In Germany's thriving metropolitan areas, the supply of new commercial real estate (multi-family, offices, etc.) is urgently needed. To satisfy the demand, countless real estate development projects ("projects" or "developments") are under way or in the pipeline. As a result of the financial crisis, the return generated by standard debt investment products is hardly satisfactory. Therefore, many private and institutional investors are looking to invest in real estate in general and in developments in particular.
We have seen a wide range of German development investment structures and know what works and what does not. The following provides an overview of key structuring approaches from an investor's perspective.
B) Three development inputs
Development success depends on the developer's ability to select and manage the following three inputs effectively and in a timely fashion:
- Project idea
C) The relevance of the right investment structure
Certainly, even the most sophisticated investment structure cannot avoid the selection of an inappropriate location or the occurrence of input misfits. Moreover, the best structure cannot prevent a project from running into difficulties. But the right structure can minimise the negative financial impact an unfortunate or mismanaged project can have on the value of an investment. Project success and investment success are not necessarily the same. The right investment structure decouples, within the realm of possibility, the investment from the developer, from management mishaps and from hard luck. The right structure also avoids unnecessary tax leakage and regulatory breaches.
D) The nature of project investments
It is a standard approach in the development business that a single purpose project entity ("Project Entity"), usually a 100 % subsidiary of the developer, is to be set up and that the Project Entity is to buy the real estate in question and to develop it. Project investments are usually agreed with the Project Entity and paid into the Project Entity. Therefore, the only possible source of a project investor's return is commonly the project itself. Unless otherwise agreed, a project investor usually has no right to take recourse against the developer's general assets. So in principle the investment decision cannot be based on the strength of the developer's balance sheet and instead the investor has to rely on the (future) value of the project (non-recourse financing). Whether or not a developer provides financial guarantees or collateral from outside the project is in practice one of the negotiation topics. Banks usually insist on guarantees but this is not always the case.
Project development is a capital-intensive activity. Aggregating the sums incurred for the acquisition of the land and for the construction of a building might be a generally accepted method of evaluating a property (replacement cost method) but not all the costs incurred correspond with an increase of the property's market value. For example, if the Project Entity needs to re-sell a property, a normal third party buyer will only want to pay a purchase price equivalent to the then current market value of the property but normally the third party buyer will not be prepared to compensate the Project Entity for the transaction costs incurred in connection with the acquisition of the land. This means that the Project Entity will automatically suffer a financial loss if the property is re-sold before a loss compensating increase of the property's market value has taken place. Market value growth is usually due to a rising market or to the developer achieving improvements of the property (particularly by obtaining building permits reflecting 'highest and best use' of the property and through leases with creditworthy tenants). Should improvement attempts fail however, e.g. because a building permit is permanently denied, or, because the development suffers a blow due to the discovery of severe contamination, the value of the relevant project will reduce significantly.
Real estate development, almost by definition, carries smaller or larger portions of financial risk that cannot be fully analysed and assessed at the outset of the investment. The best way to hedge against the financial effects of major project disasters is to diversify one's investments, be it within the sector (different developments in different locations by different developers) or across sectors.
E) Payment waterfalls
If a Project Entity accumulates financial losses and defaults and if therefore a mortgagee commences foreclosure proceedings or if insolvency proceedings are triggered, the resulting investment losses are not absorbed pro-rata (i.e. equally) by all the investors. Instead, the law grants privileges to senior classes of investors and allocates portions of losses with classes of investors that are lower in the 'payment waterfall'. The post-insolvency-related payment waterfall is reflected by the following order of payment that is applicable by operation of law:
1 mortgage lenders holding the most senior mortgage;
2 mortgage lenders holding junior mortgages (in the order of seniority);
3 general creditors;
4 subordinated creditors; and
5 equity holders.
The lower a party's position in the waterfall, the higher is that party's risk of loss allocation.
In respect of the pre-insolvency scenario, the statutory waterfall rules are less pronounced. Generally, the Project Entity has to treat all creditors alike which is typically not commensurate with the differentiation between the relevant risk and reward positions assumed by various types of investors. Therefore, it is recommendable to clearly set out in the transaction documents a pre-insolvency order of payment that reflects the risk/reward discrepancy between the various investment classes.
F) Decoupling from the developer, mismanagement risk and misfortunes
It has been said above that the right investment structure decouples, within the realm of possibility, the investment from the developer, from management mishaps and from bad luck. Decoupling, or risk mitigation, can be achieved by the following three methods:
- Proper terms and conditions
- Allocating first and second losses with lower ranking investors/parties
- Right to take over projects
The three methods are discussed below.
