Investing in Property through Construction Loans

THE UNIQUENESS OF CONSTRUCTION LENDING

When a lender makes a loan, it transfers money – the total amount loaned is called the loan principal - to a borrower for a specific period – called the loan term. For granting this credit, the lender charges the borrower interest based on the loan principal and calculated at an agreed annual rate. The lender receives repayment of the loan from the borrower either at the end of the loan period – called the maturity of the loan - in a lumpsum – called a balloon payment or bullet payment – or, where the loan is an amortising loan, in instalments during the loan term. This is how a commercial loan is structured.

The pattern and style of a construction loan is different from a standard commercial loan. A construction loan is a loan made to finance the cost of erecting or constructing a building or other real estate asset. A construction loan can be made to fund ground-up construction, as well as to act as a bridge loan used to finance improvements to an existing property. It is a kind of asset-backed security, where the asset only exists in the future, in someone’s mind, or in an architect’s drawing.

In a commercial loan, the participants are lender and borrower. The participants in a construction project are the project developer, who sponsors the project, the builder who carries out the construction, the lender who funds the construction, and the letting agent or sales agent who markets the project after completion.

Property construction is sponsored by a property developer. The developer is the borrower in the construction loan. The construction lender is a lending bank or other loan investor. Where construction is on leased land, the landowner may also be involved in the financial arrangements. Finally, a second bank, lender or investor, called a take-out financier, makes a permanent loan after the project has been completed.

In a commercial loan, the loan principal remains unchanged during the loan term, except where the loan provides for periodic repayment of principal by way of amortization, or where the loan principal is prepaid - repaid early, before maturity - by the borrower. But a construction loan has a principal amount that fluctuates, usually upwards, depending on the stage of construction of the project.

The lender does not pay the principal amount of a construction loan over to the developer in a lump-sum at the start of building operations. It disburses the loan principal to the developer or makes it available in some other programmed way according to a draw schedule. The lender permits loan draws to be made, but draws are dependent on project progress. The lender monitors construction progress through on-site inspections which are coordinated with cash advances under the construction loan.

Unlike many commercial loans that are long-term and are in place for up to several decades, a construction loan is a short-term loan. Its term is based on an estimate or expectation of how long it will take to complete the construction project. This may be months or several years.

For a lender, a construction loan is riskier than other types of property-based lending. The reason for this is that the economic feasibility of a construction project is hard to assess beforehand. And for lenders that specialise in construction loans, construction projects concentrate credit risk (the risk that a loan will not be repaid) in a small number of developers who borrow large amounts. This is different to residential mortgage lending where the lender’s risk is spread out over a portfolio consisting of a large number of residential mortgage loans made to homeowners who each borrow a small amount.

There are many risks that are construction-related and linked to construction finance. Most projects are completed on time and on budget. But it is hard to estimate the value of a project that will only be completed in two years’ time or later. Property supply and demand conditions over that time scale are difficult to predict. Office buildings in particular have long preparation times.

A two-year time horizon is standard in assessing the market. The construction lender tries to predict how the market will look over that period. What will be the vacancy rate in two years’ time; what will supply in demand look like in the market at that point?

A pro forma cash flow forecast for the completed project is prepared before the construction loan is granted and construction commences,. This forecast predicts how the property is expected to perform after it has been stabilised. But before completion of construction, actual cash flow and forecasts of cash flow will be volatile and uncertain.

CONSTRUCTION, AND CONSTRUCTION-RELATED

A loan that is made specifically to fund construction is easily identifiable as a construction loan. But a construction project is a complex process, and it progresses through a series of phases or stages. In other phases of the project life, constructionrelated loans are made.

There are three categories of construction loans and construction- related loans:

Standard construction loan. A loan for a fixed principal amount that is granted to fund the cost of constructing a building or similar property asset. The parties intend that the developer will repay the loan with take-out financing, and when the construction loan is made, take-out financing will have been precommitted to repay the construction loan as soon as construction is completed.

Extendible-term construction loan. A construction loan that is granted for an initial term, but which has conditions that give the developer an option to extend the loan term, either when the project has achieved specific milestones, or at the discretion of the lender, or when both conditions have been met.

Permanent property loan. This is a constructionrelated loan. It is a loan that is used to repay a construction loan, once construction has been completed, and the property has become stabilised and is generating income satisfactorily.

VALUATION

The principal amount of a construction loan is directly linked to or based on the value of the project and the property that is being built. But the value of the underlying property asset fluctuates as the project progresses. This means that the property must be valued or revalued at several stages during the construction process.

A construction project has four stages of value measurement: unimproved land value; project in progress value, project as completed value, and project as stabilised value.

At the start of the construction project, the amount of the construction loan may be based solely on the value of the land. During the construction phase, the loan amount increases in tandem with the project progress. In the prestabilisation phase, when construction has been completed, but the completed property is not yet generating income, the value is the potential of the property to generate cash. In the stabilised phase of the completed project, the property is valued based on its current ability to generate cash in the future, by renting out space in the property in return for rental income.

