There are three main ways to finance a real estate development:
A. Traditional Development Structure
A traditional approach involves a mix of equity and debt funding. The developer approaches a bank for a loan. If the bank is interested in the project, it will instruct an independent valuation. The value will be based on the building’s expected rents at completion. It determines how much the bank will lend on the project. As banks are usually not willing to lend more than the 60-80% of the expected value, the developer will need to provide upfront equity injection for the 40-20% balance.
A new special purpose company (SPV) will be set up for the project. The loan will ideally be structured as non-recourse. This means that if the project goes wrong, the loss for the developer is limited to the money they invested. The bank cannot come after other personal assets. If this is not achievable, the developer may have to provide personal guarantee putting everything on the line for the deal!
The SPV will buy the land, pay for the development and construction work. For a speculative build there is no formal commitment from a tenant to rent the space. Instead during construction, a tenant will be secured. The SPV will own the building at completion and refinance the development loan. This new business loan interest payments will be covered by the rental income from the tenant.
B. Forward Funding Structure
Under this structure, the developer does not borrow money or own the building. It is trading not investing in property. It sells the project to a long-term investor, who provides the short-term financing. To secure an investor, a developer needs an Agreement to Lease from a tenant to lease space in the building before the construction has started. This reduces the risk on the rental income at completion.
The deal is structured as two contracts. The first is a land contract. The investor will buy the site directly from the landowner. The investor will then sign a Development Agreement with the developer. This contains the obligations on the developer to deliver the building. In return the investor provides the funding based on milestones payments and at completion the developer walks away with the development profit.
Milestone Payments by Investor Amount
Exchange of Contract 10.0%
Start on Site 10.0%
Golden Brick 10.0%
Structural Roof Completion 20.0%
Water Tight 15.0%
Weather Tight 15.0%
Practical Completion 18.5%
Completion of making good defects (12 months) 1.5%
Total 100.0%
The main concern for an investor is the safety of the rental income upon completion. Not all of the space (especially in office construction) will have been pre let to tenants at the start of construction. The investor will therefore look for security from the developer. There are two principal methods. The ‘profit erosion’ method whereby the investor can claw back money. The second is the ‘priority yield method’ whereby the developer guarantees to pay the difference in the expected rent in the first year.
C. Forward Purchase Structure
Another trading rather than investing solution, but the developer takes out bank financing. A developer enters into an agreement with an investor or prospective owner-occupier to buy the building who puts up 10% deposit and the remaining 90% at completion. The developer borrows the money to fund the development and construction costs. The developer has ownership of title. The bank has a guarantee from the purchaser, that their short-term finance will be taken out on completion.