1 Finance for development − principles

© University College of Estate Management 2016 P10241 V1-0

Contents
1 Introduction 3

2 The nature of development 4

2.1 Development projects 4
2.2 Development risk 4
2.3 The development cycle 5

3 The structure of property finance 8

3.1 The forms and sources of finance 8
3.2 Equity and debt 9
3.3 Corporate and project finance 10
3.4 Development and investment finance 11

4 Project-based development finance: equity 12

4.1 Sources of equity 12
4.2 Forward funding 12
4.3 Joint venture 13
4.4 Partnership 14
4.5 Lease and leaseback 15

5 Project-based development finance: debt 16

5.1 The advantages of debt finance 16
5.2 Bank project finance 16
5.3 Non-recourse, limited recourse and full recourse loans 18
5.4 The structure of bank finance 19
5.5 Forward sale 21
5.6 Mezzanine finance 22

6 Corporate finance for development 24

6.1 Equity financing 24
6.2 Corporate debt 24
6.3 Multi-option financing facilities (MOFFs) 24
6.4 Convertible loans 25
6.5 Commercial paper 25
6.6 Deep discount bonds (DDBs) 26

7 Conclusion 28

1
2
 Introduction

1 Introduction
This paper is concerned with development finance and not with
property finance in general.

• Development finance, as the name suggests, is required for the

development of new projects or the redevelopment of existing
property assets.

• Property finance covers a broader field and includes sources of

finance and financing techniques for investment in property as well
as development finance.

There is a strong relationship between the two branches, and often the
distinction becomes blurred, as when an integrated financial package is
arranged to cover both the development phase and the longer-term
refinancing or investment phase. This paper addresses issues of
investment finance only in so far as they relate to an understanding of
development finance.

The aim of the paper is therefore to explain the special features

of development finance and to analyse the methods employed by
developers to finance their projects.

3
2 The nature of development

2.1 Development projects

Development projects, large or small, have a number of common
features:

• They take several months, if not years, to complete, from the initial
design stage to the point where they function as earning assets.

• They involve very large outlays by the developer, relative to the

income or profits they will initially generate when in service.

• Their expected working life is far longer than that of other types of
asset, such as machinery or vehicles.

• The entire development phase is a period of high risk for the

developer, or for whomever else stands to lose in the event of the
project’s failure.

• The construction phase often causes inconvenience to neighbours.

It imposes ‘external costs’.

• Besides the developer and the contractor, a number of other parties

are involved in the process, adding to its cost. These include
the landowner (if not the developer), the planning authority, the
professional advisers and consultants, and the financiers.

2.2 Development risk

Building projects characteristically take from six to nine months to two
years or more to complete. In many cases the developer receives no
income over this period, although units in housing estates and some
shop and office developments may be sold or let when the first phase
of the development is completed.

The risk of failure is always present during this period. Failure occurs
when those who have committed funds to a project suffer losses, either
because the project is not completed or because it is completed only
after sustaining cost or time overruns.

Risk-bearing commands a price. Funds allocated to a development

project will therefore achieve a higher return than those financing
lower-risk ventures, such as investment in a building already let.
Generally the riskier the project, the higher the premium that must be
paid to those that finance it.

This distinction between the risks of a speculative development project

and those of the less risky investment in a property that is already

4
 The nature of development

earning returns has led in the past to different financing structures,

sometimes quite unrelated to each other.

2.3 The development cycle

Most economies are subject to recurrent fluctuations in the level of
business activity, known as the business cycle, or growth path of
national output (GDP). Upturns in this cycle are accompanied by an
increasing demand for commercial space. This in turn leads to:

• rising occupancy rates if there is suitable unused space;

• rising property market rentals and capital values if space is fully

occupied.

The rise in capital values stimulates development activity, frequently

leading to competing projects in the office and industrial property
sectors, as individual developers attempt to exploit the space shortfall.

When the economy turns downward, the business demand for space
falls with it, pulling down rental values and raising the yield that
investors will require if they are to hold property. The combined effect of
these two factors is to lower capital values and to remove the incentive
to embark on new development projects. Development decisions
therefore depend on prices, values and yields determined in the
property market at large. In broad terms, the value the market places
on the existing stock of buildings is a major influence on the value of a
development, since the existing stock far exceeds any current additions
to it.

