THINK START UP MEETS LEVERAGED BUY OUT ...

A PUBLICATION OF PROPERTY DEVELOPMENT PARTNERS LIMITED

Definitive Guide To Development and Construction Finance For Property Developers

HOW SUCCESSFUL PROPERTY DEVELOPMENT IS ALL ABOUT SUCCESSFUL DEBT STRUCTURING

TABLE OF CONTENTS

1

2

3

4

5

ConceptualisationProperty Development Funding -What are the Real Costs Involved?

The Reason Why Mezzanine Finance Is Now Much Cheaper Than You Think

Calculating the Value of Mezzanine Finance To Your Project’s Profitability

External Investor Equity Participation -Is It a Development Funding Solution?

Preferential Equity vs Joint VentureFunding – An Auckland Example

Conclusion & White Papers

Think Start-Up meets LBO for the Financing of Property Development.

It’s like a Start-Up because you’re creating an income producing real estate asset from nothing - just a concept in your head - and you have no revenue at first, just a plan to negotiate control of a site for development purposes.

And it’s like an Leveraged Buy-Out because you deploy capital sources in a combination of debt and equity structured up to a very high gearing ratio to fund the successful completion of the project.

Chapter One

PROPERTY DEVELOPMENT

FINANCE – WHAT ARE THE TRUE COSTS

INVOLVED

DEVELOPMENT FINANCE – BEGIN WITH BANK FUNDING

The Loan-to-Cost and Loan-to-Value ratio’s tell you what percentage of bank debt you can use. If the total project cost is $10 million and the LTC ratio is 80%, you can use $8 million of bank debt and you’ll have to use $2 million of equity to cover the rest. The LVR is based on the completed value. Generally this is 65%. The loan facility cannot exceed this LVR.Therefore the loan sum of 80% TPC must be no greater than 65% of the completed value or equity input is required to reduce the LVR to 65%.So the amount of funding the bank will give you will be no greater than 80% of the total project cost and no greater than 65% of completed value.

Here are the main sources of capital and financing methods for property development funding:

DEVELOPER EQUITYThe developer puts down their own cash. Usually this is much lower than 3rd Party Investor Equity and the bank/non-bank debt. Sometimes the developer negotiates a performance bonus where their percentage ownership is increased based on the profitability (IRR) of the project e.g. 50% under 20% IRR, 55% above 20% IRR.

THE MAIN FINANCING METHODS FOR PROPERTY DEVELOPMENT:

EXTERNAL INVESTOR EQUITYThe developer seeks an external or 3rd party investors to invest their own cash in the project for a percentage ownership. This amount can be significantly greater than Developer Equity. Known as Joint Venture funding. The JV is governed by way of a Shareholder Agreement. Another form is Preferential Equity participation.

MEZZANINE FINANCEThis is a form of debt secured by a second mortgage with higher interest rates and higher risk than Senior Debt.Mezzanine Finance is used before external equity investors or additional developer cash. This is because debt is cheaper than equity. Mezzanine funds generally do between 80% and 90% of the LTC.

SENIOR DEBTThis is Bank debt secured by first ranking mortgage. This has lower interest rates than Mezzanine and is less risky. Senior Debt will usually fund up to 80% of Total Project Cost.Most projects maximise the use of Mezzanine and Senior Debt combined together.

THE TRUE COST OF DEVELOPMENT FINANCE

When looking at the cost of development finance the two most common questions from property developers are:

1: What is the “all up” interest rate of the Banks facility? (30 Day Bank Bill Rate + Margin + Line Fee)

2: How high is the interest rate for Mezzanine Funding?

What many property developers and investors do not realise is that the common answers to these questions are generally not the correct ones.

Why the “all up bank rate” is actually more than you think:With Bank finance the key here is the Line Fee which is charged on the Facility Limit not the loan balance. With development funding - because the loan progressively increases in balance each month - the average balance over the life of the facility is typically about 60% of the facility limit. So if Line Fee is 1.5% then the true cash flowed rate is 1.5%/60% = 2.5%Because of this amplifying effect - which many property developers overlook - consider these “equivalent” all up interest rates:

With exactly the same “all up” interest rates, there is an effective variance of 1.34%.

30 Day Bank Bill Rate

Margin Line Fee ‘All Up’ Rate True Line Fee Rate

Real ‘All Up’ Rate

3.00% 2.50% 0.50% 6.00% 0.83% 6.33%3.00% 1.50% 1.50% 6.00% 2.50% 7.00%3.00% 0.50% 2.50% 6.00% 4.17% 7.67%

HARD COSTS AND SOFT COSTSThis oversight of true cost also applies to mezzanine finance where financiers often quote rates anywhere from 12% to 25% per annum. Again the true cost can be found in the fees however given Mezzanine Finance is generally fully-drawn from day 1 the true cost is calculated differently. For the senior debt the bank will also apply an Establishment Fee, part of which is payable on acceptance of the banks indicative loan approval. The interest rate is the banks internal base rate, loosely associated to the 30 day bill rate, plus a credit margin. Bank establishment fees, line fees and interest rates are negotiable based on the quantum, equity and overall credit worthiness of the transaction taking into account elements such as pre-sales, post code, product mix and the guarantors net worth, credit history and development experience.

