Sources of Finance in Real Estate Development

TP: 4708 Real Estate Management

Department of Town & Country Planning

University of Moratuwa

Registration No: 102353B

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Acknowledgement Module Lecturer, Mrs. A. L. Susantha, Department of Town & Country Planning,

University of Moratuwa for her directive guidelines & thoughtful words to complete this

report.

Visiting Lecture Mr. Anura Lokugamage, Senior Consultant Head, Centre for Financial

Management, SLIDA for his valuable lecture help to complete this report.

All others for their help to collect relevant information that helped us to make this report

in successful way

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Table of Contents Acknowledgement ..................................................................................................................... 2

Real Estate Financing ................................................................................................................ 4

Major Aspect of Real Estate Financing ..................................................................................... 4

Why it need Finance for Real Estate? ........................................................................................ 5

Sources of Financing for Real Estate Development .................................................................. 6

Long Term Sources of Financing .............................................................................................. 6

Short Term Sources of Financing ............................................................................................ 11

Alternative Financing Method of Outer Circular Highway Project........ Error! Bookmark not

defined.

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Real Estate Financing

Real Estate Finance means borrowing and lending. In this position it can be seen in two points of

views. Subsequently it would be an investment for who lend the loan and on the other hand it

would be a liability for who get the loan as a financial support. This transaction would not be a

trivial activity as we seen. Because there is a huge responsibility and also a risk for the both

parties that it mentioned above. In real estate financing it has an accurate and massive process. In

this process it can be identified some of key areas.

Major Aspect of Real Estate Financing

The identified major aspect as follows,

Analyzing the effects of financing

The valuation of mortgages

The primary and secondary mortgage markets

The securitization of mortgages

The financing of residential and commercial real estate

The changes in tax laws affecting real estate financing

In real estate financing it should obtain the financial support in an accurate way. In that case it

should analyze the effects of the financing way that hope to obtain that support. Especially that

way should be trustworthy and after the procurement there would be a good management system

to carry out it further.

Subsequently the valuation of mortgages would be another aspect of real estate financing. In that

point it could considered about the mortgage market. Whether it is primary or secondary market

and also the originate mortgages etc. In that valuation of mortgages the security of them should

be a major point that would be considered. In this point when the financing for the real estate

finance it must be an accurate way as it mentioned above. So the protection of the mortgage

should be essential in pointed topic.

In real estate financing especially commercial real estate is a key point which directly involve.

They occasionally provide their service in financing for permanent residential purchase. Most of

commercial bankers have separate department for that activity and they doing the real estate

financing through that department. Hence the most real estate finance depends on short-term

loans. In another aspect it should consider about the tax laws changes which can effect on real

estate financing, because the lending and investing finance could directly affect by tax laws and

the interest of them. In conclusion financing real estate is a long process and procuring should be

contain and consider about the above major facts when financing the real estate.

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Why it need Finance for Real Estate?

As it discussed above finance side is essential for the success of the real estate and other vice it

could not be carrying out the project further. So the real estate would be depended on

commercial investment organizations or mortgage banks for their dependency. Meanwhile it is

important to clarify about the facts which need those financial supports.

It can be identified as follows,

Land Acquisition

Construction

Operational expenses

Cost of Capital

When it consider about the above mentioned facts the operational expenses show major aspect of

that real estate financing. Hence it contains lot of inner facts in it.

Real estate taxes

Insurance

Utilities

Repair and maintenance

General and administrative

Management

Salaries

This fact needs a good financial support to fulfill above particulars. Especially the real estate

taxes should under the tax laws and they should pay correctly. So the investment should be

strong and it must consider under analyzing of the effects of financing. And the other payments

like insurance and salaries also need a good financial support for maintain them without arrears,

because it has acted the role of security and dependency. Especially the payment of them should

do in correct occasion, other vice it couldn’t get the benefits according to their expectation.

In maintaining part the management system, repair and maintenance, General administrative also

need financial support for their carrying out. Especially the repairing thins should do on time and

the management is essential for the dependency of the company.

Considering the above facts of the operational expenses in Real estate financing the neediness of

a good investable financing method can be seen clearly. In choosing a better way for that

financing way it should get a clear idea about those financial sources which available in the

market. And also it should consider about the trends in the market also.

