This article has been written by Raghav Madan, pursuing the Diploma in Advanced Contract Drafting, Negotiation, and Dispute Resolution from LawSikho. This article has been edited by Zigishu Singh (Associate, Lawsikho) and Ruchika Mohapatra (Associate, Lawsikho).

Introduction

Project finance is the funding (financing) of long-term infrastructure, industrial projects, and public services using a non-recourse or limited recourse financial structure. The debt and equity used to finance the project are paid back from the cash flow generated by the project. In terms of real estate, a loan sanctioned to construct or develop a new real estate project is what is commonly referred to as real estate project finance. Any individual or a firm or company engaged in the business of real estate development or construction (generally a developer) can avail of project finance. 

One of the biggest challenges for the stakeholders involved in a specific project is to structure it in such a way that it requires minimum cost and fields maximum returns by way of cash flows. This structuring depends upon various factors like the type of project, development stage of the project, financial instruments and legal framework underlying them, parties involved and their background in terms of loan repayment, etc. 

Perhaps, structuring becomes vital for a project’s success and to obtain a favourable outcome. It is the effective and efficient structuring of a real estate project which yields the maximum output for all the parties.   

Key elements of an optimal real estate project structure 

A successful project must carefully consider the following points: 

• Assessing the nature of the project; 
• Selection of optimal financial Instruments; 
• Project development stage; 
• Parties involved and allocation of the risk; 
• Effective legal processes; 
• Favourable economic environment of the country; 
• Organised management of the project.  

Let’s discuss these points in more detail. 

Nature of the project 

The nature of a real estate project is divided into 4 types: 

1. Residential real estate projects which include both new construction and resale homes. The most common category is single-family homes. These projects are preferred when you are building condominiums, co-ops, townhouses, duplexes, triple-deckers, quadplexes, and other high-value and multi-generational homes.
2. Commercial real estate projects include shopping centers and strip malls, medical and educational buildings, hotels and offices. Apartment buildings are also often considered commercial, even though they are used for residences since they are built to produce income.
3. Industrial real estate projects such as manufacturing buildings and property or warehouses. These are preferred when you want to use them for research, production, storage, and distribution of goods.
4. Land which includes vacant land, working farms, and ranches. There are further subdivisions within vacant land which includes undeveloped, early development or re-development subdivision and cluster. 

The nature of the project helps in ascertaining the feasibility plan and the acceptable return on investment of a project. It provides a broad outline as to how much time and investment the project would require.  

Instruments used in funding a real estate project 

There are various instruments used to finance a real estate project. Each instrument has its own benefits as well as consequences. Accordingly, it is important to assess the available resources and use it to the advantage of the project.  Some of them are as follows: 

1. Debt 

Debt takes the form of loans, usually from the banks but occasionally from wealthy individuals or syndicates. The key thing to understand about debt is that the downside is capped i.e., if the project goes bad, the lender can generally foreclose and take the property. The upside is the stability in returns i.e., debt gets a fixed return (generally expressed as an annual interest rate). 

Some of the most common debt instruments in a real estate project includes: 

• Non-Convertible Debentures (NCDs) which are used by companies to raise long-term capital. This is done by a public issue. NCDs have a fixed tenure and investors who invest in these receive a regular interest at a certain rate. Based on the situation, they can either be secured or unsecured; 
• Loans from Banks/Financial Institutions  are like an ordinary loan except for the fact that security demanded would be much higher and a thorough due diligence would be conducted. Any delay in compliances or low credit rating is now taken very seriously and could be a ground for rejection for granting loan; 
• External Commercial Borrowings (ECBs) which though a very restrictive mode of finance for real estate but are a great way to raise funds in bulk with a very less rate of interest. But again, they also have  very demanding legal requirements such as stringent criteria of eligibility of both: lender as well as the borrower, compliance with Foreign Exchange Management Act (FEMA) Rules, end-use restrictions, all-in-cost ceiling, etc.    

2. Equity 

In simple terms, equity is ownership of assets that may have debts or other liabilities attached to them. Some common sources of equity in real estate project finance are as follows: 

• Friends and family which is usually in smaller chunks that you can raise from people you know and used in very early stages; 
• Crowd-funding which is relatively a new source of finance. Sites such as fundrise and realty mogul serve as clearing-houses for equity, connecting sponsors to a large number of equity providers; 
• Family-offices which is generally considered as the best source of capital. These are typically small offices set up by extremely wealthy families to manage their investments. Family-offices are used to investing in private deals and they often move quickly and demand reasonable if interested in the deal; 
• Institutional money for raising humongous investment. These investors are extremely sophisticated and risk averse. In exchange for the large sum of money, they demand very stringent  financial controls/ reporting/ auditing. They always keep a very detailed exit clause to ensure they are able to exit in benefit; 
• Foreign Direct Investment (FDI) which is an investment in the form of a controlling ownership in a business in one country by an entity based in another country. It is thus distinguished from a foreign portfolio investment by a notion of direct control.   

