Financing Properties for Investment
What is Property Finance?
Buy to Rent
What is Real Estate Project Finance?
Project finance is long-term financing of an independent capital investment, which are projects with cash flows and assets that can be distinctly identified. Real estate project finance is a classic example.
Other examples of project finance include mining, oil and gas, and buildings and constructions.
Real estate project finance cash flows should be sufficient to cover operating expenses and to fund the financing repayment requirements. Typically, the financing is made up of debt and equity matched to the lifespan of the asset.
Real Estate Project Finance vs Corporate Finance
When a corporation takes on a new investment, it can use cash flows from other operating activities to fund the new project. It can also use its general creditworthiness to borrow money and fund the project. The corporation might also issue equity with an indefinite time horizon. In real estate project finance, equity used to fund the project is usually repaid at the end of a specific time horizon.
Capital Stack in Real Estate Project Finance
When it comes to funding real estate project finance, the capital stack includes several considerations, as follows:
- Draws on construction loans for financing
- Security and priority for various lenders in the capital stack
- Term that matches the length of time it takes to develop and sell the project
- Trade-offs between fixed and floating interest rate
- Pricing around the equity
The capital stack, which consists of all of the different types of financing that may be used, typically comprises the following:
- Senior debt
- Subordinated debt
Senior debt is the most secured capital, while equity is the riskiest out of the three.
Real Estate Project Finance Industry Terms and Definitions
To build a financial model, we need to understand the important terms and definitions frequently used in real estate project finance:
- Loan to value (LTV): The amount of debt financing a lender will provide as a percentage of the market value of the real estate.
- Loan to cost (LTC): The amount of debt financing a lender will provide as a percentage of the cost of a development.
- Net operating income (NOI): Gross rental revenue less operating expenses (property taxes, insurance, maintenance, etc.).
- Cap rate: NOI divided by the value of the property, expressed as a percentage.
- Amortization period: The number of periods (months or years) the principal repayments of a loan take to be completed.
- Term: The length of time that the interest rate on a mortgage loan is agreed for.
- General partner (GP): An owner of a partnership with an unlimited liability – usually a manager who actively participates in the operations.
- Limited partner (LP): A passive investor who has limited ability, based on the amount they have invested in the project.
- Land loan: Financing used to acquire a piece of land with no NOI. The long-term value will be much lower than that of an income producing property.
- Floor space ratio (FSR): Used to determine the size of a building and control the density of development on a parcel of land.
- Gross building area (GBA): The sum of all building spaces from wall to wall.
- Gross leasable area (GLA): The sum of all enclosed livable space.
- Gross site area: The two-dimensional measures of a site, based on its property lines.
- Deductions: A portion of the gross site area that cannot be built on, such as public access areas, roads, lanes, etc.
- Net site area: The gross site area, less any deductions.
- Max GBA: The gross building area, calculated based on the FSR.
- Construction GBA: The gross building area, based on construction plans.
- Saleable area: The gross building area based on construction, less all common spaces or other non-salable areas.
Real Estate Project Finance – Development Timeline
Understanding the development process and timeline helps us get a clear map when building a real estate project finance model. There are several stages in a real estate development project:
Different types of funding are used at each stage of the life cycle of real estate project finance. For example, a company may use equity to finance the sourcing of deals. This is because there is high risk in the early stages of a project and, therefore, it may be hard to obtain bank loans. In the later stages, such as rezoning and pre-development, the projects are usually financed with both loan and equity.