Topic 3

Capital will be required for the different phases of development

  • Predevelopment

  • Land acquisition

  • Construction

  • Stabilization

  • Take-out


Predevelopment

  • Generally speaking there is no project specific financing available for the pre development stage

    • Considered too high a risk by most lenders as there is no certainty the project will be executed

  • The developer must use his own capital or, in some instances, corporate credit

  • Investors can enter into a project at this stage, but some developers will want to delay this in order to earn a higher promote


Land Acquisition

  • Some lenders are willing to lend for the acquisition of land

    • Typically low LTV (around 60% or less)

    • Lenders prefer land that already has services (sewer, water, etc)

    • Land acquisition loans must usually be repaid at the start of the construction loan

    • Typically variable rate loans based on Prime or Bankers’ Acceptance rate

    • Some land banking loans are also available at lower LTVs (50% or less)

  • Investors can enter into a project at this stage but some developers will want to delay this in order to earn a higher promote


Alternatives to traditional loans for land acquisition include

  • Land purchase option

    • Low cost means of controlling the land during the feasibility assessment stage

  • Vendor take-back

    • Seller finances the buyer by providing a loan

  • Ground lease: developer leases the land instead of purchasing it

    • Generally structured as a long-term lease with escalating rent

    • Avoids large initial outlay of funds

    • Buildings usually revert to landowner at the end of the lease


Construction

  • Lenders rely heavily on the developer’s credit-worthiness and the level of equity investment by both the developer and any equity partner

    • Equity capital must be injected into the project before the first draw

  • Often require a certain level of pre-sales or pre-leasing

  • Market players include 

    • Commercial banks

    • Pension funds

    • Private investors


  • Amount will be based on total expected cost and anticipated value at stabilization

    • LTC of 65% or less

    • LTV of 75% or less

    • Can include or exclude land values depending on project

  • Typically, variable rate loans based on Prime or Bankers’ Acceptance rate

    • Interest is capitalized and increases the principal amount outstanding.

  • Amounts are advanced (called draws) as the project advances

    • Often include developer soft costs

  • Construction loans can extend to the period of time it takes to lease-up a property and stabilize its cash flows.

  • Construction loans are generally repaid from the proceeds of sale of the property or from the proceeds of a term loan.


Stabilization

  • Funding for carrying (interest) and operational costs during the stabilization period are sometimes included in the construction loan

    • Multifamily

    • Condos

  • Bridge financing called a mini-perm can be arranged if property has not reached its stabilized NOI

    • Typically floating interest rate loan


Take-out

  • Once the property has reached its stabilized NOI, or has been delivered to the tenants, take-out financing is arranged

    • Reimburses the construction loan

    • Typically a mortgage loan

    • Can be fixed or floating rate

    • Term of 15 years or less

    • Amortization of 25 years or less

  • The take-out financing is sometimes arranged before the construction financing

    • Can be required by the construction lender


Equity Return

  • Most investors eventually move beyond valuation based on a single year’s income to consideration of the rate of return over the expected holding period

  • When evaluating prospective rates of return among investment alternatives, most investors start with the rate of return on Government of Canada Bonds as the baseline.

    • Investors add a risk premium to this “risk-free” rate.


  • The total of the GOC rate and risk premium gives the expected return of the investor. 

  • A certain inelasticity in the expected return is often observed


  • GOC rates are normally lower for shorter-terms than longer-terms

  • This relationship between rates and maturity is represented in the “yield curve.”


Decision Making Metrics

  • The main financial metrics used in development for decision making by equity investors is the Internal Rate of Return (IRR)

  • This metric uses the cash flow of the property or project.


IRR

  • The IRR is the rate of return of the investment

    • It is the discount rate which will give an NPV of zero

  • The IRR is compared to the investor’s hurdle rate (required rate of return)

    • If IRR > Hurdle rate:  investment is made

    • The greater the IRR the more attractive the investment.

  • IRR is the most widely used investment metric in real estate


In Development three IRR calculations are often made, depending on the investment strategy:

  • The Development IRR calculates the return for the initial investment, through the construction and stabilization periods.

  • The Holding IRR calculates the return for the period the asset is held, after the stabilization period

  • The Total IRR calculates the return for all the above periods combined, i.e., from the initial investment to the sale of the asset. 


Distribution of Profits

  • Preferred returns: when an investor has first claim on profits (or a specified distribution formula) until he has achieved a certain target IRR

    • Often given as an incentive for a financial partner to invest

    • See Excel example

  • Promote: when an investor earns a disproportionate share of the profits

    • Often given to the investment manager or operating partner as a form of bonus for achieving a higher IRR

    • Generally applies to profits after the financial partner has achieved his targeted IRR

  • Clawback: when an investor gives up a portion of his return to another investor if a certain IRR is not met

    • Applies most often to the operating partner or investment manager