Property development therefore experiences peaks and troughs,

suggesting cyclical activity similar to that occurring in the overall
economy. However, development cycles tend to be more irregular and
volatile than pure business cycles. The reason for this is to be found in
the nature of property development.

Development activity is driven by rising property values. Such increases

occur during a period of economic recovery after a recession. An
upturn in the business cycle leads to a rising demand for space. In
its early stages this can often be met by taking up vacant commercial
property, without causing any upward pressure on rents. As the
recovery strengthens, however, rental values begin to rise. This,
coupled with the lower required yields that accompany growth
expectations, increases capital values, and quickens development
activity.

However, there are lags in this chain of events, as Figure 1 shows.

Economic growth can be rising sharply before it is reflected in rising

5
 rental values. Development activity may not be fully geared up until
rental values have been increasing for some time. Such lags frequently
result in the demand for space declining before it is completed, a
problem compounded by the length of the construction period.

Figure 1 The development cycle

Apart from the difficulty of forecasting increases in the demand for new
buildings, other problems have to be addressed:

• land acquisition;

• financing;

• obtaining planning consent;

• assembling a project team;

• placing contracts;

• construction difficulties;

• finding tenants.

Failure could occur at any point in this sequence, and the possibility
of time or cost overruns, or failure to meet quality standards, is always
present.

6
 The nature of development

The process is therefore fraught with risk. Failure to complete buildings

until long after the collapse of demand for them often leaves the
developer in financial distress or facing bankruptcy. In such cases,
those who have provided the finance, particularly banks and other
creditors, become the owners, often with no prospective sale or lease
in view.

Property market collapses therefore tend to be more severe and last

longer than those suffered by business in general. Banks and other
creditors remain ultra-cautious about advancing money to property
long after a collapse.

Sources of finance therefore vary according to the position reached in

the credit cycle in relation to the development cycle. Developers have
to tap different sources, the outcome depending on the current position
in the cycle.

7
3 The structure of property finance

3.1 The forms and sources of finance

The structure of property finance is diverse. Classification of types is
difficult because the packages negotiated for financing commercial
property are more often tailored to meet the specific needs of the
developer or investor, rather than taking a standardised form. Often tax
considerations play a substantial part in shaping a package.

Besides the obvious categories of equity and debt finance, other

distinctions are present. Finance may be:

• short-, medium- or long-term;

• for development, investment or both;

• project-based or corporate;

• direct or indirect;

• generated domestically or from overseas;

• for speculative or bespoke buildings.

Financial packages carry varying levels of risk. A development for

which a tenant of some status, or a buyer, is already signed up, is
generally a less risky option than one where the outcome is uncertain.

Besides these distinctions in the form of finance, there are numerous

and diverse sources of finance. Among them the following are
important in the UK:

• UK and overseas banks;

• listed and unlisted property companies;

• insurance companies;

• pension funds;

• authorised and exempt property unit trusts;

• investment trusts (including real estate investment trusts);

• limited partnerships;

• UK building societies;

• high-worth individuals.

8
 The structure of property finance

This paper focuses on development finance, that is the methods

by which new commercial property development or refurbishment
is funded, principally in the UK, but also to a limited extent in other
countries.
The ‘Development finance’ row in Table 1 shows the position of
development finance in the overall structure of property funding, with
the principal types of financing methods employed.

Table 1 The structure of property finance

Project Corporate
Equity Debt Equity Debt
Development Forward funding Bank project Developer’s Multi-option
finance finance funds funding
Joint venture Forward sale Share issue Convertible
Partnership bridging finance loans
Lease and Mezzanine Commercial
leaseback finance paper
Deep discount
bond (DDB)
Investment Forward sale Mortgage Share issue Corporate bond
finance issue
Forward funding Eurobond issue Retained profit
Sale and Securitisation
leaseback
Finance lease

Table 1 also shows that property finance, both for development and
for investment, tends to be project-based rather than company-based.
Such funding is usually more expensive to service than corporate
finance, particularly during the development stage, but for lenders
offers a first charge on a new or refurbished property as the security.
In the sections that follow, each of the methods of funding development
is discussed in greater detail.