The value of a completed construction project is calculated by estimating the net cash flow that the project is predicted to generate, and to determine the present value of that cash flow by applying a capitalization or discount rate that is sustainable. Net cash flow from the project is taken to include rental generated by leases in place, plus rental generated by additional leases that are signed up until the time that the property is regarded as stabilised, so that there is an acceptably low level of vacancy and the assumed rentals are marketrelated. Expenses and capital expenditure are fixed at market levels, and are deducted from gross income to determine net cash flow. Some property-related expenses are deducted from the stabilised value of the property. These include rent losses, the cost of tenant improvements, leasing commissions, and free rent.

ASSEMBLING THE CONSTRUCTION LOAN

The developer assembles the construction loan. The developer finds land that it believes is suitable, say, for the construction of an office building. The developer does not buy the land, because it does not have finance of its own to make the purchase. The developer commissions an outline design for an office building, and does research into the level of supply and demand for office space in the project location. The project has no pre-construction lease commitments. The developer then commissions an architect to draw up detailed plans for the project. The developer obtains a valuation of the proposed project based on the architect’s plans. The developer funds this preliminary work with an unsecured corporate loan from a bank, that it has obtained for these prefunding purposes. This corporate loan may eventually convert into a construction loan.

The developer approaches the construction lender, which may be the same bank that made the corporate loan, or it may be another bank, or some other investor. The developer asks to borrow funds to develop the office building. The prospective lender reviews the developer’s project valuation and based on the valuation the lender gives a loan commitment to the developer. The loan commitment states that the lender will make a construction loan to the developer, and that the loan will be funded – paid out to the developer - over the construction period. The interest rate on the loan is a floating or variable interest rate based on an index such as LIBOR, and it may have a floor - or minimum rate - built into it and designed to ensure that the lender will earn a minimum spread over its own cost of funds. The developer pays the lender a commitment fee for giving the loan commitment. The developer also pays a loan origination fee to the lender to cover the lender’s costs of making the loan – preparing the loan documentation, and servicing the loan.

Because the loan has a floating interest rate, the lender offers the developer the option of buying an interest rate cap – a derivative contract that sets a ceiling on the interest rate that the lender will be obliged to pay over the period of the construction loan. A cap will protect the developer from the effects of any increase in interest rates during this period. Because a cap is contracted for a 12-month period, the developer will have to renew it on each anniversary of the contracting of the construction loan.

If the developer does not have its own funds available to pay the loan commitment fee and the interest rate cap fee, the prospective construction lender makes an unsecured corporate loan to the developer, which the developer then uses to pay these fees. The developer uses the first draw on the construction loan to repay the corporate loan.

A construction loan can be for an amount of up to 100 percent of the value of the completed project. If the project is sold for its appraised value after completion, and the construction loan has been repaid, the cash proceeds of the sale may have to cover interest and loan fees that were debited by the lender during the construction phase.

Construction loans are risky for lenders. A lender has a choice. It can play the part of an arm’s length financier and accept the associated credit risk and other risks that a construction loan entails. Or it can try to reduce these risks by playing a closer role in the project, by taking an equity interest or quasi-equity interest in it. A lender that has acquired an interest in the residual profits of a project is said to have received an “equity kicker”.

The lender’s equity interest in the projectuctured in several ways.

The lender may be given the right to receive a specific percentage of profits from the sale or rental of the completed project. This would clearly be an equity interest in the project.

Or the lender could be entitled to receive interest at a rate that is considerably higher than the market interest rate, or loan fees that are higher than the fees customarily charged in the market. The lender would then have a profits interest in the profits of the project designed in a more subtle way but giving the lender a return similar to that of an equity interest.

Or the lender could finance, in addition to the costs of construction, all loan fees and construction loan interest, in the expectation of being repaid out of the proceeds of the property or the cash flows generated by it.

For the developer, these lender equity arrangements and contributions to costs would mean that, although the developer holds title to the project, it bears little or no risk of project failure, because it has no capital invested in the deal.

THE CONSTRUCTION LENDER'S ROLE

A lender involved in a construction project gets three lending opportunities: to make the land loan, to make the construction loan, and to make the permanent loan. The lender may also fund operating deficits for short periods. Where completed property units are sold to high-end purchasers, the lender may ask for a right of first refusal to finance the purchases to be made by those purchasers.

In its role as construction lender, the lender may ask for information regarding the project: the names of sub-contractors, descriptions of the work that they will do on the project, proposed selling prices of completed project units, and details of lease negotiations and signings of prospective tenants. The lender may review plans, specifications and cost breakdowns for the project. The lender may have its own team of property inspectors who will visit the project on a regular basis to protect the lender’s interest in the project, to ensure that construction is going according to plan, and that loan funds are disbursed only for completed work.

Where the lender has a substantial equity interest in the project, this could give it effective control of the project. If the lender is the only party at risk in the project, or the main party at risk, then only the lender stands to gain from the success of the project up until the developer repays the construction loan. To protect its stake in the project, the lender controls disbursement of the construction loan, and the progress and direction of the project.

Where the developer does not receive any return until the project has been completed and starts to generate cash, the developer has an incentive to complete the project as quickly as possible. During the construction phase, the developer has nothing at stake, and only becomes interested in the project when it has been completed and starts to operate successfully. The lender must then exert control over the project to ensure that the developer does not give in the temptation to cut corners in building operations. This is specially important where the developer, or a project special purpose vehicle, is thinly capitalised and totally dependent on construction loan financing. This dependence increases the risk of defective construction. So the lender monitors construction operations, looking for errors in workmanship and design. As part of this monitoring, the lender can demand to review plans, inspect construction, approve construction methods, and supervise builders. In the pre-stabilisation phase, the lender may also participate in negotiation of leases.