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Sources of Financing for Real Estate Development

The sources available in financial market can be identified under the several groups or the

categories. Like follows;

1. Long term sources & the short term sources

2. Internal sources & the external sources

3. Primary sources, financial middlemen, other sources and the secondary mortgage market.

However this report describes the sources of finance for real estate development under the

category of long term sources & short term sources.

Long Term Sources of Financing 1. Equity Capital

Equity capital is the most common long term source of finance in the finance market & the

equity capital is unit value of the share capital of the company. Equity capital can comes from

real estate development in different forms as follows according to the website of

http://business.belgium.be/en/managing_your_business/financing/equity/,

A contribution of personal savings or a cash contribution

A contribution in kind, such as equipment and material still own

A combination of cash contributions and contributions in kind

A contribution in cash or in kind from company associates or shareholders with a view to

creating new capital with existing or new shareholders

Financing from a reserve (self-financing) – the company’s profits are not paid out to

shareholders but instead remain in the business to finance its growth

These kinds of shareholders capital can use for the real estate development. When investing

equity capital to real estate development it has lot of advantages to the shareholders as well as

real estate developers. Shareholders can invest their personal savings or a cash contribution to

the real estate development. If the investor is investing the real estate development company, it

consists of benefits in developer’s aspect as well as invertor’s aspect as follows;

Advantages based on developer’s aspect

Equity capital does not have to be paid back by a specific date.

Equity financing has no fixed payment requirements

Business that uses more equity than debt has a lower risk of bankruptcy.

Advantages based on investors’ aspect

Investor can return profit based on the investment

low risk when comparing to the other investment methods

Stockholders have voting rights

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As well as, if that real estate development is belongs to individual person & that person investing

his or her own capital to it we can identified the advantages as well as disadvantages. As an

example in the case of development of the hotel complex by using equity capital of the person, it

consist of lot of benefits to the owner as follows,

No sharing returns for other parties, because total capital of the project put by the

individual person(owner of the project)

No obligations

No rules and regulations

Right to active participation

Easily develop & manage the property

Therefore they can freely use their own capital for the without any obligations. These are the

advantages of equity capital which investing of the development of personal property.

There are some disadvantages of the equity capital when investing the real estate development. It

also has two ways. When investor investing company of real estate development it has following

disadvantages;

Stockholders are last in line for the company’s assets in case of default or bankruptcy.

Common stockholders receive a dividend after the preference stockholders

In the case of personal real estate development we can identify disadvantages on it.

Investing every part of your personal saving would be huge risk. ( if you lose )

Investing assets like retirement accounts may cause to lose the owner.

Losing and success on owners’ self-responsibility.

Therefore the equity capital financing method is most suitable for the investing real estate

development company, because if the investor investing his or her personal capital for their own

real estate development project, it have high risk other than the investing real estate development

company. As an example if the person invests his or her all capital in to one particular hotel

development project in Peradeniya or in coastal line. That project can be vulnerable to the

disasters. In that situation that investor may be face vulnerability to high risk of their investment.

2. Preference Shares

Preference shares are the one of long term real estate financing sources of the world. It has a

fixed percentage dividend before any dividend is paid to the ordinary shareholders. Preference

shares consist with following features according to the article of Preference Shares: Meaning,

Features, and Advantages & Disadvantages by Trisha Financial Management.

The dividend payable on preference shares is generally higher than debenture interest.

Preference shareholders get fixed rate of dividend irrespective of the volume of profit.

It is known as hybrid security because it also bears some characteristics of debentures.

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Preference dividend is not tax deductible expenditure.

Preference shareholders do not have any voting rights.

Preference shareholders have the preferential right for repayment of capital in case of

winding up of the company & they also enjoy preferential right to receive dividend

If the real estate development company uses the preference shares as the investments on the

projects, it has advantages as well as disadvantages.

Advantages on preference shares

The earnings per share of existing preference shareholders are not diluted if fresh

preference shares are issued.

Issue of preference shares increases the earnings of equity shareholders.

Preference shareholders do not have any voting rights and hence do not affect the

decision making of the company.

Preference dividend is payable only if there is profit.

Disadvantages of preference shares

Preference dividend is not tax deductible and hence it is costlier than a debenture.