3.2 Equity and debt

Any business can look to three sources of finance for its activities:
• it can seek additional finance from its owners;
• it can generate finance internally by generating and retaining profits;
• it can borrow from a number of different sources.

9
 Finance coming from the first two of these is called equity. In the case
of a company, it is also known as shareholders’ funds or share capital.

Finance raised by borrowing comes from four broad sources. It can

come from:

• a bank, building society or similar institution;

• the capital market;

• the client;

• a partner.

With a property development there are strong reasons why the

developer tries to finance the greater part of the cost by borrowing.
The most obvious is the difficulty and cost of raising equity on account
of the risk. By borrowing he is also able to transfer more of the
development risk to the lender.

3.3 Corporate and project finance

We have mentioned the sheer size of many developments. In many
countries these require an allocation of resources that goes far beyond
what the individual development company can command.

For example, the balance sheet of one property company showed total
long-term funds at £6.1bn as at 31 March 2000. The developments
reaching completion in the year to 31 March 2001 were valued at
£4.2bn, with those due for completion in the following year expected
to reach £6.3bn.

In cases like this the assets of the company alone are inadequate to
provide the security that lenders require to safeguard their interest, and
loans have to be secured on the project itself. Funds raised specifically
to finance development or investment in this way are termed project
finance.

Where funds raised by a company are not specific to a particular

development in this way, and are used to finance its activities generally,
they are known as corporate finance. As a general rule, loans raised
against the security of the assets of a company as a whole pay lower
rates of interest than project loans. The risks inherent in project
development demand an appropriate interest rate premium.

10
 The structure of property finance

3.4 Development and investment finance

Traditionally, finance has been required at two stages of a development:

• during the development phase itself (design, site acquisition,

construction phase and marketing);

• when the developer has to repay the loans and accumulated interest
on the completion and occupation of the building. It has to be
refinanced.

The funds raised for these two purposes are known respectively as
development and investment finance. The two are not always kept
separate. With many schemes the funds for development are provided
by the organisation which refinances it as an investment. In the past
this has often been an insurance company or a pension fund in the
UK. In some countries of south-east Asia a new development, such
as a hotel, might be financed as a joint venture among partners, one
of whom might be the hotel operator. In such a case 50% of the funds
might come from the partners’ equity, the remaining 50% from a loan.

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4 Project-based development finance: equity

4.1 Sources of equity

Most lenders require developers to inject a cash stake from their own
resources into the projects they are financing. This is often hard for
many developers to achieve. Property companies especially have found
it difficult to raise new equity since their shares have not been popular
with the investing public.

Such equity has come from a number of sources:

• financial institutions, principally insurance companies and pension

funds, but also (to a much lesser extent) investment trusts and
property unit trusts;

• property companies;

• limited partnerships;

• joint venture partners;

• lease and leaseback arrangements.

The mechanisms for providing equity shown in Table 1 are explained in

more detail in the sections that follow.

4.2 Forward funding

With this method the institution purchases the site and provides
funds for the construction of the building. This arrangement gives the
institution a greater control over the development, often leading to
the developer being charged a lower rate of interest than the market
norm. On completion, however, the developer might receive a lower
capital sum: that is, the building is sold at a higher yield. So the
lower interest charged by the institution on the development finance
is counterbalanced by the developer’s lower profit on sale. This lower
profit can be seen as the cost of the lower risk the developer bears
as a result of a guaranteed sale. The institution bears not only the
development risk but also the leasing risk. The developer’s only risk
is that of the development profit.

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 Project-based development finance: equity

4.3 Joint venture

Joint ventures have grown in importance over the last 20 years.
They take many forms and involve partners from a wide range of
backgrounds. These include:

• banks;

• insurance companies and pension funds (forward funding is an

example);

• building contractors;

• other developers;

• landlords.

The growth of joint venture arrangements is attributable to a combination

of factors:

• Property developments have become more costly on account of the

size of many new projects and the increased risk associated with
them. The equity injections required are often beyond the resources
a single developer can provide.