BALANCING THE CONSTRUCTION LOAN

A construction loan is “balanced” when the remaining funds that are available from all sources total an amount this is big enough to fund the project through to completion. These funding sources are the proceeds of the construction loan, any contingency reserves, and borrower equity.

A construction loan that is well structured and made to a developer that is experienced, motivated and financially robust is unlikely to become unbalanced.

But imbalances can still occur, and when they do occur they may be hard to cure. Even a balanced loan can run into unforeseen problems, such as strikes, natural disasters, and unexpected increases in the costs of materials and labour. These events can occur even where the loan agreement has been carefully negotiated, because it is simply not possible to negotiate away every possible negative contingency that might affect the project.

If the loan becomes unbalanced because project cost overruns are caused by unforeseen contingencies, these overruns can be covered either by an equity injection by the developer, or by contingency reserves that are included in the construction budget from commencement of the project. If adjustments are made to the loan, it becomes balanced once again and the project goes ahead. This assumes that the contingency reserve does not turn out to be underfunded, nor that the developer is unwilling or unable to contribute enough equity to relieve the problem.

The timing of an out of balance event effects the decision how to respond to it. A newly-commenced project has a greater chance of encountering an out-of-balance event, than a project that is near completion with the majority of its costs already determined and attached to the ground. An out-of-balance event is most severe in the early stages of the construction phase. It is least severe towards the end of the construction phase, when the project can be completed for only a small additional outlay, when there will be little if any loss incurred on the construction loan.

What can be done if the construction loan becomes unbalanced, and attempts to rebalance it are not successful? In extreme cases, the best course of action may be to liquidate the project, even if it is only partcompleted. This could be the most practical choice where loan imbalance has been caused by systematic – economy- wide - factors. For example, where rental rates, vacancy rates, or interest rates have changed substantially from the rates prevailing at the time the loan was contracted, or the rates that were predicted at the commencement of the project. Or where the cost of construction inputs - materials or labour - have markedly increased.

Where the construction lender is an investor and the loan becomes unbalanced, the investor is likely to complete the project with its own funds, because this may be the best way - and perhaps the only way - in which the investor can maximise its recovery on the partcompleted project.

When an out of balance event occurs and the lender does complete the construction, it adds the additional cost to the amount of the loan principal, as the property enters the prestabilisation phase.

RISKS OF A CONSTRUCTION LENDER

The construction lender bears two overriding project-related risks – financial risk, which is the risk that the project will not be completed on budget, and timing risk, which is the risk that the project will not be completed on time.

Although financial risk is the main risk, construction projects often deviate from plan. Construction budgets change and cost overruns are common. But as long as deviation from original budget is not too severe, the project participants usually accept that the construction loan remains balanced. Provided that the property market has not changed dramatically, the lender can assume that it will eventually end up with a mortgage over a completed property. Timing risk can be reduced by a having a carry reserve attached to the construction loan.

A construction lender also assumes a number of lesser risks. It assumes construction risk - the risk that the project will not be completed on time or on budget. Carry risk is the risk that during the construction period and the prestabilisation period there will not be enough cash flow available to pay interest on the construction loan. Takeout risk is the risk that there will not be enough funds available to repay the construction loan when the project has been completed.

Also, the identity of the parties involved in the project will affect overall project risk. For the construction lender, the two parties who are critical to the success of the project are the developer and the letting agent. The lender investigates the developer’s previous experience with construction projects. And a developer with significant financial strength has the ability to service the construction loan if it becomes unbalanced, or to come up with additional funds that might be needed to complete the project.

The lender has risks, but they can be mitigated.

Firstly, by ensuring that the developer makes an equity investment in the project. The investment can be in the form of cash or a contribution of the land on which the project is to be built. If the developer makes this investment, the lender is not financing the entire project on its own. The developer has some equity at risk, and will have an incentive to take steps to protect its investment, and if it does take those steps it protects the lender’s interest at the same time.

Secondly, by requiring the developer to give collateral. The collateral can be substantial, marketable assets with a determinable sale value, that are owned by the developer. The assets should not be encumbered in any way and should not already have been pledged as security for any other loan. Alternatively, the developer can give the lender an irrevocable letter of credit from a financially robust loan guarantor, that covers a substantial part of the construction loan over its entire term. The implication of the developer giving collateral is that the developer has something substantial to lose if the project fails, as well as a strong incentive to make the project succeed. For the lender, the best type of collateral a letter of credit because it covers interest, fees and loan principal for the full loan term.

Thirdly, by a creditworthy outside financier giving a take-out commitment for the full amount of the construction loan. Such a commitment should be unconditional. If it is conditional, the conditions should be reasonable. If the take-out commitment will “cash out” the lender for the amount of the construction loan on completion of the project, then the outside financier – rather than the construction lender - bears the risk that the project will fail. With the take-out commitment in place, the construction lender’s only risk is that that the project will not be completed on schedule, and project value is no longer an issue because an outsider has agreed to effectively repay the construction loan, including all of its interest and fees, once the project has been satisfactorily completed.