Property Development Hard Costs and Soft CostsIn a borrower’s development and construction feasibility report, hard costs refer to costs directly involved in the construction of a building, like timber, concrete, plumbing fixtures, roofing, etc. These are usually expressed as a per square metre rate which also includes the builders margin. Soft costs refer to indirect costs that the developer pays to progress the project forward, like legal fees, architectural fees, engineering fees, insurance and pre-construction interest costs etc.In a more general sense, hard costs are items that are tangible, which add value to a site – in the situation that a lender had to sell it.

DEVELOPMENT FINANCE – THE SOFT COSTSDevelopment Finance Soft CostsThere are three main soft costs in development finance which are, firstly, the consultant reports that the banks loan approval is subject to. These are the Registered Valuation report and the Quantity Surveyors report. Second is the initial 50% of real estate agent commissions due for obtaining the pre-sale contracts.The reports and bank hurdle pre-sale contracts must be provided to, and be acceptable to, the bank for the loan facility to become unconditionally approved. Then mortgage documentation is issued for settlement. On this date the first draw-down occurs and commencement of construction begins.

When the developer has obtained the resource consent and building consent for a project, the RC, its conditions, and the council stamped BC plans are given to the Q.S who then calculates the cost of construction and the Total Project Cost. This report is then provided to the Valuer who will determine the Residual Land Value which is based on the completed value or Gross Realisation (ex.GST) less the selling and new C.T costs, the development profit and risk margin (20%), the construction and associated project, finance and holding costs.

The balance is the Residual Land Value. This is the value that a prudent developer should pay for the site for the project to be bankable. If the RLV is less than 20% of the Total Project Cost, then further equity input is required. This dilutes the developers Return on Equity.

DEVELOPMENT FINANCE – SOFT COSTSSo when the bank approves the construction finance facility it is subject to QS and RV reports and the pre-sale hurdle as well as other conditions precedent and any special conditions.

The cost of these reports is paid by the developer and are addressed to, and instructed by, the bank. These Reports are critical to the deal - and the developer - as they have the potential to be deal-busters if the Total Project Cost and Gross Realisation (ex.GST) create a development profit margin that is too low. The cost of each report is 5k to 25k plus. Always use project consultants – particularly valuers and quantity surveyors - that are acceptable to the bank or these costs will be duplicated.

The pre-sale contracts must be ‘qualifying pre-sale contracts’ according to the banks criteria. 10% deposits, enforceable and to genuine buyers (not family and friends) with sunset clause dates no earlier than 3 months from the date of practical completion as certified in the Q.S report.

The real estate agents commissions are paid 50% up front – when pre-sale target is achieved prior to commencement of construction - and 50% at settlement upon completion, when the new C.T’s have been issued by LINZ. Therefore the developer has to pay the first 50% from cash resources. The second 50% is covered by the funds paid by the purchaser under the contract.As you can see these development finance soft costs are material to the deal and must be budgeted for from project equity. The funds used must be deployed wisely by the developer to achieve the required result in terms of bankability. These soft cost expenses are a true cost of development finance.

Chapter Two

THE REASON WHY MEZZANINE FINANCE

IS NOW CHEAPER THAN YOU THINK

MEZZANINE FINANCE IS CHEAPER THAN YOU THINK

For transactions where a project or property development company has more than one cost of finance, e.g. where a Bank Debt and Mezzanine Finance for Property Development are used, Weighted Average Cost of Capital (“WACC”) is essentially the calculation of the overall cost of all the sources of finance combined.Because Bank funding is currently so cheap as interest rates are at an historic low point - and combined with the fact that the Mezz Debt is typically a relatively small percentage of the total debt- the WACC of Bank plus Mezz Debt is actually very low.

Here is a simple and typical current example.

Bank debt is 80% and Mezz debt is 10% of the development’s Total Project Cost (“TPC”) with the true “all up” interest costs being say 6%

for the senior Bank debt and 25% for the Mezz. With this funding structure the WACC would only be:

(Bank 80%/ 90% TPC) x 6% + (Mezz 10% / 90% TPC) x 25%OR 5.33% + 2.78% =

8.11% p.a. WACCSo what seems expensive on the surface, mezzanine funding when

averaged out, is actually lower than what bank rates for development loans were only a few short years ago.