In case of cumulative preference share, arrear dividend is payable when the company

earns profit, which creates a huge financial burden on the company.

Redemption of preference share again creates financial burden and erodes the capital base

of the company.

Preference shareholders get dividend at a constant rate and it will not increase even if the

company earns a huge profit, which makes this form of finance less attractive.

Preference shareholders do not enjoy the voting rights and hence their fate is decided by

the equity shareholders.

(Source: Preference Shares: Meaning, Features, and Advantages & Disadvantages

by Trisha Financial Management)

In the real situation Overseas Realty (Ceylon) PLC issues preference shares for the Shing Kwan

Investment (Singapore) Pvt Ltd & Overseas is the developer of the Havelock City project. In that

case we can identify use of preference shares for the real estate development purpose in Sri

Lankan context due to the advantages of it.

3. Debentures

According to Thomas Evelyn, a debenture is a document under the company’s seal which

provides for payment of a principal sum & interest thereon at regular intervals, which is usually

secured by a fixed or floating charge on the company property or undertaking & which

acknowledges a loan to the company. We can identify there are some features of debenture in the

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real estate market as Date of maturity, Charge on assets & profits in case of default,

Convertibility, No voting rights, Fixed rate of interest.

In real estate market investing debenture on real estate development has merits to the developers,

because if the real estate development company can raise funds for a specific period by issuing

debentures. As the preference shareholders debentures not issuing any voting rights to the

owners of the debenture & it cause to without face any dilution of the projects. The debenture

enables the company to trade on equity. It can play dividend to equity shareholders at a rate

higher than overall Rate of Investment (ROI) & it has fixed rate. Therefore debenture is most

profitable & less obligation sources of long term financing for the investor who would like to

invest on real estate development. As well as we can identified there are few more advantages of

issuing debenture in real estate market as Suitable for conservative investors who seek steady

ROI with little or no risk, Interest on debentures is treated as expense and is tax deductible,

Company can adjust its gearing in accordance to its financial plan, Debenture holders are

regarded as creditors of the company and they receive preference over equity shareholders and

preference shareholders.

When considering the disadvantages of issuing debenture in the real estate market it has fixed

maturity is disadvantage to the company, because provision has to be made for repayment on the

date of maturity. There is a limit to which funds can be raised through debentures is another

disadvantage of it & Debenture financing enhances the financial risk. As well as Common

people cannot buy debenture as they are of high denominations. These are the few of

disadvantages when employing debentures for the real estate development.

We can identify Urban Development Authority debentures draws over Rs. 5 billion in 2010 as

the example for real development. According to that article of 14th September 2010,

www.dailynews.lk, By Harshini Perera, it says about “This will be a self-financing debenture

issue which will be utilized to construct a low-income housing scheme for shanty dwellers in the

Colombo metropolitan city limit & there has been over Rs five billion commitment from

individuals and institutions so far for the debenture. Bank of Ceylon as the managing body of the

debenture needs to distribute it among every party representing society, Bank of Ceylon

Investment Deputy General Manager, P.A. Lionel told Daily News Business”, “The debenture

issue has already received a good response from the public and private sector investors and

expects to exceed the limit of Rs five billion, Urban Development Authority Deputy Director

General Wasantha Geeganage told Daily News Business” these are the real example for the

debenture in the real estate development.

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4. Bonds

The bond is the long term debt agreements issued by governments, corporations, and other

organizations. These types of sources of financing can use for the government related real estate

projects. Most of the countries use project bonds as the alternative source of financing for the

infrastructure projects. When considering about the advantages of bonds it has low volatility than

equities. It causes to safe keeping the investment on real estate development project.

5. Retained Profits

Retained profit implies investing past profits. In such case, past earnings can be retained or

reemployed as new capital for the real estate development company. These sources of finance

can use only for the previously completed projects which engaging the profit earning stage.

However these sources of finance can be used for the redevelopment of the real estate property

or the improvement of the real estate property which earn more profit. Retained profits have

several major advantages;

They are cheap effectively the "cost of capital" of retained profits is the opportunity

cost for shareholders of leaving profits in the business.

