Understanding the Intricacies of Real Estate Funding

Real estate development remains a highly lucrative business line, which is why most builders retain skin in the game even in the face of strong market headwinds. However, real estate development also remains a highly capital intensive business, and among the many new market truths that RERA has brought to the fore, the fact that only well-capitalized players will endure going forward stands out.

The ‘time-honoured’ practice of raising funds from the market via ‘pre-launches’ has now become untenable. In this route, which was always hotly debated but never fully suppressed, developers raised money from the public by privately marketing properties in projects that did not yet have the benefit of all regulatory approvals through informal investor and broker channels.  Now, with RERA in place, this route has become an impossible one for developers.

Fund raising for a real estate project via other channels is also far from easy these days. Project finance is now available only if thorough and convincing information about the development stage of the project in question is available. Financiers are aware of the fact that the ‘transitional’ phase calls for the highest amount of funding in the project development cycle. They will now want to know exactly what the funds will be used for.

Additionally, financiers will want to be sure of the strength of the developer’s management team and want to have a good understanding of the business plan involved. This means that the developer will need to project his estimated costs for at least the first several months and maybe even longer. He will need to draw up a new plan and cost estimate for every project, since every project has its own specific funding requirements at various development stages. There is no general yardstick for start-up costs in a real estate project.

Some projects call for only minimal funding, while others will entail huge costs in inventory or equipment. With RERA’s strict guidelines and requirements with regards to completion timelines now looming larger than life over every real estate project, developers must ensure that they have sufficient funding to see their projects to completion.

For a reasonable estimate of the overall costs, he must include all ‘soft costs’ that will be incurred during the initial development stage. These will include the cost of fees for obtaining permits, engineering costs and infrastructure and construction costs. Continuous expenses for utilities, inventory, insurance, etc. must also be included in this estimate. After eliminating all unnecessary costs and finally arriving at a realistic budget to complete the project, a developer would have a funding estimate which financiers may accept.

The paper trail a financier will expect to have access to begins from the word ‘go’, so even start-up costs will need to reflect in a worksheet that mentions all possible cost categories, both one-time and ongoing. Thereafter, the developer must maintain regular financial statements to provide the financier with a ready financial history of the project. This will help the financier to detect anomalies that could result in losses at any given time.

Obviously, the challenges for a poorly-financed builder with no real and established financial discipline to raise formal capital for his project are tremendous. This, of course, brings us back to developers who are well-capitalized – that breed of players who are most likely to prevail in the post-RERA era because they can raise a sizeable part of the real estate project financing through their own resources. Thereafter, they have the option of choosing debt and/or equity financing or a more complex financial instrument structuring.

Debt-based real estate financing

In debt financing, the developer borrows money from a creditor in exchange for future repayment along with periodic or regular interest payments based on a pre-defined coupon rate. The lender has no ownership rights to the developer’s business or business interests, including the project he is financing. However, being a secured, senior lender will accord him the first right to be paid from project revenues. Debt financing is a suitable funding avenue when a builder does not wish to surrender any ownership interests in his business. In debt financing, the financing cost does not fluctuate and the loan is deductible.

Equity-based real estate financing

If the developer decides on real estate project financing through equity, he can opt for either private equity through real estate venture capital or private equity fund, or public equity. In public equity, he can opt for a listing on the local stock market, or a listing on a foreign market such as the UK’s AIM. When REITs (real Estate Investment Trusts) become a reality in India, Grade A commercial space developers will be able to raise development capital via this route.

In any case, raising real estate financing from the public markets often turns out to be a costlier proposition, since it involves investment banking fees and other listing procedures plus considerably higher levels of transparency and corporate structure.

Lenders are also creating structured financial products, especially in debt structuring or mezzanine financing, to protect their interests. These offer developers another source of formal funds.

Finally, the way a developer generates real estate financing must depend on his own strategic standpoint. Without a doubt, he must research his exact needs extensively before choosing any particular real estate financing route. Expert help from real estate consultants who understand and specialise in project funding often plays an integral role in helping a developer to determine the exact needs, and to suggest and enable the most appropriate funding route.