• Central banks are often concerned with the destabilising effects of

rapid bank credit expansion, such as that which occurs during a
property boom. This is the case in the UK, and a number of other
countries, where development finance is provided primarily by
banks.

• As already mentioned, property companies have had difficulty in

raising new equity since their shares have not excited investors.
They have therefore looked to joint venture and partnership
arrangements to plug this gap.

• Cross-border investment is generally more risky than investment

in domestic projects, partly because of information deficiencies.
Overseas investors therefore often favour joint venture arrangements
to limit the risk.

Joint ventures typically offer a number of advantages. Their purposes

include:

• securing additional finance for a project;

• acquiring expertise;

• reduction in gearing through off-balance-sheet financing;

13
 • risk reduction;

• addressing the needs of foreign investors.

The structure of joint ventures varies widely, but a common approach

has been to set up a special purpose vehicle (SPV), jointly owned by
the parties concerned. SPVs take various forms. They may be limited
partnerships or limited companies, or they may be based on profit
participation. Their structure will be determined by the purposes for
which they are established. Certain questions guide decisions on this:

• Are they concerned with just one or with a number of projects?

• How can they be constituted to reduce either or both parents’ tax

liabilities?

• How can they be structured to minimise stamp duty land tax?

Apart from the pooling of resources, the purpose of these vehicles in

the past was to keep assets, and particularly liabilities, off the balance
sheet. Many of the joint venture SPVs, set up during the UK property
boom of the late 1980s, borrowed heavily to finance their activities.
Where each of the two parent organisations had a 50% equity stake
in the joint venture, the borrowings did not appear in either of their
balance sheets, with the effect that investors were unaware of the
extent of their liabilities. When interest rates rose, many companies
collapsed under the weight of these liabilities.

This practice of concealing off-balance-sheet financing was restricted

by a provision in the Companies Act of 1989. This required the
accounts of a non-subsidiary (such as an SPV in which it held 50%
or less of the equity) to be consolidated into those of the parent
organisation, where the parent exercised control through its voting
rights. The ability to conceal liabilities from shareholders has thus been
curtailed in the UK. Further restrictions were introduced with the issue
of FRS 9, ‘Associates and joint ventures’, in 1997. It is still permitted
in the United States, where collapses such as that of Enron point to its
dangers.

A notable example of a joint venture is that established by AMEC,

Balfour Beatty, Kumagai Gumi of Hong Kong, China State Construction
Engineering Corporation and Maeda of Japan for the construction of
the new Hong Kong airport on the island of Lantau in the 1990s.

4.4 Partnership
Partnerships have become a significant method of releasing the
development potential of land and property in recent years. By the
terms of the Partnership Act of 1890, partners have unlimited liability

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 Project-based development finance: equity

for decisions taken, but the Limited Partnership Act of 1907 allowed
a limited liability to members, provided that they do not participate in
management and that at least one member remains a general partner
with unlimited liability. If the general partner is a limited company,
with the responsibility of managing the business, this difficulty can
be overcome. In situations like this the partners themselves would be
shareholders.

The great virtue of a partnership is that it offers tax transparency to

its members. There is no taxation at the corporate level, since the
partnership is not a legal corporate body. The incidence of tax on
profits and capital gains from property transaction falls on individual
partners.

4.5 Lease and leaseback

Owners of a site, intending to develop it for their own business, may
lease it for a period of 25 years to a bank at a nominal (peppercorn)
rent. The bank then contracts with a construction firm to build the
warehouse or other property the owner wants. On completion, the bank
leases the building back to the owner at a rent that covers the bank’s
construction costs and the rolled-up interest. The owner is thus spared
the problem of finding the equity for the development and the bank
benefits from any capital allowances that may be payable.

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5 Project-based development finance: debt

5.1 The advantages of debt finance

The greater share of development finance is raised through borrowing
in its many different forms. There are good reasons for this:

• By borrowing, the developer is able to transfer much of the risk of

the development to the lender, although at a cost that reflects this
risk.

• Interest paid on borrowed funds is an allowable expense for tax

purposes, thereby reducing the net cost of the finance.

