models.
• Financing of construction is usually long-term and reaches 10 years or more.
• Possibility of financing in the absence of access to other sources such as loans.
• The capital provider actively participates in the company to create value.
• The debt is usually paid at the end of the agreed period.
• All elements of the agreement are discussed and agreed by the parties.
• The mezzanine allows the use of high financial leverage.
• The company retains its shareholding and control over the enterprise.

Mezzanine finance is generally characterized by organizational simplicity and low fixed costs compared to public share issuance and capital raising from a private equity fund.

It is important to note that mezzanine funding is not suitable for startups or early stage companies. They are very susceptible to external market factors and, most importantly, they do not have regular cash flows. This solution is only for medium and large enterprises that have the potential for further growth, but at the same time do not have access to credit instruments.

Residential property construction financing on flexible terms

The cost of housing construction after the crisis begins to rise, requiring significant investment.

The cost per square foot in the most expensive cities in the United States, for example, has exceeded $ 400. It may seem that large developers should not have problems with financial resources. However, maintaining financial liquidity and investment continuity usually requires external financing, mainly through bank loans and bonds.

Are you looking for residential property construction financing services?

GCAM Investment Group is ready to offer you a full range of services for the implementation of large investment projects. The geography of our services covers Spain and the countries of the European Union, Great Britain, the USA, Canada, Latin America, the Middle East, Asia and Africa.

We offer investment loans from 10 million euros for up to 20 years to effectively finance promising business ideas in accordance with your plans and expectations.

For detailed advice, please contact GCAM representatives at any time.