When it comes to REF deals, these structures represent along with Project Financing the most sophisticated deals. Therefore it is very usual that those deals are conducted by specialized Departments, are concluded in line with external credit documentation (LMA standards or LMA like) and are supervised by external bodies confirming the stage of project development. Also, what is very important to highlight with REF deals, is that they are very often carried-out by SPV entities, which means that these are empty companies created for certain project. This means that when development project is finished, also the companies are discontinued. SPV concept is beneficial to Creditors as well, while it provides full transparency of the Balance Sheet, as no other business activities are interfering the accounting of the Project; further this provides better comfort whereas fully ring-fenced structure is possible with SPV so that all Assets owned by SPV can be pledged in favor of the financing Bank and there are no other Creditors waiting in a row to be satisfied. This is partially in connection with fact that Profitability as such is not a key target for Developers, so that these entities usually report loss-making activities with huge Debts and low Equity, especially in early stage of the Project (when only Development costs and purchase costs for lands are incurred into Income statement), which might have increased the risk of Insolvency/Bankruptcy to be declared if there were more Creditors for the entity. And this would jeopardize the whole financing process. In addition, these SPVs are usually asked by the Banks to sign also Notary deed on direct execution, which de-facto acknowledges Developers debt even before it actually arises. This is very crucial mitigant for the Banks, which gain the possibility to speed-up the whole proces of claiming the receivables within the Court dispute.
As the financing structure pretty much differs from other Lending products, also the applied financial covenants are “tailored-made” for REF deals, such as Loan to Value ratio (LTV), Debt service coverage ratio (DSCR), Interest coverage ratio (ISCR), and other specific measures are mostly concluded and followed.
During the Development stage, the very critical risk mitigating component is Escrow Account, which is used for depositing the purchase prices and advanced payments before the actual sale of flats/ houses takes place, which is very typical for REF Deals and unlike the other Products.
Commercial real estates are in general split into following areas of financing:
a) Residential development – construction and sale of flats and houses for a living;
b) Industrial and logistics parks – construction and renting the Warehouse and light-industrial premises to Tenants;
c) Office buildings – construction and renting the Office and commercial building premises to Tenants.
What is quite clear from above mentioned distinction is that the project course can be divided into two Stages, which are Construction and Sale/ Investment phase. While in the case of residential projects, there is more usual that Developer will sell the flats and houses after their constructions to final users and financing as such is finished, in case of Industrial and Office buildings, there is very common that Developer continues in financing relationship with Bank, holds the Real estates in his own books and is renting these premises to Tenants based on LT-rental conditions in order to repay the loans in longer horizon.
This is quite important to keep in mind, as the final purpose of Real estate after its construction plays very critical role in determining the financing structure and how the loans will be repaid. Therefore any negotiation with “speculative Investors” may be quite cumbersome, especially when they do not have clear idea on for how long they want to keep those assets in books, resp. at which moment to sell the Real estates on market. This may be the case of some Real estates located at very attractive venues like City center, whereas the Developer is weighing the options between constructing the (i) luxury flats for further re-sale and (ii) modern hotel consisting of luxury flats for purpose of further management. These two different purposes of financing for the same Object are simply totally not compliant so that both versions of Projects will have different collateral package, covenants, conditions precedent/subsequent as well as repayment profile. To avoid further discussions with Clients it is very necessary to manage these expectations from very beginning.
Developers of Industrial and Office building premises are usually represented by experienced Groups/ Market players who usually have clear strategy and pre-agreed rental contracts with their Customers as final Users, so that there is quite clear financing strategy, which is given up-front.
a) Residential development
As already described above in some minor aspects, the purpose for this type of financing is to construct the set of flats or houses and sell them immediately on public market to final owners (private persons). So that the main risks are connected with: (i) On-time completion of development stage and (ii) Proper realization of sale/hand-over of flats onto the buyers.
