As Boyack aptly narrates, at its most basic level, the story of real estate finance starts with land valuation.
Since mortgage finance frees trapped asset values, the price of land depends on the availability of capital. The more funds available, the more liquid the collateral asset, and the higher its market value. In other words, finance opportunities grow real estate values.
For development projects beginning with humble barren green sites, one cannot but think of the process of property development as a dream works factory, transforming nothingness by creating alternative realities. There is something for me that sees the highest form of vision at play here, with property development endeavours giving credence to the adage, “The audacity of hope.”
In reality, the stakes are often high as are other barriers to entry. In Botswana, where the land is predominantly held by the state and granted by leasehold to beneficiaries, typical structures often involve the landowner (government/or lessee for state owned land), a funding institution (investor), and a developer, each of the parties with varying degrees of interest in the development/investment.
The players
Landowners are typically interested in retaining an ongoing interest in the development, particularly for large commercial or retail sites, which are often lucrative. The developers’ interest is in ensuring viability from the context of demand, and that the site suits the intended purpose. Research is intended to ensure that the development value (after completion) far exceeds development costs and that the investment will be beneficial to all the players by the time construction is concluded, bearing in mind that markets are volatile and that the best conceived plans are subject to some element of chance. The development manager must contend with property level risks (e.g. loss of tenants) which must be managed.
For the funder/investor, the major interests would be in the cashflows of the investment, the main interest being ensuring long-term growth of income streams as well as capital growth of the development. Each of the parties must have consensus on who bears the risk and to what degree, and consequently the risk premium due to each party. The methods of calculation of each of these factors must be aligned and objectively derived.
Investment form and structure
Investment vehicles in development schemes may take the form of Special Purpose Vehicles (SPVs). SPVs are convenient ways of parcelling out the real estate in a discrete entity with its own legal personality, and which can enter into contracts, including to finance the property, manage the property and/or develop it.
Alternatively, Limited Partnerships are favoured investment vehicles for development projects in that they offer flexibility as they have a relatively less stringent regulatory regime (compared to companies), and therefore less restraints in terms of ease of doing business. This is partly due to them being unauthorised vehicles. Joint ventures may also be considered as they are a means of combining resources and sharing risks in development projects.
Tackling risk and reward
There are a number of permutations available, but it all falls down to agreement. However, a common way of sharing risk involves a four-slice agreement. Here a funder may agree to meet development costs excluding the land, the land being made available on a long lease by the lessor (e.g. local authority) in exchange of ground rentals (this is the first slice). The funder, aided by his predetermined target yield, would determine his required percentage stake in the income from tenants (this represents the second slice). The third slice represents the developer’s profit. The fourth slice is any additional profit earned (if any), which would be shared amongst the parties. This provides much incentive to the developer to ensure that the project is a success.
However, where certain parties are risk-averse, for instance, it is possible for the landowner to forgo the fourth slice for a greater proportion of the rentals. It is therefore important that objectives are clearly communicated from the onset.
The reality
Beyond the numbers working out and risks being modelled, a feature of development projects is that they resolve to bring them to fruition. The truth of the matter is that a lot of developments do not take off at all. The reality is that these are high risk ventures involving huge capital sums and seemingly insurmountable challenges such as acquisition of finance (a mammoth task on its own) and a regulatory environment to navigate and overcome.
Property development requires a lot of stakeholder management skill on the part of the development manager because it is indeed a specialist segment of the real estate sector, requiring grit and perseverance. It could be two years of setting up the parties before there is any traction at all and is therefore a marathon that is not at all for the fainthearted. Even so, it can be argued that the end product is worthwhile.
About Tema: MREAC, MBA, BSc Property Studies(UCT) and currently pursuing MRICS Charter and MSc in Real Estate Investment Finance Oxford Brookes University. She is Property Investment Analyst at Khumo PAM.