3. Asset class 

• Real Estate Investment Trust (REIT) is a company that owns, and in most cases operates, income-producing real estate. REITs own many types of commercial real estate, ranging from office and apartment buildings to warehouses, hospitals, shopping centers, hotels and commercial forests; 
• Infrastructure Investment Trust (InvIT) which is a business trust (like REIT), registered with the market regulator, that owns, operates, and manages operational infrastructure assets. These long-term revenue-generating infrastructure assets, in turn generate cash flows, which are then distributed to the unitholders periodically. 

4. Lease rental discounting 

Lease Rental Discounting (LRD) is a term loan offered by banks against rental receipts derived from lease contracts with corporate tenants. The loan is provided to the lessor based on the discounted value of the rentals and the underlying property value.   

Financial Instruments play a key role in structuring the project as per the needs. It also depends upon the discretion of the project developer. Some developers avoid equity to prevent dilution of their control over the project and some may avoid debt in order to get out of rigid obligations. 

Status of development of the project 

The development status helps in finding out the funding requirements and building trust towards lenders. The closer a project is to its completion, the easier it is to fund since the lenders will have a lot more reliability on a project’s ability to generate cash flows. Different instruments of funding are used in different stages of the project. Broadly, the financing of a real estate project could be divided into 3 categories: 

1. Land Acquisition Phase;
2. Construction Phase;
3. Completion Phase 

Let us discuss how a real estate project is financed in different stages and challenges pertaining it. 

1. Land Acquisition Phase

This is the preliminary stage of a real estate project. At this stage, there is a lot of uncertainty and risk around the project and its success. Therefore, the funding is extremely difficult especially with regards to the debt since the RBI has set out very rigid regulations that restrict the commercial banks to fund the land acquisition. On the flip side, adventurous equity investors are motivated by the high risk-high return factor and thereby equity is more dominant at this stage. 

Generally, these projects are financed through Non-banking Financial Companies (NBFCs). And since the risk is high, NBFCs generally fund the project at this stage based on certain conditions. For example, one of the most common requirements is NBFCs asking to keep a debt-to-equity ratio of 40:60 whereby the bank will give 40% debt provided you have 60% equity.  Generally, the project developers will not have 60% equity at the start and they accumulate it by entering into two kinds of transactions:  

a. Joint Development Agreement

Joint Development Agreement (JDA) is an arrangement between the landowner and the builder/developer, where the landowner contributes his land and the developer takes the full responsibility of obtaining approvals, construction, launching, and marketing the project with the help of financial resources. However, the downside of this agreement would be that you will have to share profits and dilute control by giving certain rights based on the terms of this JDA. 

b. Joint Venture Agreement

A Joint Venture Agreement (JVA) is a business arrangement in which two or more parties agree to pool their resources for the purpose of accomplishing a specific task. This venture will have its own identity, separate from the participants’ other business interests. In project finance, it is specifically called a Special Purpose Vehicle (SPV).  

The main benefit of this SPV is less requirement of daily management and limited liability to repay the amount (since the risk of repayment would restrict towards SPV only and not the parent company). However, since the SPV has very limited assets and limited liability, the NBFCs will now demand twice the security. For instance, a loan of Rs. 50 given to an SPV should have provided security of Rs. 100.   

2. Construction Phase

After acquiring the land, the construction of the project begins. At this stage, a loan becomes relatively easier. NBFCs will now provide the loan even if the debt-to-equity ratio is 70:30 (provided the SPV has no compliance or regulatory issues). 

Once the construction starts to yield returns (by way of cash flows from the project), the SPV can now start paying off all the loans, dividends, or any other funds raised for the project. If the cash sales are generated beyond expectations, the developer can also pre-pay the loans (subject to a prepayment penalty). 

3. Completion Phase

At this stage, the project is almost or fully complete. Although a developer has very little or no funds left, loans are now granted very easily. Even the project starts to generate revenue at a very high pace.  

The project is now assessed from the estimated cost to the actual project cost. The outcome of the project is valued to measure whether it was profitable or loss-making. Generally, the actual cost always exceeds the estimated costs followed by delays, in prices, unforeseen circumstances, etc. 