• There is considerable competition among suppliers of finance

which exerts downward pressure on interest rates. Overseas banks
compete in a global capital market along with domestically based
banks to give competitive terms.

• For most types of borrowing the drawdown and repayment terms

can be negotiated to meet the developer’s requirements, often
allowing interest to be rolled up and capitalised with the cost of
construction.

With the majority of projects therefore the developer commits no

more than 15% of the gross development value (GDV) from his
own resources. The sections that follow detail the main forms of
project-based borrowing.

5.2 Bank project finance

Banks are a major source of development finance. Their loans are
mostly for the short term (under five years) and are secured on the
development project itself. Interest rates may be variable or fixed.

• Variable or floating interest rates are the norm on large projects,

the rate being geared to the London Interbank Offered Rate or
LIBOR. It is fixed at so many basis points (one-hundredths of one
percentage point) above LIBOR, which is a wholesale rate of interest
charged on loans by banks to other banks. For example, if LIBOR
were 4% and the borrowing rate fixed at 150 basis points above
this, interest would be charged at 5.5%. The greater the risk, the
higher is the margin above LIBOR. On smaller projects interest is
geared to the bank’s base rate, which is a retail rate, slightly higher
than LIBOR.

• Fixed rates on short-term loans are rare. They are most commonly
found in longer-term borrowing vehicles such as mortgage

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 Project-based development finance: debt

debentures, which are used to refinance completed projects rather

than developments.

Interest may be paid on an ongoing basis over the period of development,

and charged to the profit and loss account. Alternatively, it may be
rolled up and paid with the capital on completion when the building
is sold. Capitalisation of the interest in this way keeps the interest off
the profit and loss account, thereby enhancing the profit figure, and
includes it in the price of the building.

Development finance carries risk for both the lender and the borrower.

• For the lender, funds raised for speculative development always

carry a higher level of risk than those used to finance a building
where a sale has already been agreed or a tenant with a sound
covenant has taken up a lease. The security of a development loan
is therefore a critical part of the loan agreement. This depends
on whether the lender has full recourse to all the assets of the
developer or to those invested in the project itself. (See Section 5.3.)

• For the borrower, a variable rate loan leaves him exposed to rising
interest rates. The lender will conversely be exposed to falling
interest rates. Borrowers can, at a cost, negotiate a cap, or ceiling
on the interest rate, with a bank to limit their exposure. Conversely,
the bank might purchase a floor from the borrower. With this, the
borrower would compensate the bank to the extent of the difference
between the rate prevailing and the agreed floor, should the rate fall
below it. A collar combines the virtues of both the cap and the floor.
It places a restriction on interest rate changes in both directions,
creating a band within which it may fluctuate. Figure 2 shows how
an interest rate collar works.

Banks tighten the terms of lending during recessions. The measures

taken vary but frequently include:

• more rigorous loan-to-value appraisals;

• lower percentage of GDV advanced;

• full recourse or, at best, limited recourse loan terms;

• higher interest rates;

• moratorium on lending against speculative projects;

• withdrawal of funding to smaller organisations.

17
 Figure 2 An interest rate collar

5.3 Non-recourse, limited recourse and full recourse

loans
• Non-recourse finance
In the past, rising property values have led banks to provide
development finance that is secured on the project itself, without
giving recourse to the assets of the development company in the
event of failure. Where this occurs and the parent company has
given no guarantees, the loan is non-recourse. In such cases a
special purpose vehicle has been set up to organise the financing
of the project and it is this vehicle to which the lender has recourse.
Because of the risks borne by lenders there have been very few
genuine non-recourse loans in the UK property sector, although
a well-located project pre-let to a blue-chip tenant can still attract
such terms.

• Limited recourse finance

Banks have become more cautious about lending for development
as a result of previous property collapses. They are more likely to
require limited recourse to corporate assets, as well as those of
the project, as security, particularly in periods of unsettled values.
With this arrangement the development company guarantees the
interest payments, but not the repayment of capital. In determining
the precise nature of the loan, contract lenders will be very much
influenced by the company’s past performance and the viability of
the project.