Fourthly, by arranging some other type of implied guarantee of the project’s success. This guarantee can be in the form of sale agreements or lease agreements entered into with creditworthy independent outside investors or lessees. Arrangements like these substantially reduce the construction lender’s risk. They generate the cash flow on completion of the project that is needed to repay principal and interest on the loan.

CONTROLLING CONSTRUCTION RISK

Construction risk is correlated with the percentage to which a construction project is incomplete. The closer the project is to completion, the less the construction risk. A newly-commenced project has plenty construction risk, a completed building project has no construction risk.

A construction lender bears construction risk, but it can be reduced.

Firstly, by the developer putting up project equity of its own. The developer contributes its own capital or assets to the project, in the form of cash or land.

Secondly, by ensuring that the construction contract is a fixed-price contract, in which the developer or builder agrees to construct the project for a price that is firm and fixed before construction begins. But for this contractual feature to have value in reducing risk, the builder or developer must be reputable, experienced and creditworthy.

Thirdly, by using a system of retentions. Instead of the construction lender paying out the full amount of the construction loan to the developer when construction starts, the lender pays the developer in stages and holds back part of the loan. Loan payments are made when specified project milestones are achieved. For example, a loan for the construction of a multistorey office development may be disbursed to the developer in stages as and when specified number of floors of the building have been completed. This enables the lender to monitor the project and to reduce its risk by keeping back part of the loan and taking a waitand- see approach to the project.

Fourthly, by providing for budget contingencies. If the project budget has an overrun cushion built into it, then that cushion acts as a surplus amount that can be used if construction costs turn out to be greater than predicted. How much of cushion is needed depends on how complex the project is, and how long it will take to complete. Budget overruns are usually about 5 percent to 10 percent of the amount budgeted for the project.

Fifthly, by arranging guarantees. Construction project guarantees come in three forms, all of them surety bonds – performance bonds, payment bonds, and completion bonds.

Performance bonds are guarantees that protect the construction lender if the contractor, developer or builder fail to complete the project. The surety is then obliged to take control of the project and complete it, or to make a payment to the lender or developer that can be used to hire a new builder to complete the project. The performance bond penalty should be the full amount of the cost of construction. Performance bonds are critical in reducing constructionrelated default on a construction loan. Construction loan losses then depend on the type of performance bond, the penalty that it imposes, the conditions under which it is payable, and who issued the bond. If the surety who issued the bond is financially strong and is obliged by the bond to complete the project, then potential losses on the construction loan during the construction period will be minimised.

Performance bonds usually only require the surety to perform if the original contractor was obliged to perform, and then to the same extent as the original contractor. So if the original contractor is not liable to perform, then neither is the surety. This means that performance bonds are often hard to enforce. Also, not all construction-related problems are covered by performance bonds. Natural disasters, undisclosed or unknown conditions, such as land subsidence, are not covered.

Payment bonds are guarantees given by a surety who guarantees that all third party suppliers of labour or materials to the project will be paid.

Completion bonds are guarantees that a part-completed construction project will be completed, regardless of cost.

CONTROLLING TAKE-OUT RISK

What will the property market be like when the project is completed? Will it be tight with property shortages, or will there be a surplus of property driving down the value of the project on completion? These factors have a bearing on take-out risk.

Take-out risk is the risk that the balloon payment or bullet payment due to be made at maturity of the construction loan by the developer, as borrower, to the construction lender, will not be made because the developer does not have the funds to repay the loan. This risk is introduced or increased because of increases in interest rates, or because the property fails to perform as expected.

After construction has been completed, the probability of take-out financing failing may depend on the type of take-out financing that has been arranged. Or it may depend on the economics of the completed project.

CONTROLLING PROPERTY RISK

Even after construction has been completed, there is still construction-related risk because the project value may not be enough to repay the construction loan. The project may be worth less on completion than was projected when the loan was made. So the value of the property may be less than the amount owing on the construction loan.

Property risk can be reduced by getting an investment grade tenant to lease a substantial portion of the property for a long period.

CONTROLLING CARRY RISK

The construction project must be able to generate enough cash from operations or from other sources to pay interest and principal on the loan, through all of the project phases.

The payments that are due to be made under the construction loan are called loan servicing. Loan servicing may include the payment of interest only, or both interest and principal where the construction loan is designed to amortise during the construction and stabilisation phases.

The risk that the project will not be able to generate enough cash to service the construction loan is called carry risk.

The lender must ensure that carry risk is reduced or eliminated. The project must be able to meet its debt service obligations, from the time that the construction loan is contracted up to the time that the property is leased up to the point at which it can be said that the property has become stabilised.

During the construction phase and the pre-stabilisation leasing phase, a debt service carry reserve is used to ensure loan servicing. The role of the carry reserve is to cover cash flow shortfalls. The carry reserve provides for the servicing of the loan from the construction period through the pre-stabilisation phase before the property is leased up to break-even point. The reserve is needed if at this time the property is not generating enough cash to service the construction loan, that is, to pay interest on the loan. The carry reserve is established and maintained so that it contains enough funds to cover construction loan interest. The reserve is then used to service the construction loan until the project reaches stabilisation, or at least until the cash flows that the project generates are able to satisfy debt servicing requirements. It ensures that interest on the construction loan is paid on time.

What should the size of the carry reserve be, relative to the construction loan principal? Big enough to ensure that interest on the construction loan is paid on time, during the period in which the property is not generating enough cash flow to service the debt. A major complex construction project will have a big carry reserve buffer, a small project will have a minor reserve or some other form of provision for loan service.