As concluded, the funding of the project becomes easier over time since the lenders start to build trust in the project completion and possible returns. Therefore, projects should be structured in such a way that they move towards the completion stage as soon as possible. 

Favourable economic environment 

Interest rates impact the price and demand of real estate. For example, lower rates bring in more buyers, reflecting the lower cost of getting a mortgage, but also expanding the demand for real estate, which can then drive-up prices.  

Real estate prices often follow the cycles of the economy, but investors can mitigate this risk by buying units of REITs or other diversified holdings that are either not tied to economic cycles or that can withstand downturns. Government policies and legislation, including tax incentives, deductions, and subsidies can boost or hinder demand for real estate. These economic and market-friendly environments influence not only how a project would be financed but also whether a project would be worth it in the first place.  

Legal processes

Due diligence 

A legal due diligence investigation is seeking information about the business to make sure that the investment or purchase is beneficial. The investigation seeks to reveal all important facts and potential risks and liabilities. Once the facts are collected and analysed, an informed decision can be made. In project finance, typically 3 types of due diligence are carried out: 

1. Title Due Diligence;  
2. Lender Due Diligence; 
3. Investor Due Diligence. 

Appropriate due diligence is conducted for the purpose of ascertaining risk assessment and credit rating so as to find out what is the possibility of repayment. If the bank is satisfied, then the developer would be allowed to go forward with the loan. However, if the bank is not satisfied and feels the risk factor is too high, the project would require alternative structuring of finance. Therefore, it is important that before indulging in project finance, a party must come with a clean background. 

Some of the typical assessments in due diligence include credit history, market position, company profile, cash flow analysis, technical parameters, development mode, etc. Based on these factors, a sanction letter is provided with few terms and conditions followed by legal due diligence reports and technical valuation reports. Accordingly, legal documentations and approvals take place. 

Structuring 

Suppose Mr. A decides to build a skyscraper near an airport. He finds out that this would yield him a lot of returns compared to what he would invest in the project. Now this project may sound very fancy for a developer but a lawyer knows that such projects will never get approved. Hence, it is important to properly legally structure a project. Let us discuss it in more detail: 

The structuring of the project can be divided into two parts: 

1. Commercial structuring which is in consonance with the objectives of client; 
2. Legal structuring which is in consonance with the objectives of law. 

There might be a situation where what is commercially viable would not be legally viable. This is where the job of a lawyer is the most important. Legal representatives have to bridge this gap by structuring a solution that is legally viable keeping in mind the commercial interests of the clients. 

This structuring gap could be the nature of the project, place, financial aspects, govt. policies, etc. Typically for resolving this issue, legal teams carry out thorough due diligence, take out the necessary red flags and create an alternative approach to the red flags by way of enforceability. 

Project management of the parties 

Since the project is dealing in thousands of crores, multiple parties are included for its completion. Therefore, it is important that a project is properly organized and managed by all the stakeholders through a collaborative effort. The main aim is to avoid two of the biggest risks in the project- Time Overrun and Cost Overrun. As a result, there shall be setting up of practical plans, effective designing of leaders, data collection and testing, timely evaluation of the project, and comparing it with the setup plan. Apart from all the technicalities, it is the effective management of the project that has the biggest influence on a project’s success. 

Conclusion

It is often viewed that structuring a real estate project is an art considering the complex challenges that are needed to be overcome such as type of project, development stage of the project, financial instruments and legal framework underlying them, complex legal structures, objectives of the parties, etc. 

Perhaps, structuring becomes vital for a project’s success and to obtain a favourable outcome. It is the effective and efficient structuring of a real estate project which yields the maximum output to all the parties. Having said that, there is no perfect structure to any project. Parties involved in the project can have contradicting objectives and would prefer different structures. This is where the role of stakeholders becomes even more essential. Different objectives lead to the two biggest problems in the project- cost overrun and time overrun. It is important that the different set of parties collaborate and critically analyze from a broader perspective and come to a common point. The objectives should be dedicated towards what is healthy for the project and its completion with no (or bare minimum) cost overrun and time overrun. As quoted by Henry Ford, “Coming together is a beginning, keeping together is progress, and working together is a success.” 

References

• https://www.rbi.org.in/Scripts/BS_ViewMasDirections.aspx?id=11510 
• https://www.investindia.gov.in/foreign-direct-investment 
• https://corporatefinanceinstitute.com/resources/knowledge/finance/real-estate-project-finance/ 
• https://psgroup.in/blog/guide-to-real-estate-financing/ 
• https://www.sonamgmt.org/journal/current-issues/cs-funding.pdf 

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