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1.3 CORPORATE FINANCE AND PROJECT FINANCE

Compared to other forms, real estate financing is characterized by a common feature, namely the procurement of the financial resources required by the borrower from the value of the property provided as security, and hence from its projected cash flows.

Whilst they may be straightforward from a financial point of view, real estate assets may also be financed using highly complex structures and techniques, and no longer solely through traditional means such as a mortgage loan. For a long time, financing in the real estate sector has been based on a limited number of instruments. Mortgage loans have been predominant for a long time and banks have regarded such a state of affairs in a favourable light since it makes it possible to tie in the borrower for a relatively long period of time, in addition to the rather contained level of risk thanks to the mortgage guarantee. Today, however, particularly since the Global Financial Crisis, banks too appear to be dedicating greater attention to real estate financing by privileging project finance solutions, in which the individual transaction is assessed from the same perspective as that of the equity investor. The reliability of the borrower in terms of management capacity does remain important, although the focus of analysis is becoming increasingly centred on the project itself.

The distinction between companies and projects may often appear to be somewhat theoretical since in reality it is not equally easy to draw this distinction, given the significant overlap between real estate projects and investments and SPVs. Consider the differences between a project finance arrangement[1] (which, as the name suggests, is an instrument for financing a project), under which the return is associated with the project's ability to generate cash flows to remunerate investors, and a mortgage loan (which is an instrument for financing an asset), the disbursement of which in many cases depends upon the value of the asset and the registration of a mortgage on it.

An investment project secures sources of finance, whether through debt or equity, according to its future capacity to generate cash flows to make payments. Depending on the object of the loan a particular approach may be adopted:

• corporate finance, focusing on the loans disbursed to a party (e.g. a company);

• asset based, in which lending activity is directly associated with a specific asset (e.g. mortgage loan or financial lease);

• cash flow based, under which loans are disbursed to a project (e.g. real estate developments or projects operating under concession as Private Public Partnerships).

Depending upon which of the previous approaches is adopted, the guarantees requested by the lender will differ, and so consequently will the risk profile. Within a corporate finance approach, an assessment of the corporate situation will take on significance in guaranteeing the loan, whilst within an asset based approach the collateral value of the guarantee will predominate. Finally, under a cash flow based approach the quality and volatility of the project's cash flows will be paramount. The last two approaches are becoming increasingly predominant for real estate financing when there are no guarantees external to the project, whilst corporate financing is often reserved to larger real estate companies or funds, although this will always be accompanied by guarantees on properties.

When choosing between corporate finance and project finance approaches, a fundamental difference lies in the principles used in order to ascertain creditworthiness. Moreover, whilst project finance arrangements may be more flexible because tailor made to a specific transaction, by contrast they have a more complex structure.

According to the corporate finance approach, lenders will assess the economic and financial equilibrium of the company which intends to carry out the investment, using the company accounts as their basic instrument, but also the impact which new investments and the relative financing will have on these accounts. It is also necessary to predict the company's future performance by identifying the internal factors (such as strategies and assets) and the external factors (such as the conduct of competitors, and the performance of the market, the industry, and the economy in general) which influence it.

From the project finance perspective on the other hand, the assessment concerns the economic and financial equilibrium of the project to be financed, which is separated in legal and financial terms from other assets of the sponsors through the creation of a dedicated SPV, thereby ring-fencing the investment in order to isolate it from the sponsors' core business or other assets. In this way, should the project be unsuccessful, the sponsors' assets will not be affected in any way; similarly, should other projects be unsuccessful, the relevant creditors will not in turn be able to seek satisfaction on the ring-fenced property. The situation therefore involves a non-recourse form of financing.

Corporate finance involves the granting of bank loans, but also bond issues, that is debt securities issued by financial institutions or companies providing for repayment of the capital loaned either upon maturity or in instalments determined in advance prior to maturity. In this way there is a clear separation between the investment and the loan and there is no clear correspondence between the in and out cash flows.

In contrast in the case of a structured financing, the assessment as to the convenience of the project may already be made with reference to a specific form of financing.

The choice between corporate finance and project finance approaches depends upon various factors, including whether it is preferable to include the new project within the sponsors' assets and to attempt to secure financing through the traditional lending channels, or whether it is more appropriate to incorporate a specific vehicle which will secure financing in its own right.

  • [1] There is a wide literature on project finance; a selection of relevant books and articles includes Gatti (2013), Dewar (2011), Esty and Sesia (2011), Lynch (2011), Hoffman (2008), Yescombe (2002) and Fabozzi and Nevitt (2000).
 
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