The carry reserve is treated as part of the construction budget. The reserve must be big enough to cover interest payments, as well as property tax and insurance, during the construction period and the prestabilisation leasing period.

The existence and size of a carry reserve are important factors relating to the credit risk of the construction loan. The size of the carry reserve determines whether the loan needs other form of credit enhancement. The bigger the carry reserve, the lower the chance of default on the construction loan, and the smaller any loss that might be incurred on default will be.

The reserve can also take the form of an insurance policy or a letter of credit that covers all payments due under the construction loan, until the project has achieved a debt service coverage ratio of 1:0, that is, until there is enough free cash flow being generated by the completed project to cover all payments that are due under the construction loan.

OTHER RESERVES

The lender should monitor the project’s ability to generate enough cash to meet operating costs. The project should be able to cover operating costs from the date on which the loan is made by the lender, to the date on which the whole of the loan principal is repaid. Construction loan structures often have a modest buffer period built in, usually several months. Reserve are thus maintained to cover fixed operating costs, for example, property taxes, insurance, and security expenses.

A delay cost reserve is used to cover expenses that might be incurred because completion or stabilisation of the project has not been completed on time. For example, payments may have to be made to compensate a key tenant that has leased space in the completed project but is unable to take possession of the leased premised, because the project has not yet been completed. Or a penalty may have to be paid to an anchor tenant, such as a supermarket chain, for late opening of a retail centre.

PRE-SALE AND PRE-LEASING

The amount of space that is pre-leased varies from project to project. The more space that is pre-leased, the less exposure there is to the real estate market in the future. So the more pre-leasing, the lower the credit risk of the construction loan. A large amount of pre-leasing to creditworthy tenants reduces project cash flow volatility. Preleasing depends on supply and demand in the property market, and the amount of speculative construction that is taking place in the market.

But even a property that is fully pre-leased to an investment grade tenant is not absolutely guaranteed to perform. The tenant may go bankrupt in the interim, and because a lease is an executory contract, the tenant’s administrator may reject the lease and walk away from the project.

Pre-leasing can reduce carry risk. If all or part of the property is pre-leased to a tenant, the tenant may make payments to the developer that are sufficient to cover the construction debt servicing costs. A high percentage of pre-leased space also reduces property risk.

The extent and quality of pre-leasing can be important with respect to establishing construction loan commencement and final maturity. The parties may agree that the construction loan will not be made until a specified number of units of the proposed property have been pre-sold or pre-leased prior to the commencement of construction The loan agreement may give the developer the right to extend the maturity date, provided that the property meets predetermined performance standards.

STABILISING THE COMPLETED PROJECT

The expected performance of any newly-constructed property is uncertain. An existing property has an established tenant clientele and several years of historical performance statistics. But a new building has only pro forma accounts drawn up by the developer, valuations, and market data, on which to base a view on how the property will perform. Uncertainty about how the property will perform is increased, depending on the type of property and the time that it will take to get the property fully stabilised after completion. And net cash flow volatility is greater if it is unknown how the property will perform when it has been completed, how much rental income it will generate and what expenses will be incurred in maintaining it.

Once construction of the property has been completed, the project goes into a phase of financial and operating stabilisation. But before stabilisation can be achieved, the property goes through a prestabilisation phase. In this phase, there is uncertainty about how the property will perform. A loan that is secured by a newly-built property that has not yet been stabilised has a greater probability of default and a greater loss given default, than a loan that is secured by stabilised property. The implication of this is that in the prestabilisation phase the developer is more likely to default on the loan, and the lender is likely to incur larger losses if default does occur. But if the property is pre-leased, these risks are reduced.

Construction loans with extendible terms that run through the prestabilisation phase have stabilisation risk. The extend of that risk depends on the net cash flow from the property once it has stabilised and a loan-to-value ratio has been worked out.

CONSTRUCTION LOAN REPAYMENT

Every construction loan must eventually be repaid. This can effectively be done in three ways – firstly, by using the proceeds from the sale of the completed project to an outsider; secondly, by the developer obtaining permanent financing from another lender; or thirdly, by the construction lender converting the construction loan into a permanent loan.

For the construction loan to be repaid, the project must be successful. If a construction project fails economically, then the loan based on that project will result in a loss for the lender. So, after the initial valuation of a planned construction project, the lender analyses the project’s net realisable value to determine whether the construction loan is likely to be repaid.

Construction loan principal may cover both the cost of the land on which the project is built as well as the construction costs. The developer may pay loan interest and loan fees out of its own resources. If so, for the lender to be repaid in full, the final project value need only be equal to the land cost and the construction cost. If the developer has an investment of its own in the project, the lender should recover the full amount of its loan, even if the project value falls, because this loss in value will be borne by the developer.

Where the construction loan also includes loan interest and fees, and the developer has invested little if any of its own money in the project, the lenders’ project risk increases. For the lender to recover the full amount of its loan, the project must then be sold or refinanced for an amount that is at least equal to the land cost, construction cost, interest and loan fees. If the lender has no cushion of safety from the developer’s own investment, any decrease in the value of the project will be borne by the lender, not the developer.

A construction loan may be structured on a non-recourse basis, so that the lender is not permitted to call on other resources of the developer for repayment. The lender’s only security is then the project itself, perhaps strengthened by a mortgage over the land on which the project is being developed.

