With financing, cash-flow and returns all the more challenging, we examine the potential advantages of a forward funding or forward sale structure and the economic sense it can make.
Forward funding and forward sale transactions add significant flexibility to the market, in terms of funding and delivering real estate product.
The nuances involved, particularly with forward funding, give the parties a negotiation point, while such transactions can also provide direct benefits to the economy, by addressing PRS and hospitality sector shortages, for example.
And, between the impact of Covid-19 and the potential effect of a hard Brexit on occupier demand, our uncertain economic climate could precipitate a slowdown in development activity.
With this in mind, property owners, developers and investors continually seek new and evolving funding strategies to deliver real estate product and to generate acceptable returns in a changed real estate environment.
It is expected that forward funding and forward sale transactions will remain a prominent feature in Irish commercial real estate for the foreseeable future.
So, what’s the deal, and why are these transactions gaining favour?
Let’s start with a brief comparative analysis of the traditional sale of a site, to highlight the potential advantages a forward funding or forward sale structure can provide.
The common way to arrive at a hypothetical land value is based on ‘residual’ value. This method makes fixed assumptions about the construction cost, financing cost, developer’s profit and expected development value (NDV), to estimate a notional land value, as below:
So, basically, the sum of parts (site cost, construction costs, cost of debt and developer’s profit) equates to the total development value.
The site owner’s profit is derived from the price paid for the site. With the site cost being inversely related to the developer’s profit, the willingness of potential developers to buy the site will depend on whether or not they feel there is a reasonable level of profit to be made, considering the various risks they take on.
The reward in this case is the market uplift, if the asset outperforms expectations on completion.
Right now, Covid-19 has impacted negatively on investor confidence. And, as is typical with any period of market stress, many are expecting a softening of yields and, ultimately, a decrease in gross development value, a major driving force of site value.
The site or property owner may argue that little transactional evidence exists to support this.
But, with individual standing real estate prices being ‘sticky’ and generally having a low correlation with equity markets (which rebounded significantly from large losses posted in February and March), a relative disconnect exists between investor, funder and property owner price expectation.
This disconnect, along with fewer development finance contracts available from lending institutions, has led some developers to turn to more attractive structures to secure funding and deliver the necessary real estate product to the market.
Forward Funding Approach
With a forward funding structure, a maximum commitment from an investor is agreed on contract initiation.
This commitment, as indicated in the chart below, involves the land payment at the outset, monthly drawdowns aligned to build costs throughout construction, and a bullet payment at practical completion.
A notional coupon, typically equivalent to the implied net initial yield of the development, is applied against any sums advanced by the forward funder, and then netted off against the bullet payment.
The investor has contractual ownership of the site, from contract initiation, and the developer is incentivised to complete the development, as otherwise the investor or funder can retain their bullet payment.
Key benefits of a forward funding structure for the investor are that they can leverage the expertise of a developer, secure product at an early stage in the development lifecycle, accrue an implied return on any funds committed to the project, and reduce their stamp duty liability.
The benefits for the developer are the ability to secure their exit, to recoup the land value at the outset, not having to commit further funds to the project or raise traditional development finance, and the potential to negotiate a development management fee through the development period.
Forward funding structures like this have been particularly prominent in the office space, of late, with the Exo Building, City Quay and The Exchange Building all financed through forward funding structures.
An appetite for forward funding is also becoming apparent in the PRS and hospitality market, in an effort to deal with limited stock availability.
Both DWS and Tristan Capital have committed capital through forward funding structures, while major US investors such as Greystar and Cortland Group have expressed an interest in forward funding PRS opportunity in Ireland.
Forward Sale Approach
A forward sale allows the developer to lock in a future price today for a completed development.
In contrast to forward funding, the full purchase price is paid on completion of the development, with the developer funding their own construction costs through traditional finance.
For the investor, structuring an acquisition as a forward purchase has the advantage of securing the development expertise of the developer, and locking in an entry price for a good quality product at an early stage in the development lifecycle.
For the developer, a secure exit strategy with an investor in place removes any speculative market risk, while also making it easier to secure the necessary funding for the development. This particularly applies where the exit strategy involves a reputable investor, as there is less counterparty risk.
Successful forward sales recorded recently in the Irish market include the BNP Paribas REIM acquisition of 8 Hannover Quay from TIO, as EMEA HQ for Airbnb, the Marlet Property Group’s recently finalised agreement to forward sell 166 PRS units in Mount Argus to a German fund, Patrizia AG, and Cairn Homes agreement to forward sell 229 PRS units in Lucan to Angelo Gordon.