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1.1 FORMS OF FINANCING: DEBT AND EQUITY

The various forms of capital used to finance an investment can be arranged along a continuum ranging from the two extremes of (pure) debt and (pure) equity. In order to understand where best to place each form of financing it may be of assistance to define some of the main characteristics of these two main forms.

1.1.1 Debt

Debt capital is characterized by:

• an explicit cost defined under contract;

• the absence of any link between its cost (e.g. leading to different remuneration for the lender) and the actual return of the investment financed;

• tax deductibility in most cases.

The cost of debt is explicit since it depends upon a contractual agreement between the borrower[1] and the lender. This cost is precise and defined and (subject to certain limits such as in cases of default) is independent of the actual return of the investment financed since a set amount of money must be paid. Furthermore, the procedures and maturity dates for repayment are determined in advance and specified under contract.

Moreover, under most tax regimes, interests on debt are tax deductible,[2] thereby contributing to enhance the equity's return by reducing the tax burden. Although the financial advantage of using debt[3] results from this characteristic, debt financing continues to be used for various reasons, even where there are no tax benefits, such as:

• capital rationing (lack of equity capital);

• risk diversification;

• increase in projected earnings (in return for a greater risk);

• greater control over management.

Real estate investments, due to their large size, usually involve a significant debt-financing element. In fact, most operators work under capital rationing constraints, since they do not have access to all the capital which is necessary in order to implement all value creating projects with positive net present value (NPV). In particular, the real estate market is not efficient enough to swiftly allocate resources to projects with positive NPVs which therefore often cannot be implemented due to the lack of adequate financing. In addition, for many investors the recourse to debt financing is fundamental since they may wish to distribute their equity capital over several investments in order to reduce the concentration of risk within the portfolio as a whole. This is often the case of tax exempt investors, that notwithstanding the absence of tax shield benefit, use leverage in order to have a better diversified property portfolio.[4]

In other cases, such as for opportunistic funds, the quest for a high return results in the financial risk[5] being added to the (sometimes already significant) operating risk, without however directly creating value (in the sense of generating a higher NPV), since the higher return (greater cash flow to equity) is counterbalanced by a higher risk (equity expected return or consequently a higher discount rate).

Finally, whilst it may be less relevant for real estate investments, the need to service the debt limits management's discretion and facilitates investor control, as agency costs.[6]

Properties are apparently well suited to be financed with high amounts of debt because they can easily be provided as security as they cannot be concealed, their value is quantifiable with a fair degree of precision, and they represent sound collateral thanks to the possibility of mortgage guarantees. Moreover, the bankruptcy cost[7] is lower than that registered in other sectors (such as manufacturing or services) because the value of a property,[8] especially if it already exists or is already generating income, is less influenced by the owner and hence by the company going concern. The situation is different for companies in which the disposal value of individual assets is often irrelevant compared to the operating value of the company. However, complexity may increase significantly even in the real estate sector, and in particular in development projects, leading to an increase in the bankruptcy costs when the developer's role becomes fundamental for the successful completion of the operation.

The possibility of guaranteeing the debt by mortgaging the properties in respect of which the loan is granted apparently reduces the exposure of lenders to the risks generally associated with these type of investments, and therefore disposes them more favourably towards financing these operations. However, the value of guarantees[9] is heavily influenced by the legislative regime and the time-scales for enforcement procedures which enable them to be effectively implemented.

Real estate financing agreements may come in many different forms, and are specifically tailored to the characteristics of the individual operation, the parties involved, and market conditions.[10]

Within a sector which has undergone significant changes over time, lenders also play a significant role in promoting the use of more advanced techniques, such as mezzanine and private equity financing,[11] instead of traditional bank financing instruments alone. Depending upon the level of risk which lenders decide to accept, they may accordingly receive a share of the profits and play a more significant role in the capital structure.

Existing financing methodologies may be subdivided into two main categories:

1. financing instruments identifying a specific contractual form (such as mortgage loans, financial leases, or ordinary shares);

2. financing techniques which specify financing methods made up of multiple instruments (such as hybrid mezzanine financing with a mortgage loan and an equity kicker).

The financing technique therefore assumes that various financing instruments will be used in conjunction with one another in order to best satisfy more complex and detailed requirements.

1.1.2 Equity

The definition of equity includes all forms of capital contributed by shareholders and any money pertaining to such contributions. In addition to paid-in capital or contributed capital, equity also includes retained earnings and treasury stock, if any. Equity is characterized by:

• an implicit opportunity cost;

• a remuneration which depends upon actual economic performance, and is payable after all other investors;

• non-tax deductibility.

Contrary to the position for debt financing, equity is characterized by the lack of a maturity date for repayment, or indeed of any formal obligation to repay. Expected remuneration will depend mainly on the perception of the overall risk, including the operational risk (investment type, procedure, and sector) and the financial risk (amount of capital with higher seniority than equity).

Finally, there is also a form of mixed capital, consisting in mezzanine financing or preferred equity, which covers all hybrid forms which cannot be classified either as debt, or as equity capital (for example profit participating loans, convertible bonds, and subordinated loans), since they share the characteristics of both.[12]

  • [1] In the book the term borrower is mainly used as synonymous with client, the entity receiving money.
  • [2] Interest due on loans is often tax deductible, although there are limits in certain jurisdictions. The issue will be considered in greater depth in Part Two of the book which is dedicated to specific legal systems.
  • [3] Starting from the seminal work of Modigliani and Miller (1958), there is a wealth of literature focused on the advantages of debt. On the importance of tax deductibility please see Miller (1988).
  • [4] Geltner et al. (2007).
  • [5] On leverage and risk please see also Cummings (2010) and Geltner et al. (2007).
  • [6] Jensen and Meckling (1976).
  • [7] Warner (1977).
  • [8] Brueggeman and Fisher (2011).
  • [9] In Part Two of the book guarantees in different legislative systems are analysed.
  • [10] The examples and methodologies which will be presented cover only some of the solutions most frequently used when concluding loan agreements. However, since the contracts concerned are negotiated on a case by case basis, the clauses may be created and amended taking account of the specific requirements of each individual case. As a matter of fact, operations on commercial properties are increasingly characterized by their implementation through ad hoc structured loans.
  • [11] On mezzanine finance and private equity see also Willis and Clark (1989).
  • [12] On hybrid forms of financing please refer to Chapter 7.
 
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