If the loan is structured to be recourse to the lender, then some form of guarantee will be given to the lender by the developer, the developer’s holding company, or an outside guarantor. The value of a loan guarantee is measured by the ability of the guarantor to perform, the practicality of enforcing the guarantee, and the demonstrated intent of the lender to enforce the guarantee. A guarantee of a construction loan only has value for the lender if the guarantor’s ability to meet the guarantee can be reliably assessed, and the amount of the guarantee covers a substantial part of the loan.

IN THE EVENT OF DEFAULT ...

If the borrower in a construction loan defaults, the lender will incur a loss. The amount of loss that will be incurred by the lender will depend on any shortfall in project value, and on cost overruns that are incurred in completing the project.

If the borrower defaults, the lender has a number of ways to retrieve its money. It can look to portions of the loan not yet paid over to the developer, loan principal that might be held in trust, cost reserves, retentions held back by the lender, a claim against the developer for repayment of the loan if the loan is a recourse loan, and the liquidation or sale value of the uncompleted project.

The lender knows that default losses can be minimised by completing the project. This might involve the lender itself taking over the project, rather than by trying to sell a partly built property.

PERMANENT FINANCING

A construction loan is a short-term loan that meets a specific need – to pay the building costs of a construction project. It is a stop-gap between a land loan and a permanent property loan. A construction loan commences when the first sod is turned, and ends at the time when the construction is expected to be completed. At that time it is replaced by a permanent property loan.

The maturity date of a construction loan is set at the date or slightly after the date on which the lender and the developer agree the completed project will become stabilised. The time between construction completion and the maturity date of the loan may be longer for big, complex projects, like major office developments, and shorter for small simple project, like industrial buildings.

Once the project has been completed, the developer obtains permanent financing for the project. The permanent loan is a form of longterm financing that is repaid over the useful life of the completed project, which may be years or decades. This can take the form of a roll-over of the construction loan into a permanent loan. Or it can involve obtaining a new loan from another lender. Or the developer can sell the property once it has been completed, use the proceeds to repay the construction loan, and take any remaining surplus as its profit from the project.

If the construction lender agrees to also make the permanent loan, then another loan commitment is made, and a new loan agreement is entered into. The lender is again paid a commitment fee and a loan origination fee. Here again, the developer may use a draw on the construction loan to pay this initial cost of obtaining the permanent loan.

The permanent loan can include the lender’s agreement to fund initial project operating deficits in the prestabilisation phase, up to a set limit, until the property has been fully leased. This gives the developer the cash that it needs to turn the newly constructed building into a profitable operation.

Once a permanent loan is in place, the owner of the property uses cash flow that is generated by operation of the property to repay the permanent loan. Under the permanent loan, the property owner is required to make monthly or quarterly payments of principal and interest. Interest on the permanent loan is also calculated at a floating rate, at a fixed level above LIBOR, usually between a floor and an optional ceiling. The interest rate that is payable on the permanent loan is lower than the rate payable on the construction loan, because the risk to a lender on a newlycompleted building is less than the risk on a building that is under construction.

Not every construction loans is made with the intention that it will be replaced by permanent financing as soon as construction has been completed. Some construction loans have their terms extended and they continue through the stabilisation phase of the property, and are only replaced after the property has been leased and is generating a stable cash flow.

CONSTRUCTION LENDER AS INVESTOR

A construction lender has a choice. It can make the construction loan, be repaid after completion of the project, and withdraw from the project. Or it can take an ownership role in the construction project and morph into an investor in property through careful structuring of its role as a construction lender.

Where the investor takes an ownership role in the project, the transaction structure differs from that of a standard construction loan.

Giving the investor an equity interest in the project can change the nature of the transaction from construction loan to joint venture or partnership between developer and investor, or into an investment by the investor in the developer.

To determine whether the nature of the transaction has changed, questions are asked. How much risk is the lender taking? Does the lender have an interest in the project’s profits? Will the lender earn an amount over and above the regular arm’s length interest and loan fees that a construction lender normally earns?

Construction lenders are not usually liable for defects in the projects that they finance, but a lender who is a partner, joint venturer or investor could become liable, possibly jointly with the developer for project defects.

STRUCTURING THE INVESTMENT

The investor’s equity participation in the construction project is made in conjunction with the developer, and often uses a partnership to take advantage of the flow-through of early-year tax losses that are common in construction projects. There is a range of investor participation structures.

In a non-convertible participating mortgage loan structure, the investor funds the construction project by making a loan that is secured by a mortgage that calls for the payment of interest at a fixed rate as well as an equity kicker based on a percentage of incremental cash flow, gross income, refinancing and sales proceeds, or some other measure for determining the investor’s profit from its equity participation.

The effect of structuring the investment as debt, not equity, is that neither the investor’s current profit share nor its claim for repayment of its investment are subordinated to any equity claim. The investor’s claim to a share of profits is treated as contingent interest, so that the investor’s equity participation return is distributed to it as interest.

Advantages of the structure for the investor are firstly, the structure gives the investor the foreclosure rights of a debtholder, secondly, the investor does not have to recognise partnership losses for accounting purposes. Other project participants also benefit from treating the investor’s participation as debt: debt treatment increases the partners’ cost bases in their partnership interests, and interest payments (both fixed minimum interest and contingent interest) are deductible as interest by the partners, and taxable as interest in the hands of the investor.

