How are investments in value-added projects changing the real estate market?

Introduction to International Real Estate Investments

Global real estate markets have seen an increasing interest in investing in projects related to their construction and redevelopment, which can be classified as value-adding strategies. According to research conducted by the European Association of Investors in Unlisted Real Estate Funds, the number of those willing to invest in overseas real estate based on such projects rose from 22% in 2012 to 47% by 2016.

Return on investment in European real estate

With global yields declining, real estate tenants in Europe can expect returns in the range of 3-7% per annum, while value-added projects are able to deliver returns of 12 to 20%.

Difficulties in project implementation

While such investments are attractive due to their high returns, they can be difficult to realize due to the lack of necessary financial resources. Banks, as the most cautious lenders, seek to minimize their risks and usually agree to finance no more than 50% of the total amount of funds required to implement a project, which is called the loan-to-cost ratio (LTC).

Financing models for development projects

In the traditional model, a developer launches a project with 50% of its own funds. In case of a shortage of capital, he can turn to investors to raise additional resources.

Options for investors

Investors planning to invest in a developer's project can choose from several options to participate in such a scheme:

• Become a mezzanine investor:it implies that the investor lends borrowed funds to the developer in exchange for a predetermined percentage and receives a portion of the profits from the project.
• Participate as an equity partner:In this case, the investor must contribute some of his own capital, participates in the project and receives his share of the profits, but also bears the risks associated with a business partnership.

Comparison of investment strategies

Each of these schemes presents different aspects, pros and cons. As for mezzanine loan, this type of financing is a combined approach that includes elements of debt and equity.

Mezzanine loan and its benefits

It works as a subordinated loan, which is issued later than senior debt and bank loans, and is often guaranteed by a pledge of shares or interests. The borrower is usually a company created by the developer specifically for the project, a so-called special purpose vehicle (SPV).

The main advantage of a mezzanine loan for an investor is that interest rates on such loans are often significantly higher than those on standard bank loans. In the United States, for example, such rates range from 8 to 15% per year, which provides investors with the opportunity to generate additional income.

Conclusion

Thus, combined financing schemes help both developers and investors achieve their goals in a rapidly changing real estate market.

Introduction

Despite the current high interest rates, developers are actively looking for new opportunities to apply mezzanine lending to increase financial flows in their projects. Usually, this form of loan allows to attract about 70% of the total volume of financing, taking into account already available bank lending. This significantly reduces the need for in-house investment and, as a result, increases potential profitability. For example, thanks to the attraction of mezzanine investors, developers can limit themselves to only 30% of their own funds.

Additional benefits for investors

In addition, there is a special technique that allows investors to earn additional profits related to the success of the project beyond the normal mezzanine loan payments. This is called“additional remuneration from the net profits of the project”or equity kicker, which may take the form of options or warrants.

Risks of mezzanine lending

It is important to emphasize that schemes involving mezzanine lending have greater risks than traditional leases, as a variety of situations can put participants in a position where they not only fail to make a profit, but also lose their invested funds. In the most unfavorable scenario, the investor risks a complete loss of capital.

Search for projects on the international market

However, experienced investors tend to find such opportunities in the commercial real estate segment outside their home country, as even in a difficult market there are chances to “go to zero”. The real estate market always carries risks, including:

• delays in obtaining construction permits;
• increasing the cost of the project;
• bad sales.

All these factors require detailed analysis. An investor needs to assess how vulnerable his project is to negative circumstances and calculate how much the price per square meter can fall or the implementation period can increase before the project becomes unprofitable. The lower this vulnerability, the higher the international development risk. Ideally, the project should be able to withstand fluctuations of 20%.

Protection for investors and developers

It is important to note that both banks and mezzanine investors are in a more protected position with respect to risks.

The role of equity partnership in the project

The equity partner plays a key role in the successful realization of any project, being the fourth participant who makes a financial contribution according to the principle of equity investment. This investor usually contributes about 20% of the total cost of the project, which allows him/her to receive a corresponding share in the profits during the development process. This model implies that financial risks and possible profits are shared among all participants in the endeavor.

Responsibilities of the developer

In this case, the developer is obliged to provide the remaining 10% of the total investment cost, which demonstrates to the equity partner its confidence in the success of the project, since the developer is also risking its own funds. It is worth noting that the financing structure can include both mezzanine loans and simple joint working with the equity partnership.

Funding structure

In situations where mezzanine lending is not utilized, financing may be available:

• the bank that provides the underlying loan;
• equity partner;
• one investor.

Profit distribution

If the mezzanine loan is not involved and the equity partner is present, the profit sharing of the project is done according to the outcome of the approvals. Usually, the equity investors are the first to receive their income and are provided with a certain return in the range of6-8%on the invested funds (this is considered a priority return). After that, a similar percentage is received by the developer.

Progressive distribution of profits

As for the remainder of the income, it is distributed on a progressive scale, where the equity developer receives an increasing share of the profits as the profitability of the project increases. For example, there is a common scheme under which a developer may receive30%of profit if the yield is within8-15%per year, and anything over15%shall be divided among all participants in equal shares.

Economic situation in 2016

Inin 2016When a certain economic environment has emerged in the U.S. and Europe, such profit-sharing schemes are able to provide investors with returns in the range of12-20%per year in value-adding projects.

Risks and returns to the investor

Thus, if an investor participates in a project through a mezzanine loan, he becomes a lender, which implies lower returns, but with associated lower risks, since in case of failure it is the developers who suffer the first losses, then the equity partners, and only lastly the lenders. In contrast, an investor acting as an equity partner can expect higher returns, but also faces significantly increased risks.

Conclusion

In conclusion, investments in value-added projects in foreignreal estate markets continue to gain popularity due to their high returns and growing investor interest. The growing share of stakeholders in such projects, as shown by the European Investors Association survey, confirms the growing awareness of the potential that redevelopment and construction strategies hide.

Despite the available prospects, there are many financing and risk challenges that arise, requiring investors to carefully analyze and be willing to take informed risks.

Financing and risks

Bank loans and mezzanine financing are the main instruments to provide capital for such projects. While mezzanine loans can provide higher returns for both developers and investors, it is important to be mindful of their risks, especially in a volatile market.

• Mezzanine Loans:Include high interest rates.
• Risks:Investors should be prepared not only for potential gains, but also for potential losses.

Strategy selection

It is also important to realize that the success of a project depends to a large extent on the developer's ability to manage its capital and assess risks. The choice between a mezzanine loan and equity participation is a strategic decision that should be based on the conditions of the specific project and the investor's willingness to accept the risks.

Advantages and disadvantages:

• Advantages:High potential profitability.
• Disadvantages:Possible losses and risks.

Result

Investing in foreignreal estate markets is not suitable for everyone, but for those who are ready to delve into the specifics of this sector and carefully approach financing issues, it can be a profitable and promising direction. We are at the beginning of a long journey, and at every stage it is important to draw conclusions, analyze and adapt to changing market conditions in order to make the most of all opportunities to create a sustainable and profitable investment structure.