• Full recourse loans

These are secured entirely on corporate assets. They are effectively
corporate loans, not project finance.

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 Project-based development finance: debt

Non-recourse and limited recourse loans generally carry a higher rate

of interest than corporate loans to cover the higher risk, although
potentially corporate assets may offer less collateral.

For small and medium-sized construction companies, the problem

of financing new work is much more acute than that of the larger
companies. They often lack the collateral to satisfy banks’ requirements
for loans, and also present greater risks to lenders because they do
not have a large portfolio of projects to diversify those risks. Often
they do not command sufficient financial expertise to manage their
resources adequately. They are, therefore, more inclined to fail than
larger organisations, so sources of finance are more likely to be limited.
Bank finance on a project basis is likely to be their mainstay, providing
they can make a sound case for their projects. Capital equipment is,
perhaps, easier to acquire through leasing than the finance for the
ongoing costs of a development.

The Centre for Business Research at Cambridge publishes an annual

survey, entitled Financing UK Small and Medium-sized Enterprises,
which highlights some of the difficulties of small and medium-sized
enterprises (SMEs) in obtaining finance. Construction SMEs have been
one of the largest groups of respondents to the questionnaire (almost
500 of a total number of 2,500 firms in 2007).

The survey report is available at:

www.cbr.cam.ac.uk/research/policy-evaluation-unit/output13.htm
[accessed 1 March 2013].

5.4 The structure of bank finance

Banks normally advance up to 70% of the GDV of a project that is
either pre-sold or pre-let to a tenant with a strong covenant, that is, a
financially sound tenant. Experience of property market collapses has
led banks on occasion to re-examine their loan-to-value ratios and they
now conduct more rigorous valuations than previously to ascertain the
likely value of completed projects.

A loan of 70% of the GDV would leave the developer with some 15%
to find from his own resources, assuming a profit of 15% of GDV was
sought. A simplified structure of such an arrangement is shown in
Figure 3.

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 Figure 3 Bank project finance: structure

It is obvious that lenders would require an intimate knowledge of the

financial status and record of potential clients and would conduct
detailed enquiries before committing funds to a project. They generally
look to the ‘four Cs’. These are:

• Character

Evidence of the borrower’s ability to manage and complete the

project on time is required. His financial integrity is a necessary
condition for making an advance.

• Cash stake

The extent and source of the borrower’s equity in the project is

also a concern. The lender is interested in whether the equity was
borrowed elsewhere or arose from past profits, whether it had an

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 Project-based development finance: debt

existing charge against it, or whether it arose through the revaluation

of the property.

• Capability

The concern here is that the borrower will be able to meet the
interest and capital repayments when they fall due.

• Collateral

The value and liquidity of any loan security is important, as is the

basis of the valuation. Personal guarantees may well be sought.

A major concern of all lenders is that the development, whether

speculative, pre-let or pre-sold, will be completed according to the
terms of the loan agreement. In particular they will require the borrower
or contractor:

• to inject equity either upfront or on a side-by-side basis;

• to meet the completion date or accept liability for cost overruns;

• to observe the schedule for interest and capital repayments

rigorously;

• to accept liability for any losses on the sale of the completed

development.

The projects that find most favour with lenders are those that:

• occupy excellent locations;

• are pre-let or pre-sold;

• are leased to a blue-chip tenant, such as a company in the top 100

quoted on the stock exchange;

• are leased for 10 years or more;

• are leased subject to periodic five-year rent reviews.

5.5 Forward sale

With this form of funding a financial institution gives a forward
commitment to purchase a development on completion, once agreed
conditions have been met with regard to the specification of the
building and its letting. The institution does not become involved with
the development, but the commitment to buy it on completion allows
the developer to borrow at a lower interest rate from a bank, since the
bank avoids the risk of letting or sale. As an alternative to bank finance
the developer might negotiate a bridging loan from the institution.

21
 A guarantee to purchase such as this enables the developer to
attract development funding more easily and cheaply. There are
some similarities between a forward sale and the forward funding
arrangement discussed under Section 4.2. The cost of finance is likely
to be greater in the case of the forward sale with a bridging loan, but
the completed development will sell at a lower yield.