Disadvantages of the structure include assumption by the investor of the risk that the loan will not be repaid, which would mean that the investor would lose its equity claim to share in future profits. Tax benefits could be lost by the investor if the developer and other partners claim all of the tax losses (including capital allowances), on the ground that because the investor’s participation is structured as a loan, the investor is not entitled to have any losses allocated to it. Further, if the contingent interest arrangement awards the investor a substantial participation percentage, say 50 percent or more of incremental benefits, it may be anomalous enough for HMRC to claim that it is not interest for either the partnership as debtor, or for the investor as creditor. Or HMRC may try to recharacterise the contingent interest into another type of income or participation, for example, rental income or a share of partnership income from partnership assets producing rental income, which could result on the investor being taxed on trading income rather than interest income.

Interest is the amount paid as compensation for the use of borrowed money. For interest payments to be tax deductible by the borrower, it is not necessary that the lender limited the interest charge to a percentage of the loan principal, or that the interest is computed at a fixed stated rate. All that is required is that an amount that is definitely ascertainable is paid for the use of borrowed money, pursuant to an agreement between lender and borrower. Where the lender is a creditor with the right to the repayment of the loan principal and fixed interest as well as the right to share in appreciation in the value of the property, the question arises whether a payment made under the right to share would be a liquidation of the lender’s equity in the borrower. In other words, the issue of contingent interest (or other equity participation) involves the issue of debt versus equity. Should the lender be regarded as a partner in the borrowing partnership? What is the effect where the conversion privilege or other equity kicker remains payable after the loan has been repaid? These issues should be kept in mind by the investor.

In a ground lease with leasehold mortgage loan structure, the investor purchases the land earmarked for the project, and leases it back to the partnership under a long-term ground lease that provides for a fixed minimum rent, and additional rent based on a percentage participation in the gross revenues of the project, or other equity participation measure. The investor makes a construction loan to the partnership secured by a leasehold mortgage, either fixed return or participating. The investor’s purchase and leaseback means that the investor’s rights are not subordinated to any equity claim, and that the investor has foreclosure rights in the event of nonpayment of ground rent or debt service on the leasehold mortgage. The investor’s equity profit participation is treated as contingent rent, so the investor’s equity participation return is distributed to it as rent.

Advantages of this structure are that the investor has good legal security rights, secondly, that it avoids having to recognise partnership losses for accounting purposes, and thirdly, benefits to the partnership and maybe also to the investor from the treatment of the participation as rent: the rent payments – both the fixed minimum rent and the contingent rent – are deductible by the partners as rental expenditure, and taxable as rental income in the hands of the investor.

If the investor’s participation includes a share of proceeds from the sale of the completed project, then that profit will reflect its gain on disposal of the land owned by it. This profit should qualify for capital gains treatment in the hands of the investor.

Disadvantages of this structure do not include the possible loss of the investor’s equity claim on future profits at the instance of the partnership, unless the partnership has an option to purchase the land from the investor. But the other partners will be claiming all of the tax losses including capital allowances, because the investor’s participation has been structured as a ground lease and loan that are not entitled to any allocation of losses.

In a straight equity structure, the construction project is owned by a partnership and the investor, the developer and other partners in the project fund the construction costs in exchange for an equity interest in the partnership. The investor’s partnership interest may be a pro rata interest, or it may grant priority and preference to the investor with respect to current project cash flow, sale proceeds, or refinancing proceeds. Because the investor’s participation is structured as equity, both the current yield on the investment and any residual profit share will be subordinated to any future debt financing, even if the investor’s partnership interest entitles it to priority or preference or even to guaranteed payments, and the investor will have no foreclosure rights against the developer or against any other participants in the project.

In a combined equity and mortgage loan structure, the investor funds the project by making a construction loan that is secured by a mortgage, and in addition it receives a partnership interest in the project. Increases in the partners’ cost bases in their partnership interests attributable to the partnership’s mortgage loan liability may facilitate the taxfree distribution to the partners of cash provided by the investor. Interest payable on the mortgage loan is deductible by the partners – including the investor - as interest.

For the investor, the advantage of the straight equity and the combined equity and mortgage loan structures is the opportunity to share with the other partners in the tax losses from the property, including capital allowances. But if partnership accounting losses have to be taken into account for accounting purposes, this could have a detrimental effect on the investor’s earnings per share.

Depending on the terms of the arrangement and on the debt-equity mix, these structures may be the least vulnerable to recharacterisation by HMRC. But there can still be an imaginative allocation of tax benefits: depending on the respective claims of the partners on cash flow, refinancing proceed, and sales proceeds, and on the investor’s preferences, priorities and any guaranteed payments, it should be possible to allocate tax losses to all the partners in the desired proportions.

Disadvantages of the straight equity and the combined equity plus mortgage loan structures for the developer and for other parties, are firstly, the inability to buy out the investor through a refinancing of its interest, and secondly, the inability to claim a disproportionate allocation of tax benefits.