This is resulting from fact that Bank require as Condition precedent certain ratio of future purchase contracts to be signed (e.g. at least 30%) even before the Development stage has started to make sure that there will be sufficient level of buyers when the project is completed. This level of “Pre-sales” is actually derived from the share of Own Equity vs. External financing required for this, so that it should secure that vast part of Loans will be self-liquidated from these Proceeds. In case of larger Projects, the Developers may opt for splitting the construction into several phases so that for instance Bank provides funding for Block B after the Block A has been finished and sold in pre-agreed level etc.
This risk is also connected with Completion risk, so that Developer must carefully select General constructor, who will able to deliver the construction on time and in required quality/ technology standards. This is quite critical for those future purchase contracts, as they are usually concluded for a certain period (like 1-2 Years) and in case that Construction is in larger delay, the Buyers should have option to step-out from Future purchase agreement (FPA), which will then translate into reducing expected Cash-inflow from future sales (which will have negative impact on ability to repay the loans, in final). Therefore it is heavily required from General contractor to either (i) demonstrate sufficient references of completed projects or (ii) conclude experienced sub-contractors that will be able to work on the project and finish its various parts.
However, given the fact that not only financing Bank faces several risks, it is also the Customers who wish to buy their premises and usually deposit advanced payments for future purchase even in moment when the construction of their homes has not yet started. This is because the Bank is willing to start funding the Project, after some ratio of “Pre-sales” is reached. But, in order to mitigate their risk of losing own money in case that Project was not finished, they can be safe only when purchase price is paid to Escrow Account. This represents three-party agreement, when the Bank plays a role of “independent judge” and release the money from this Account only in case that Developer met his obligations and underlying flats/houses were finished on time and ownership was transferred onto new Owners. The Bank usually distributes the purchase prices from this Escrow A/C directly to Repayment A/C, so that they will gradually reduce the outstanding balance of the Development loan. When the loan is fully repaid, remaining part of these proceeds serves to cover another operating costs connected with Project and generates the Profit, if there is still excess of the funds on Escrow A/C.
Within the security structure, the Bank usually prefers to have such transaction fully “ring-fenced” meaning that almost all following tangible assets are pledged:
- Pledge on all Bank Accounts
- Pledge of Future purchase receivables and Pledge of Performance contract
- Mortgage on Land plots owned by Borrower, lateron Mortgage on constructed Buildings (usually after the 2nd floor is erected above the ground)
- Parent company guarantee
- Pledge of SPV business shares
- Costs Over-run guarantee (securing that Developer will fund exceeding construction costs over Budget from Own Equity)
- Subordination of Intra-Group loans
Usual documentation type to be signed/ delivered with/ by Client:
- Development financing Loan agreement (LMA like standard)
- Agreement on pledge of Bank Accounts
- Agreement on pledge of Future purchase receivables/ pledge of performance contract
- Notary deed on direct execution and debt acknowledgement
- Mortgage agreement on Real estates owned by Borrower
- Pledge agreement on SPV business shares
- Insurance policy for Real-estates immobilization agreement (in case of reconstruction of existing premises)
- Supervision contract with external partner (to check Project evolution, invoices, complaints etc.)
- All necessary permits for construction (zoning plan, development approval etc.)
- Purchase contract for Land plots (might be subject to external financing as well)
- Subordination of Intra-Group loans agreement
This credit facility is usually supported by additional financial covenants like:
- Solvency ratio is replaced with Own Equity funds to be put into Project up-front (min. 20-30% usually invested into the Land plots etc.)
- Maximum Loan to Value resp. Loan to Costs to be capped at 70-80% according to required level of Own Equity
- Minimum required level of “Pre-sales” to be at 30% for instance for each Phase of Development project
- And some others if needed.
