Project Finance in Real Estate Development: Key Considerations

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Sponsors and developers do not play games when it comes to raising funds for their real estate projects. Rising inflation and interest rates, together with legislative changes, have caused shifts and difficult challenges in the real estate market. Traditional financial sources are under pressure as a result of economic instability, forcing the industry to look into other finance options. Total commercial real estate mortgage borrowing has declined for the third year in a row, and calling your favorite banker may no longer be enough.

In this article, we’ll go over some important financing choices to consider during this period of high interest and economic instability.

1. Traditional Financing

This tried-and-true technique of obtaining commercial real estate funding through loans from financial organizations has consistently been a viable choice for obtaining capital. Developers can keep control by financing the majority of the required funds themselves. Standard debt also offers a planned and predictable repayment schedule. However, increasing interest rates raise the cost of capital, discouraging some transactions. When interest rates were low, lenders vied for the opportunity to lend. High interest rates raise risk for both the lender and the borrower, prompting fair-weather lenders to abandon the real estate market when the market flips.

Commercial real estate borrowing has been significantly reduced during the last three years. According to the Mortgage Bankers Association (MBA), total commercial real estate mortgage borrowing and lending will reach $429 billion in 2023, down 47% from $816 billion in 2022 and 52% from the record $891 billion in 2021. This downturn has affected all asset classes and capital sources, showing a drop in borrower demand due to slowing sales and refinance transactions. Property owners who could wait did so, resulting in a decrease in originations.

According to Jamie Woodwell, MBA’s Head of Commercial Real Estate Research, “The sustained growth in the amount of CRE mortgage debt outstanding signals that much of the drop in originations was driven by a decline in borrower demand stemming from slowdowns in sales transactions and refinances.”

CBRE Group reported that banks remain the top contributors to CBRE’s non-agency loan closings for the seventh consecutive quarter, accounting for 39.5% of the total in Q4 2023, up 38.4% from the previous quarter. In Q4 2023, floating rate loans accounted for one-third of total loan volume, with 38% devoted to refinancings and the remainder supporting property acquisitions.

2. Alternative Financing

Although alternative financing sources are challenging traditional commercial real estate lending processes, there are indications that the fall in regular financing is slowing. Hard money loans, often known as bridge loans, provide quick collateral-backed finance to investors. These loans usually have higher interest rates and shorter repayment terms than traditional loans, and they are less regulated, allowing for faster processing. While not considered long-term solutions due to the prices and terms, they give investors time to plan their longer-term funding if necessary.

Another option is mezzanine financing, which is offered to investors looking for a hybrid type of investment that mixes debt and equity to provide greater financial support than bank loans or asset-based lending. While payment options are typically flexible, rising interest rates result in increased prices. Although not the best long-term investment option, it does provide investors with potentially faster processing, but at the expense of being less secure than other loan types.

3. Convertible Debt

Convertible loans, also known as convertible notes, allow lenders to convert the borrower’s debt into equity in their property or firm. Instead of getting cash return, the lender has the option of becoming a part owner of the asset. This structure provides flexibility for both the borrower and the lender, as the borrower can return the loan in cash or convert it into equity.

Convertible debt often has lower interest rates than traditional financing since the lender can benefit from property appreciation through equity conversion. Anticipated property appreciation has a significant role in the application and processing of convertible debt. These financing solutions can help owners avoid diluting their ownership by converting debt into equity after the property has appreciated, rather than issuing new shares at a lesser value. Both the lender and the borrower must have similar objectives and aims in order to benefit from the property’s appreciation.

4. Capital From Investors

Raising funding from investors can be tough, necessitating strong sales skills or an extraordinary concept. When deal volume was high, it was easy to locate investors willing to invest in deals. Obtaining funds from investors normally incurs no upfront costs for the sponsor/developer, but it may result in diluted ownership or a lesser profit allocation. While collecting funding from investors is less hard than obtaining finance from a lender, working with investors might become complicated if specific milestones or exits are met.

To tempt investors, some sponsors/developers use preferred returns or complex waterfall processes, which may result in different levels of earnings being allocated differently. Private equity firms can also offer financing for larger transactions, lowering risk and exposure for individual investors while resulting in diminished ownership and loss of control. Crowdfunding is a relatively new funding option that brings together money from investors online, changing real estate funding. However, the possibility of diluted ownership, loss of control, and reporting issues makes crowdfunding more difficult than it may look.

Real Estate Project Finance Industry Terms and Definitions

To build a financial model, we need to understand the important terms and definitions frequently used in real estate project finance:

Loan to value (LTV): The amount of debt financing a lender will provide as a percentage of the market value of the real estate.
Loan to cost (LTC): The amount of debt financing a lender will provide as a percentage of the cost of a development.
Net operating income (NOI): Gross rental revenue less operating expenses (property taxes, insurance, maintenance, etc.).
Cap rate: NOI divided by the value of the property, expressed as a percentage.
Amortization period: The number of periods (months or years) the principal repayments of a loan take to be completed.
Term: The length of time that the interest rate on a mortgage loan is agreed for.
General partner (GP): An owner of a partnership with unlimited liability – usually a manager who actively participates in the operations.
Limited partner (LP): A passive investor who has limited ability, based on the amount they have invested in the project.
Land loan: Financing used to acquire a piece of land with no NOI. The long-term value will be much lower than that of an income-producing property.
Floor space ratio (FSR): Used to determine the size of a building and control the density of development on a parcel of land.
Gross building area (GBA): The sum of all building spaces from wall to wall.
Gross leasable area (GLA): The sum of all enclosed livable space.
Gross site area: The two-dimensional measures of a site, based on its property lines.
Deductions: A portion of the gross site area that cannot be built on, such as public access areas, roads, lanes, etc.
Net site area: The gross site area, less any deductions.
Max GBA: The gross building area, calculated based on the FSR.
Construction GBA: The gross building area, based on construction plans.
Saleable area: The gross building area based on construction, less all common spaces or other non-salable areas.

At each stage of the real estate project financing life cycle, various funding sources are used. For example, a corporation may use stock to fund the sourcing of agreements. This is because the early stages of a project are high risk, making it difficult to acquire bank funds. In the later stages, such as rezoning and pre-development, projects are typically funded using both loans and equity.