In a deferred equity takeout structure, the investor looks for the assurance that it will receive an ultimate or deferred participation percentage in the project’s cash flow, refinancing and sales proceeds, and other non-tax benefits, while initially limiting itself to a lesser role. The object is to maximise the allocation of early year tax losses and other tax benefits to the developer and other partners. The initial structure can involve the investor receiving, in exchange for funding the project with a construction loan, a convertible participating or non-participation mortgage loan which will be convertible at a later date into an equity partnership interest. Or, the investor’s initial interest may be a convertible “preferred” equity partnership interest, that provides it with a fixed yield guaranteed or nonguaranteed payment, and a priority or preferred claim against liquidation, sale or refinancing proceeds, together with a nominal residual allocation percentage interest. Later the investor will convert its preferred equity partnership interest into a full ordinary partnership interest that provides for a large residual allocation percentage.

For example, the investor might contribute a nominal amount to the partnership capital, and in exchange for additional capital for the project, it will receive either a convertible mortgage loan or a convertible preferred partnership interest that would be similar to a preference share. The mortgage loan or preferred partnership interest would eventually be converted into an ordinary partnership interest, that would share fully in the current and residual values of the partnership. After conversion, the investor could even own the majority of the or preferred partnership interest into an ordinary interest, the ordinary or residual profit and loss sharing percentages during the preconversion period would be received by the other partners.

Instead of using either a convertible mortgage loan or a convertible preferred partnership interest, the mortgage loan or preferred partnership interest received by the investor could be coupled with an option or warrant to acquire an ordinary equity partnership interest in the partnership at a later date for a specified exercise price. The exercise price could be equivalent to the value of the equity interest at the date of grant of the option.

Because ordinary partnership equity ranks in priority behind a non-convertible mortgage loan or nonconvertible preferred partnership interest, its value at the date of formation of the partnership would reflect both its subordinated claim on capital in the event of immediate liquidation, and its claim to receive unlimited future rentals (if any). Such value could turn out to be a fraction of the actual value of the equity interest at the time the warrant or option is exercised.

In either case, the aim of the participants would be firstly, to defer the stepping up of the investor’s residual equity percentage interest in the partnership until the early-year tax losses had been allocated to the developer and other partners, while secondly preserving the participation of the investor in the potential economic upside of the project.

The disadvantages of the deferred equity take-out include a potential tax issue for the developer because of the change in partnership percentages either at the date of conversion or the date on which the option is exercised. If the cost bases of the developer or of the other partners in their partnership interests have been reduced by losses or cash distributions that were effectively been financing with partnership debt, then a further reduction of their cost bases resulting from the change in partnership percentages could result in taxable capital gain for the partners. The object would be to ensure that the investor would not earn income on the conversion of its convertible mortgage loan or convertible preferred partnership interest, or on exercise of its option to acquire a full equity interest (the option initially acquired as part of an investment package consisting of both the option and either a mortgage loan or a preferred partnership interest). The value of the partnership equity interest received at the time of the conversion in exchange for the mortgage loan or preferred partnership interest (either of which would have limited potential for appreciation because of their fixed face amount or redemption amount, other than the conversion feature) could exceed the investor’s cost base in the debt or preferred partnership interest that it had exchanged for the partnership interest. The same applies to the exercise of an option to acquire a partnership equity interest, because although the exercise price of the option would have been fixed, the value of the equity interest may have appreciated before it was received.

It is unlikely that the transfer of a partnership liability, a preferred partnership interest, or cash, in exchange for an ordinary partnership interest, would have corporation tax consequences for the parties. On the contrary, the acquisition of a partnership interest in exchange for cash or property, and the restructuring of a partnership’s capital interests are not taxable transactions. Thus, the exchange of partnership debt or a preferred partnership interest for an ordinary equity interest in the partnership should be a tax-free exchange or conversion. The exercise of an option resulting in the payment of cash in exchange for an ordinary partnership interest is a non-taxable purchase of the interest.

Where the investor is both a loan creditor of the partnership as well as the holder of a deferred equity take-out interest in the partnership, that is, where the investor has made a loan, such as a convertible mortgage loan, or a mortgage loan with an option to acquire either an ordinary partnership interest at a fixed price or a convertible preferred partnership interest (or option coupled with a preferred partnership interest), that is recharacterised as debt, and the interest rate on the debt is more favourable to the partnership than it would ordinary partnership interests. Because the investor’s additional percentage of ordinary partnership interest would not materialise until he converts his convertible mortgage loan have been but for the equity kicker, then the equity kicker is effectively an economic substitute for interest paid as consideration of the cost of the use of money.

In the developer fee structure, the investor purchases in its own name the land earmarked for construction. It then makes a construction loan to the developer. The developer builds the project, using the construction loan funds. Interest on the construction loan accrues monthly, and the interest rate is adjusted whenever market rates fluctuate. But the developer is not required to make any payments of interest or loan principal until the project has been completed, so that interest that accrues during the construction period is added to the loan principal. The developer completes the project, and receives a developer’s fee equal to a percentage of the construction loan. Ownership of the project remains with the investor.

Finally, in a land warehousing structure, the developer earmarks land for construction. At the instance of the developer, the investor purchases the land and takes title to it, and grants an option to the developer to purchase the land. The investor holds the land – warehouses it - until the developer is ready to start building, at which time the developer exercises the option and acquires the land from the investor. The option price is higher than the cost of the land to the investor, so that the investor realises a gain from purchasing the land and reselling it to the developer under the option. This gain is treated by the investor as a capital gain.