That means the return they could have obtained elsewhere. Investments can be a source of

further earnings if they increase in value and pay dividends. Therefore when the company use

retained profits for the further redevelopment of real estate property, this source of finance is

more applicable, because real estate development companies can earn finance for the

development without any waiting. As an example, we can use this method for build another

residential apartment by using retained profit of the previous development of residential

apartment.

Retained profits are very flexible. Therefore management has complete control over how

they are reinvested and what proportion is kept rather than paid as dividends.

Retained profit does not dilute the ownership of the company.

When applying these finance source for the real estate development it is very flexible to manage

as well as it don’t affect to the ownership of the real property. That means if the property

development company use retained profit on the shares, it does not dilute the ownership of the

property or the company.

However if it is has more valuable advantages, it has some demerits. In retained profits methods

is holding cash of the shareholders. It is more danger, because shareholders may prefer

dividends.

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Short Term Sources of Financing

1. Short Term Loans

When company need cash for a short term emergency or when there is a need for liquid cash

short term loans is the most suitable source of financing. Short term loans are provided depend

on the creditability of the company. It consists with following features;

Repayment not to exceed 12 months

Affordable rates of interest based on market rates

No early repayment fee

Flexible and convenient

In the urgent need of the cash for the real estate development we can use this short term loans as

the sources of finance due to the several advantages on it. Short term loans more important for

the personal real estate development projects other than the real estate company. As an example

when the individual person develop a commercial real estate development like hotel, that person

arise emergency need for the cash. In that situation that person can directly call for the financial

institutions & obtain short term loan for the development. It allows replaying the loan in shorter

duration. Actually it wants to pay less interest then on longer duration loans. Though lenders

tend to charge higher interest on short term loans but in fact at the end of the loan term pay less

interest as compared to larger duration loans which though have lower rate of interest. These are

some of key advantages of short term loans that benefit the borrower. It considers the financial

stability of the company when providing the short term loan. Therefore if the company has

financial instability they can’t afford for the short term loans. These are some disadvantages of

short term loan as the financing sources of the real estate development.

2. Trade Credit

According to the small business encyclopedia define trade credit as an arrangement to buy goods

or services on account, that is, without making immediate cash payment. It is an essential tool for

financing growth. Trade credit is the credit extended to by suppliers who let buy now and pay

later. It consists with following features;

There are no formal legal instruments/acknowledgements of debt.

It is an internal arrangement between the buyer and seller.

It is a spontaneous source of financing.

It is an expensive source of finance, if payment is not made within the discount period.

When applying trade credit for the real estate development we can identify several advantages.

Trade credit is important for real estate development because it has connection with the building

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materials. It is easy and automatic source of short-term finance & when real estate development

use trade credit, it reduces the capital requirement. As well as it helps the business focus on core

activities. It does not require any negotiation or formal agreement. These are some identified

advantages on trade credit.

When considering about disadvantages of trade credit. Trade credit is available only to those

companies that have a good track record of repayment in the past. As well as for a new real

estate development company very difficult to finance working capital through trade credit. It is

very expensive, if payment is not made on the due date.

3. Factoring

“Factoring is a financial transaction between a business owner and a third party that provides

instant cash to the former in exchange for the account receivables of the business. In other words,

a cash-strapped business, unable to get desperately needed funds, sells off its invoices, that are

called account receivables, to a third party and in exchange, gets the much needed cash”.

(info@businessblogsHub.com, 2010) There are some advantages of the factoring when use for

the real estate development. It is quick setup & funding, it not a loan & it is the purchasing the

accounts receivable with cash. Factoring is less costly than equity & factoring is based primarily

upon accounts receivable, small businesses with large amounts of accounts receivable for goods

or services sold to financially strong customers can often obtain a bigger line than they would

qualify for with conventional bank lenders. But factoring is more expensive than a bank loan is

main disadvantage of it.

As an example Ceylinco Homes International Limited use leave alone factoring for the cost of

construction of luxury apartments & luxury homes in the property market in Sri Lanka.

As well as, there are several sources available in financial market which can identify as

investment organizations they can be short list as follows,

Savings Banks

Commercial Banks

Development Banks

Mortgage Banks

Finance Companies

Insurance Companies

Pension Funds

Individuals

However when selecting suitable sources of finance, want to identify features of that sources

as well as advantages & disadvantages for the good real estate development project.