Table 2

Forward funding Forward sale

Expected rent £50 million p.a. £50 million p.a.
Capitalisation rate 7.0% 6.5%
Value net of costs £695 million £750 million
less cost of site and £460 million £460 million
construction
less interest charged at 8%: 12%:
£65 million £96 million
Developer’s gross profit £170 million £194 million
Return on cost 32% 35%

5.6 Mezzanine finance

Mezzanine finance is individual project loan finance, which normally has
a second charge on a development. It therefore carries a higher risk for
the lender than conventional project loans. It occupies an intermediate
position between pure debt and pure equity.

Developers have to bridge the gap between the cost, which is around
85% of GDV, and the 70% advanced by the senior lender. Developer
equity may fill all or part of the gap. It is often the case that the
developer exploits the higher-risk mezzanine finance market, either
because he cannot bridge the gap or because, for tax or accounting
reasons, he prefers to take on more debt.

Mezzanine finance ranks after the bank loan (senior debt) in servicing
the debt but will earn a priority return before the developer’s own
equity contribution. The same order of priorities will apply should the
development fail. As there is greater risk attached to the mezzanine
finance than the senior debt, a much higher return is required on this
slice of the funding package. The required return will normally be
expressed as an internal rate of return in the region of 25−30%. This
will consist of interest payments, often at 500 basis points (5%) over
LIBOR, plus a share in the profit of the project. The logic behind this
is that the provider of the mezzanine finance is really contributing a

22
 Project-based development finance: debt

substitute for equity funding to the development and should therefore

receive an equity reward. This reward may be taken either as a
percentage share of the profit or as an extra fee charged when the
development is successfully completed and sold.

Mezzanine finance is not normally available for periods of greater than

three years and is often used to finance shorter-term development
loans. If the developer wishes to retain the completed project as an
investment then the mezzanine finance itself will need to be refinanced.
This can be done by the use of a ‘holding’ or ‘investment’ loan, which
is long-term lending calculated by reference to a valuation of the
completed project.

Severe credit restrictions experienced in property market troughs have

given added importance to this type of finance. The normal sources
of senior debt for development, the banks, become more reluctant to
finance projects at levels of 70% loan-to-value, leaving a gap between
what lenders will provide and what developers and investors require.
The collapse of other funding sources, particularly the commercial
mortgage-backed securities market, and tightening financial regulation
have given added stimulus to mezzanine finance.

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6 Corporate finance for development

6.1 Equity financing

It is clear that developers neither wish to fund new projects with equity,
nor find it straightforward to do so. Equity sources for development
come from:

• ongoing partnership arrangements;

• disposals of currently owned investment properties, a course which

carries the risk that the property market may be flat at the time;

• new capital issues, such as ‘rights’ offers.

To be successful the last of these requires a buoyant market in property

company shares. Recent experience has not been favourable in the UK.

6.2 Corporate debt

Companies can finance development by issuing corporate debt, This
is not as commonly found in the UK as the project-based methods
discussed earlier, although in certain countries it is used more widely.

The main types of corporate debt instruments are explained below.

6.3 Multi-option financing facilities (MOFFs)

A MOFF is a specialised form of corporate funding which includes a
variety of financing options within one package. The financing options
can include both sterling and euro commercial paper, multi-currency
arrangements and straightforward loans.

MOFFs are only available to the largest of property companies and

borrowings are normally in the Euromarket. This type of facility is
generally unsecured.

In essence, a MOFF involves a group of banks providing a company

with a commitment to provide cash advances for a certain period.
Attached to that group is another group of uncommitted tender panel
banks which can bid to provide short-term advances at a margin below
that of the committed facility. If the borrower is unable to raise funds
at a satisfactory rate through the uncommitted tender panel of banks,
then it can fall back on the committed facility at the slightly higher cost.