Chapter Three

HOW TO CALCULATE THE VALUE OF

MEZZANINE FINANCE TO YOUR PROJECTS

PROFITABILITY

CALCULATING THE VALUE OF MEZZANINE FUNDING TO PROJECT PROFITABILITY

The Key to Calculating the Value of Mezzanine Finance is in Considering these Property Development Key Performance Indicators:The WACC of the Bank and Mezzanine Debts and How much less Equity you need to put into the project as a result of the Mezzanine Finance and therefore what the net effect to your Return on Equity (“RoE”) is.

Step 1. Calculate the WACC:Lets use the example contained in the previous chapter which has a WACC of 8.11%.

Step 2. Calculate the Level of Equity Reduction:If the bank will fund 80% of Total Project Costs (TPC), you would need to put in 20%. However if you use Mezzanine Finance of say 10% you would only need to put in 10%. Therefore, the required equity is HALF of what it would be solely with bank debt.

The leveraged effect on your Return on Equity is profound in terms of profitability. This is why most property developers

prefer to use the minimum amount of capital required.Step 3. Calculate the Effect on Return on Equity:Because the cost of Mezzanine Finance increases your WACC your net project profit will naturally be lower than if you only used bank debt. However, given the WACC is only marginally higher than the bank’s rate, the effect on your Return on Equity is profound – see this typical example calculation on next page:

HOW TO CALCULATE THE VALUE OF MEZZANINE FUNDING TO YOUR

PROJECTS PROFITABILITYThe low WACC combined with resulting significantly higher RoE is

a key reason why many of the country’s leading developers are currently taking advantage of Mezzanine Debt or methods such as

Preferential Equity either to complete larger projects or more projects than they would otherwise be able to.

While higher gearing does present higher risk on a single project mezzanine funding when used appropriately to spread your equity across various projects or investments can actually

decrease portfolio risk by increasing diversification. A well planned Mezzanine Finance Facility produces an

increased return to the developer and allows them to preserve Equity. They maintain full control of their Projects and can allocate their available capital across more developments.

Your Property Development Bank Debt Only Bank + Mezzanine Funding

TPC – Total Project Cost $10,000,000 $10,000,000

Bank Debt at 80% of TPC $8,000,000 $8,000,000

Mezz Finance at 10% of TPC nil $1,000,000

Equity Required $2,000,000 $1,000,000

Dev Margin at 20% of TPC $2,000,000 $2,000,000

Cost of Mezz Finance at 25% nil $250,000

Net Project Profit $2,000,000 $1,750,000

Return on Equity 100% 175%

Chapter Four

PREFERENTIAL EQUITY PARTICIPATION BY

EXTERNAL INVESTORS - IS IT A

DEVELOPMENT FUNDING SOLUTION

EXTERNAL INVESTOR EQUITY OR “PREF EQ” IS IT A DEVELOPMENT FUNDING SOLUTION ?

It is common knowledge throughout the world that Bank’s LVR’s have retreated a long way from pre GFC levels due to the capital controls imposed by the Basel Committee through central Banks.

Compounding this challenge to Property Developers have been the changing As Is and Resource Consent/Building Consent approved Land Values due to construction cost escalation - not to mention the higher levels of qualifying pre-commitments and personal guarantees now required by the Banks credit policies.

Further frustrating Property Developers is the Banks requirement for significantly higher levels of equity in the form of cash to be contributed before the Project becomes Bankable.

Defining a well-known problem is one thing - developing a funding solution is really what matters. In some cases Preferential Equity may provide part of the solution. So what is it? How does it work? What are the upsides and downsides? How is it different to the old Mezzanine Finance products?

Pref Equity is a form of hybrid debt and equity financing to fill the gap between what the Bank will fund and what the client is ideally willing or able to contribute towards the Total Project Cost (TPC) of an otherwise bankable property development.

For example, when a developer has 5% of the TPC in equity and requires 95% in external funding Property Development Partners Limited would arrange a structured facility incorporating senior bank debt, mezzanine finance and preferential equity.

PREFERENTIAL EQUITY OR “PREF EQ” IS IT A DEVELOPMENT FUNDING SOLUTION?

So What are the Key Positive’s ?

(A) The borrower is able to generate a higher return on equity as their cash contribution is significantly reduced.

(B) Banks are more willing to provide senior debt with Pref. Equity as they are reluctant to consent to second mortgages for construction projects.

(C) Immediate access to illiquid equity lying dormant in brick and mortar assets.

(D) Ability to restructure debts and rectify potential or existing loan covenant defaults without suffering significant losses due to the forced sale of the asset.

(E) Ability to restructure ownership/equity/partners within existing property portfolios.

(F) The Pref Equity participant provides additional experience, capability and strong management support to help manage risk and profitably complete the development.

(G) The reduced cash equity required by the borrower may allow them to take advantage of other opportunities which would not otherwise be possible.

PREFERENTIAL EQUITY OR “PREF EQ” IS IT A DEVELOPMENT FUNDING SOLUTION ?