1) Proper terms and conditions
To address the risks associated with project investments, project documents should include a number of project specific terms and conditions, including a number of conditions precedent, representations and warranties, affirmative covenants, negative covenants, the granting of mortgages and other forms of security and events of default. In line with the nature of non-recourse financing (see "The nature of project investments" above), the revenues generated by a project are generally the only source of cash flow available to project investors. Therefore, these revenues must be used to pay all costs, including capital and debt service costs. To ensure proper use of such revenues, project documents should include provisions that require all project revenues to be deposited into one or more collateral accounts, as well as provisions specifying the priority and timing of any payments to be made from such accounts (i.e., a pre-insolvency payment waterfall, see "Payment waterfalls" above). In most cases, these accounts will be controlled by, or on behalf of, the investors, although some investors may permit the Project Entity to maintain control over these accounts unless and until an event of default has occurred. In almost every case, the finance documents will prohibit payments to the developer and/or the developer's affiliates until (i) all other project costs have been paid, (ii) certain financial ratios have been achieved, and (iii) certain other predetermined conditions have been satisfied.
2) Allocating first and second losses with lower ranking investors/parties
In follows from the payment waterfalls applicable prior and post insolvency that major portions of investment risk can be allocated with lower ranking investors, particularly with the developer, other equity holders and with subordinated creditors. We have seen project investments where our clients, acting as non-bank lenders, secured by way of first ranking mortgages, recovered their full investments plus interest thereon although the relevant projects were disasters (poor location, catastrophic project management) and went into foreclosure or even insolvency. The main criteria our clients relied on were waterfall seniority, property values and LTV. In the relevant projects, all stakeholders but our clients suffered severe losses. In terms of loss allocation, we cannot stress strongly enough that it is the developer who knows the project best and who 'steers the ship' and that therefore the developer should invest serious amounts of equity into the project and assume the first loss position. Developer equity is usually injected in the form of cash. However, there are smaller developers with solid backgrounds who are starting new promising developments that look like investable projects. Given the small size of these developers, cash equity is often not available. Nevertheless, immediately enforceable guarantees, collateralised in one form or another, constitute ways of allocating the first loss risk with the developer regardless of the developer's cash position. We call this the 'synthetic equity approach'.
3) Right to take over projects
For many investors, especially the ones who are not senior mortgagees, it is important to make sure that the project will be managed in a way that realises the project's full potential. Junior debt and equity investors should control the cashflow of the project (see above 'Proper terms and conditions') to avoid unwelcome liquidity leaks. If the developer breaches covenants or misses milestones (i.e. mismanages the project), investors should be allowed to take the project over, fire the developer and put in charge a developer they trust and thereby save the project. This can be achieved by structures that give the investor the majority of shares and voting rights in the Project Entity (51 % or more). Quite common are also options that give investors the right to call the majority of the shares in the Project Entity which call options become exercisable on the developer's default. It must be noted however that lenders that become shareholders qualify as subordinated creditors and as such they are in the penultimate waterfall position post-insolvency. Thus, call options are less suitable for senior creditors but they are great features for 'born' junior investors, i.e. equityholders and subordinate debt investors.
If a Project Entity defaults on a senior loan, non-senior investors face the risk that the senior lender will foreclose. Under German foreclosure rules, the court governed auction has to generate sales proceeds sufficient to satisfy the most senior lender only. Non-senior creditors can lose everything unless they buy the senior lender out. This means that junior creditors should have access to funds as and when needed. The purchase of the senior loan is ideally combined with the takeover of the Project Entity.
G) Optimising after-tax returns
Domestic and international tax laws provide structuring options which investors should know about. Debt finance investors based in (relative) low tax countries such as Ireland or the UK can use thin capitalisation. Incorporated equity investors can rely on the various forms of participation exemptions offered by domestic tax laws, by the European Parent-Subsidiary Directive and by bilateral tax treaties. We have structured bespoke German development investments for 'resident non-domiciled expatriates' living in the UK and also for Swiss tax payers invoking Swiss tax rules regarding the exemption of capital gains.
H) Regulatory compliance
To make regulatory compliant loans in Germany, in principle a lender has to hold an EU banking or insurance license. A breach of the regulations constitutes a criminal offense. The German financial regulator BaFin regularly intervenes when it has become aware of illegal lending. In these cases, the BaFin usually orders the immediate repayment of the relevant funds and it also informs the public prosecutor's office. This typically leads to the instant insolvency of the relevant borrower (Project Entity) given that funds are typically invested in the project and are therefore not available in liquid form for immediate repayment. In the past, we completed structures that mitigated the regulatory risk.
Real estate development investments do not fall under the European and German rules on alternative investment fund management and therefore the developer does not need a fund management license even if funding is obtained from a multitude of investors. However a prospectus is still required unless one of the private placement exemptions applies.