The mechanics of MOFF involve a company instructing a lead bank to

arrange a syndicate that will provide the required amount of money if
asked to do so. This is the committed facility and is usually priced at

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 Corporate finance for development

so many basis points over LIBOR. The arranging bank will then form
a tender panel which will be another group of banks but probably
containing a number of the original banks in the syndicate. When the
company wants to borrow, the tender panel banks are invited to bid
to provide the required finance. Those offering the cheapest rate can
expect to make the loans. If the tender panel banks fail to bid the
required amount of the loan or do not bid at an interest rate below that
in a committed facility, then the company requiring the finance can use
the committed facility instead.

The cost of the uncommitted facility is usually less than that of the
committed facility because the banks are not entering a commitment
to supply finance whether they want to or not. Thus, by separating
a committed term facility from a more opportunistic uncommitted
arrangement of borrowing alternatives, a borrower is able to take
advantage of the benefits that may arise on a short-term basis.

Typically, a MOFF will provide a two- to 10-year commitment to provide

a fixed amount of finance. The tender panel facility will be able to
provide the borrower with low-cost funds in a variety of different
instruments. The borrower may therefore draw funds in a variety of
currencies. The loan size of MOFFs ranges between £50m and £300m,
with £120m being the average.

6.4 Convertible loans

Convertible bonds enable the largest listed companies to raise finance
by the issue of debt at beneficial rates of interest.

A convertible bond is one that will pay a conventional rate of interest

and will be redeemed but can convert into ordinary shares at some time
in the future. The price at which the holder of the bond can purchase
the ordinary shares is determined before the bond is issued and at
a figure above the current price of the underlying ordinary shares. In
essence, the convertible bond is similar to convertible loan stock and
convertible preference shares.

6.5 Commercial paper

This is a short-term security issued direct to investors in a number of
currency denominations. As short-term debt it has been used by large
property companies for development funding. To secure competitive
borrowing costs, however, the debt requires favourable ratings by the
rating agencies (Moody’s, and Standard and Poor’s).

Commercial paper normally has a maturity of between seven days and

one year. The paper is usually sold at a discount rather than paying

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 interest. For example, commercial paper with a life of three months may
be issued at £97.50 for every £100 that will be repaid. The discount
or ‘interest’ earned is usually expressed as a number of basis points
above LIBOR. Commercial paper is an attractive short-term investment
for investors who wish to gain a return in excess of the yield of bank
deposit rates. Investors tend to be the institutions, banks and other
companies.

There is also a euro commercial paper market which was established

in 1985. In principle it is similar to the sterling market but has two
important advantages:

• there is a small secondary market which enables trading to take

place and thus these short-term debts are securitised;

• the market is a cheaper source of finance since it offers money at

rates below LIBOR.

In the US, the commercial paper market is more developed than

comparable markets elsewhere. It is used more widely to finance
short-term developments than comparable markets in Europe and the
Far East.

6.6 Deep discount bonds (DDBs)

DDBs, as the name suggests, are issued at a discount, frequently at
prices with up to 35% off par value. A DDB will have a final repayment
date, and may pay a fixed interest coupon or, in the case of zero
coupon bonds (ZCBs), will carry no coupon at all. The advantage to
the investor of these particular instruments is that the capital gain on
redemption together with the running interest coupon, if there is one,
will give a gross redemption yield comparable to other issues. The
discount is comparable to the rolling up of interest on a loan.

There are two main benefits from using deep discount securities:

• cash flow;

• tax efficiency.

With regard to cash flow, the profile of a DDB mirrors that of most
investment properties with a coupon rate that may equate to rental
income and, hopefully, an increasing capital value. Thus it enables
retention of high-quality investment assets without the need to fund a
shortfall in interest payments.

In the past, certain tax structures made DDBs attractive. Differences

in the rate at which rental income and capital gains were taxed made

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 Corporate finance for development

such instruments attractive to lenders. Such differences are no longer

significant.

Since the issuer had either very low or zero interest payments to make,
they were also suitable for financing developments.

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7 Conclusion
This paper has focused on the sources and instruments employed
to finance property development. Funding for investment in property
has been discussed only where the financing packages have linked
the two areas. Development finance by its very nature is subject to
higher risks than finance raised to fund the purchase of completed
properties, where tenants are already paying rents or the buyer has
completed the purchase. Although financing packages might cover
both requirements, the costs and risks of the two are the source of their
differential treatment in the financial markets.

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