There are couple of market players in Czech Republic, that have carried-out major development projects in area of residential buildings, among others you can visit the web sites of main Groups like Skanska, FINEP, CRESTYL, YIT CZ, Vivus, Sekyra Group, Metrostav and others for more references and information.
b) Industrial and Logistics development
c) Office building premises development
These two lending sub-products within the REF segment can be considered as very identical platforms with main distinction in final purpose of the premises usage. Otherwise, their financing structure is nearly the same so as the final conditions and covenants that are regulating the provided financing. Further, when compared with Residential projects financing, herewith included main stages are (i) Development and (ii) Investment one. This means that Developing entity is after construction stage turned into an Investor, who will hold the assets on LT-basis with clear intention of reaching solid and stable Yields from Investments, while regular Cash-flow is generated from renting these commercial Premises to Sub-Tenants securing sufficient funds for reducing the financing Debts (loans).
Based on that, the Bank will have to analyze the underlying rental relations with Sub-Tenants to forecast future Cash-flow to cover future Debt service (loan instalments). In addition, not only Debt service, but also another costs connected with Commercial premises operations (like CAPEX, Brokerage fees, Taxes, Incentives for a new Tenants, remodeling fees etc.) need to be honored from this commercial rental income. So that the Bank will have to perform complex Cash-flow Projection securing that pre-agreed Debt Service Coverage ratio will be reached.
What is quite clear, such Projects are demanding for certain Expertize in the field of commercial R/E, so that each Investor will have to look for:
- Proper location to be suitable for the purpose of R/E (for Offices – City center or outskirts area with good connectivity, for Warehouses and Logistics – greenfield locations close to Highway/Railway with sufficient parking area)
- Lands plot area with clear history and ownership titles, available permits under the zoning plan for further development
- Renowned Anchor Tenants that will secure stable rental Income and will attract other Tenants in future as well
- Design architecture that will fit into the surrounding area
- Skilled and experienced team of General constructor, Architects, Lawyers and Supervisors.
The course of Development stage is almost the same as in case of Residential financing, the Bank as well as Investor must focus on fulfilling sufficient mitigating factors including sufficient count of future Rental contracts, gaining all necessary permits and approvals etc. To achieve this, it is common that Bank cooperates with external partners like Real estate professionals like Colliers, CBRE, Knight-Frank, DTZ among others, which focus on analyzing (i) the Office/ Industrial market (ii) trends in Sub-lease segments (iii) legal aspects and naturally on releasing their regular market researches, as they follow closely current trends and try to predict future development in market prices and achievable Yields per individual segments or locations, which may further influence the ratio of demand/supply for a new premises to be developed in a near future.
The sample of such research on logistic and industrial segment for UK market published bz Knight-Frank is available here:
So that, when analyzing the presented project, the Bank can make its own assessment coming out of the (i) presented pre-contracted rental agreements and (ii) expected future development, and as a result it should approve the proposed financing based on the set of covenants as follows:
- Maximum LTV (between 60% and 85%)
- Minimum DSCR (e.g. 1,25-1,50x)
- Minimum Occupancy rate (around 60-75%)
- Minimum average rental price per 1 sqm (depending on location and final usage of Premises)
- Minimum average tenor for rental contracts (to cope with remaining period of loan)
- Maximum Balloon instalment at maturity (between 30 and 50%)
These afore mentioned covenants will be also appearing in the covenants set reflected in loan documentation. In addition, the collateral structure for these deals is almost the same as in case of Residential development financing, just with one exception for Investment stage of transactions:
- Assignment of rental agreement receivables with Sub-Tenants
- Pledge of Cash Sweep Account to cover potential shortfalls in scheduled installments (usually 2 regular installment reserve to be blocked aside).
Similarly to the residential segment, there are also couple of market players active in Czech Republic, that have carried-out major development projects in area of Office/ Industrial projects, however these Developers represent also big Investors that keep such Real-estates in their balance sheets. Very often these Investors belong to large International Groups, that are traded on Stock Exchanges and Bond markets, as they are well recognized local and international market players like for instance CTP, Prologis, Immofinanz AG, CPI Property Group, HB Reavis Group, Passerinvest Group and many others.