(H) The Pref Equity’s returns are usually fixed, reducing the potential for conflict with respect to calculating the “Project Profit”. This gives the Property Developer the opportunity and the incentive to make additional profit if the project achieves development margins beyond those originally forecasted.

(I) The borrower is able to bring the project to market faster and significantly reduce holding costs.

(J) By bringing the project to market faster the Property Developer realises development profits sooner.

(K) Pref Equity provides the bank and Property Developer with an additional source of cash equity in the event of cost overruns beyond the existing contingency budget.

(L) If structured correctly the addition of the Pref Equity participant can make the project more Bankable from a senior lenders perspective.

OK.. What About the Key Negatives ?

(A) As you would expect Pref Equity is more expensive than traditional debt and as such it needs to be used wisely.

(B) In the event of an unremedied event of default the Pref Equity lender can enforce steps within its rights with respect to control of the development company to ensure the project is completed and their capital and return is preserved.

PREFERENTIAL EQUITY - IS IT A DEVELOPMENT FUNDING SOLUTION? How Preferential Equity is Different to the Old Mezzanine Finance Second Mortgage Facilities: If structured correctly the main advantage of Preferential Equity vs Mezzanine Debt is that Pref Equity does not require a registered 2nd mortgage or a deed of subordination of debt to be negotiated with the senior lenders such as banks and their legal advisors. Property Development Partners Limited’s Director of Project Finance – Fergus McMahon - has selectively used Preferential Equity to finance Property Developments however he has also used this innovative form of financing to “Sell Down” equity and/or pay down and restructure existing debts secured by existing income producing commercial properties to maintain bankable LVRs enabling clients to refinance/rollover facilities.

The pricing of the Preferential Equity is generally calculated upon a risk adjusted return on capital basis and must achieve a minimum Internal Rate of Return (“IRR”).

As the name suggests the Pref Equity lenders capital and return is secured in priority to the developer and obviously behind the Bank. Pref Equity financing is basically debt capital that gives the Pref Equity provider the rights to convert to an ownership and control position in the development company under certain circumstances. These generally include a negative credit event such as the loan not being paid back in time and in full or there being a prolonged un-remedied default relative to any loan documentation including the senior lender or the Pref Equity facility itself.

Chapter Five

PREFERENTIAL EQUITY VS JOINT VENTURE

FUNDING – AN AUCKLAND EXAMPLE

PREFERENTIAL EQUITY v JOINT VENTURE FUNDING - THE OPTIMUM FUNDING

SOLUTIONThe Optimum Funding Solution

A professional Property Development Company were seeking a Joint Venture on their 30 apartment project situated in Auckland, with the aim of efficiently spreading their capital across their pipeline of projects in high-demand areas of Auckland, maximising their activity in the current strong market.

The apartment project is located in one of Auckland’s designated high-growth inner-city areas, with an affordable price-point, on a quiet street yet walking distance to a range of amenities including the new Busway Station and Shopping Centre. These factors make it an attractive project to not only buyers, but also to any potential Joint Venture partners.Property Development Partners Limited was engaged by the Development Company to provide a JV funding solution to meet the client’s requirements.

Upon assessing the merits of the project and the developer, PDP recommended to the Development Company that giving away up to half of the project profits to a JV partner may not be the most efficient solution for them.

A Preferential Equity solution was proposed, which would see the Development Company’s Return on Equity being significantly greater than under a JV arrangement, while ensuring that the Development Company retained full control of their project.

PREFERENTIAL EQUITY v JOINT VENTURE FUNDING – THE BEST FINANCIAL

OUTCOMEThe Best Financial Outcome

Property Development Partners quickly secured an offer for Preferential Equity in conjunction with Major Bank Senior Debt, which the development Company accepted.

The Pref Equity investor did not require any further pre-sales than the Bank’s hurdle.

Compared to a JV agreement, using PDP’s sources of Pref Equity, the Development Company’s share of profit is forecast to be 56% greater, while their RoE is forecast to be significantly improved from 86% to 168%.

There is nothing worse in development finance than surplus equity diluting Return on Equity as the bank does not require it. Although they will be happy to take it once you give it.

A well planned Mezzanine Finance and/or Preferential Equity Facility produces an increased return to the developer and allows them to preserve equity – or recycle equity back out - as well as maintaining control over their capital and importantly full control over their Project.

The Multiplier Effect of Mezz/Pref Eq Financed Projects over a 10 Year Period Creates a Huge Difference to the Project Sponsors Net Worth.

These Are The Methods Professional Property Developers Put To Action When Making Money with Mezzanine Finance and Preferential Equity. You Know What To Do. Keep It Strong.

How Successful Property Development is All About Successful Debt Structuring.

Author Fergus McMahonProperty Development Partners Ltd

2016 All rights Reserved

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