Real Estate Developer Financing Perspective
The real estate developer is a craftsman just as much as the jewelry manufacturer, whose fine high-end products, although are not basic widgets, clothing or automobiles products, are the result of manufacturing. The difference is that the real estate developer’s products are real estate values or appreciation of real estate values. The successful real estate developer focuses primarily on value creation, consequently performing an economically beneficial and socially desirable task. This discussion will be concerned with the three primary effects of financing on real estate values, which are the product of the developer:
- Risk and Reward Equation of the Lender
- Maximizing financing using various techniques
The real estate developer produces the product by converting ideas and concepts into physical realities by joining land, utilities, bricks, and mortar into well-designed piece of real estate. Not only is value set by combination of demand, land, and labor and materials, but by introduction of debt contracts and commitments in the form of mortgages, leases, and fee instruments into an achievable real estate project. The nature of these financial instruments affects value explicitly.
The most meaningful appraisal techniques are not those which consider the property free and clear of financing. As a real estate developer, you may find the best appraisal techniques are those which consider the property with a completed and contemplated financing. Financing is an encumbrance, the same as a lease, and either enhances or diminishes the property’s value.
A knowledgeable and financially sophisticated developer will maximize the value of a property by giving attention to the timing of each step in the financing process and by the matching financing with particular needs of a lender.
Three excellent questions for calculating positioning of real property in relation to time:
- Will there be an increase in value before financing the project? It is a wise decision to postpone long term financing, if a developer can perceive a rise in the property’s value. Short-term, bridge loans might comprise of lines of credit from financial sources capable of raising capital via investment funds, secured real estate loans from commercial banks, or interest only short term permanent loans from real estate investment trusts, with three to five years.
- How to avoid expensive exit strategies during periods of low interest rate environments? While seeking substantial increases in value, a developer, may wish to contemplate a permanent mortgage, and, if so, should seek out those financial companies who will permit early prepayment with only a small prepayment penalty. To the extent that, one of the major motivations of a real estate owner is the ability to refinance property when the time comes, the rights to prepay in full should be looked at more carefully than many other items.
Risk and Reward Equation of the Lender
- Where to find capital willing to take on the risk of land acquisition?Retail shopping centers, for instance have a real estate process which involves land acquisition, assembly, zoning, the introduction of roads, and utilities, and restrictive covenants, the creation of buildings or build to suit development, and, finally, the management of a group of buildings. With this process in mind, a developer could maximize values by furnishing a lender with an opportunity to invest an equal amount, say, 50 percent of acquisition cost of the land and 100 percent of the cost of the roads and utilities. Since this would be a conservative loan, short term duration, a period of 18 to 36 months, the interest rate should be a reflection of the modesty of the risk. This sort of loan often matches the need of the commercial lender.
- When value increases due to development of raw land?The second step in financing this proposed retail development center could involve the financing of the balance of the acquisition cost plus the debt service on both loans through some form of secondary debt. This will allow the developer to fully finance the acquisition and early development expenses on a temporary basis and to postpone long-term mortgage until an increase in values has occurred by reason of the assembly process, the zoning changes, the imposition of restrictive covenants, and the introduction of roads and utilities. Later, the developer can substitute imputed or created equity for the guarantee.
- How to obtain construction loan from the right lender?The third step would be for the developer to borrow from a lender on a moderately short-term basis—six to twelve months—the cost of the construction of the retail building or buildings to be created. The cost would be no more than a conventional construction loan. If the retail center is of any size, several buildings would probably be under construction at the same time, some being created on a build to suit basis for a known tenant, or some speculative or retail buildings.
- How to see a real estate project through to stability?The fourth step would involve the proper packaging of several individual buildings as the security for a single secured loan. As previously stated, some buildings could be under lease and others available for lease. The loan amount would be equal to the amount due the due the developer, to allow repayment of the loan and sum of the two release prices paid to the first two lenders. The term of the loan might be for three years or thereabouts, with a right to release pieces of the security from time to time. I might state, parenthetically, that a well-conceived retail development center would experience a second increase in land valuations once a number of leases has been secured and the center has a history of some degree of success, either in land sales or leases. At this point, lenders typically shift valuations from wholesale to discounted retail.
- Why patience and accuracy produce successfully stabilized income producing property?As soon as the second increase in the property value has occurred is the correct time when to request permanent financing, the fifth and final step. Definitely, the developer would delay such action until the second increase in valuation, the fact that the buildings had been leased, and that an upward movement in occupancy rental rates had been clearly demonstrated. With the existence of the prior loan package, the developer could “spin off” the particular properties which match the interest and appetite of certain permanent lenders such as regional bank, local banks, or life insurance company, in each instance matching the need of the lender for the credit or rate.
Maximizing financing using various techniques
Though it may appear that large or long-established developers have some extraordinary advantage in the marketplace on mortgage financing, this is not necessarily so, as there are no special benefits in real estate development of scale.
Leverage is the double edged sword of real estate finance. Real estate players have found it extraordinary difficult to resist obtaining just enough funding. Enough funding should be defined as the amount to cover out of pocket cost and leave a margin of post debt service cash flow. Unless, the value or appreciation has occurred, the developer, who has not fulfilled a role as a manufacturer is not entitled to enough.
There are many financial tools and approaches accessible to the sophisticated developer, but in the final analysis, there is no substitute for a solid real estate property values.