CONSTRUCTION FINANCE

CONSTRUCTION FINANCE

Student Projects ( posted on 30 /10/ 2006)
Real estate developers are processors and producers of goods which are tangible product and enormous cost from concept to completion. It is impossible for any developer firm to bear the entire cost, hence the need for construction finance.
The flow of resources in each of the real estate parcels being studied here, i.e. the commercial and the residential facilities follow a different model. This will imply different natures of financing arrangements.
For the real estate sector, the one time pure vanilla product “construction finance” is no longer available and it has out lived its purpose. The time has come for innovative products as the market conditions have changed in the past 5 years. The establish of lending is the rupee ‘Rupee Term Loan’ (RTL), when it comes to one of the project.
Rupee term loan/ Project finance: This would function like any term loan, with first charge on the premise being constructed and other foreclosure arrangements like collateral’s, personal guarantee etc.
Line of credit: Line of credit is essentially short-medium term loan, with duration of 2-3 years. Funds are available for all general operations – capital and revenue expenses. The borrower opens an account with lending institution – which is usually in bank case of line of credit, and a certain sum is marked aside for the borrower in that account. As per his needs, the borrowers withdraws his funds and may deposit them back into the account wherever revenue is received.
Lease discount rentals: ‘Lease discount rentals’ as a financial product is a new concept in India. It focuses on repaying capacity of property. The lending model for multiplexes, clubs etc follows the concept of LDr’s, hence an attempt to understand the concept:
Loans are provided by banks and housing finance companies against the future rent that the property will earn and not on the repaying capacity of the borrower.
The loan amount is calculated by discounting the cash flows by the prevailing rate of interest. The terms and conditions regarding the extent of finance, rate of interest, service charges, etc. differ with companies though the basic concept remains the same. Eg: An individual wishes to invest in a mall, which will cost Rs 1 crore, but does not have the requisite income to repay the EMI or wants to be cash neutral with this purchase. We are assuming that since he is buying a commercial property, he will lease it out and earn rent. The financier will discount all the future cash flows by prevailing rate of interest and arrive at the net present value (NPV) of the property. This will be the estimated loan amount and the borrower will be eligible for a loan to the derived NPV.
The lesser and lessee will have their own rent agreement. In addition, the financier will enter into an agreement with the lessee to pay the rent directly to the former. This way the financier safeguards its loan.
This product could be used to fund the working capital requirements or other such financial needs as well
The financiers generally will not want to lend for a very longtime and restrict the term to 7 or 8 years.
While calculating the NPV, escalation clause is considered.
The rent receivables will have to be the net rent receivable i.e. the gross rent minus TDS to arrive at the NPV.
At the time of construction of such a commercial property, barring a few anchor tenants, the rest of the space is unallocated. Thus the financier would generally refuse to assume such a risk in case of real estate where a smallest change in the business cycle will bring down the real estate rents to bottom. So LDRs at the construction phase may not be possible unless the borrower have absolutely impeccable relations with the financier, good track record, brand value and a project with definite potential. Instead, the general practice is to take a 2-3 year loan for the construction and in last phases, when most of the space is let, obtain LDR loan, pay back the original acquisition loan. The future rents will directly got to the financier through a separate account into which the lessees will pay the rent.
Escrow Mechanism
From the lenders perspective, disbursals made to the residential project are the safest baits in the real estate sector.
Under the Escrow mechanism the loan amount is decided after doing a thorough due diligence of the accounts of the develop. Al transaction (inflow and outflow) are routed through a designated Escrow account, the control in which remains entirely with the lender. The progress of the construction is monitored by the appointed auditors who submit periodic progress reports. Disbursements are made strictly on the basis of the progress reports. This system will not be successful without the co-operation, commitment and support of the developer community.
The Escrow mechanism which has become like a lending standard throughout the industry these days. The developers obtains loan and at the same time receives inflows from the buyers at every stage of construction. What in effect is achieved is bridge financing and lower cost of construction; while from the point of view of the lender , timely payback of loan is ascertained. The balance of escrow account, net of repayment of principal and interest is the profit of the developer.
Trust and Retention Account:
TRA mechanism is intended to capture the revenues of the project company and ensure utilization of revenues so deposited and collected in a given order of priority. This utilization is administered by the bank with which TRA is established and which holds the revenue of the project company in trust for the project company and payees of project including the lenders. The TRA mechanism is intended to ensure timely payment of interest and installments of principal to lenders. The security package includes pledge of sponsors shares in the project company with voting rights.
Basic difference between an escrow account and the TRA mechanism is the fact that while in escrow the lender is concerned only with own money and will not interfere in the remaining amount, the way it is utilized, in TRA, utilization of cash inflows is monitored. The borrower will receive allocation specifications from the lenders in which to divide the incoming cash flows.
While escrow is almost a norm incase of residential lending, TRA is preferred way of running things incase of project finance which is usually for commercial and retail projects mainly these days.
Critical lender requirements:
The very basic is that the builder will obtain all the relevant statutory approvals prior to disbursal. Following are the steps:
Loan to be secured by the mortgage of the property of the proposed project.
Property should have clean title.
Property should be easily marketable.
In case of residential projects, the lender has exclusive charge on the company’s receivables, which may also may be the case in case of commercial property.
Additional collateral could be in the form of
Additional property with its development rights assigned in favour of the lender
Personal guarantee of the promoters
Builders usually provides undertaking for minimum price as incorporated in cash flow projections.
Loan repayment would accelerate in case property sale happens faster than envisaged.
Usually the process of purchase of land happens along with processing of loan application. Thus, depending on the arrangements between the developer and the land owner, the developer may be given the possession of the land either on the basis of guarantee issued by the lending organization or the disbursals of loan may happen very quickly, with outright purchase of land being effected.
Real Estate – Appraisal:
Since lending will succeed a thorough appraisal of real estate property, we have included a brief, basics steps in appraisal. More or less, these may remain uniform everywhere. While all lending institutions ideally have their own lending guidelines, they all require appraisals in one form or another to assure them that the value of the home is in line with the amount of money they will be lending. Following are the steps:
Collection of factual data on:
Location
Land area
Style of dwelling
Square footage
Quality and condition
Site plan, floor plan which will offer explanation on:
Number of rooms and bath rooms
Garages
Amenities – such as pools, decks, enclosed porches, out buildings.
Verification of property data and information through town records, tax information, deed information etc.
Study of atleast three comparable homes, (called “comparable sales” or “market alternatives”), that have sold within the last six months and that are, ideally, within one mile of the subject property.
Appraiser begins to make monetary adjustments for the features that differ from the subject property for such items as:
Location
Site
Quality
Condition
Overall room count
Square footage
Heating and air conditioning (i.e., electric heat vs oil or gas)
Garages fireplaces
Estimation of final value. The appraiser will look at how the contributory value adjustments affected the sales prices of each comparable sale. The end result is an adjusted sales price range that allows the appraiser to estimate the value of the subject property.
The risk factors considered by lenders while lending:
During the appraisal of loan proposal, following risk factors are studied closely if builders are insisted to obtain RATINGS from rating agencies, which rate the developer as well as the projects separately on the following criteria:
A complete overview of the state of the economy and the real estate sector contemporarily.
The position of the developer vis-à-vis other players and the developers general reputation in the market.
Project mix in terms of number and value of projects in hand. Present sate of all the projects undertaken by the developer and the extent of adherence to milestones indicates the chances of any time overruns.
The quality of the completed project ahs a vital bearing on the developers business risk.
The internal planning and project management systems adopted.
Organization structure, commitment of the management, management policies and resources deployed.
Conformity with building bylaws and regulations and trade practices followed.
The nature of contracts entered into by the developer with the construction agencies.
Track record of the developer in terms of quality, timely completion and transfer of ownership to the customers.
Nature and extent of litigation against the developers by public sector agencies and the general public
Extent of satisfaction of the customers/investors and redressal of grievances of the purchaser/investor.
Financial flexibility: The ability to arrange funds in case of a liquidity crunch and erratic cash inflows
Working capital management: Current state and practices, any contingent liability that may significantly affect the risk profile of the developer
Insurance cover taken by the developer for its various projects reduces the risk.
Accounting practices and standards followed.
Thus are the practices in financing the construction projects in current times.





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