There are numerous ways to finance a real estate development, but commonly a mixture of equity and debt funding is used, with debt typically being provided by a third party lender. Part-debt funded transactions can be structured in a multitude of ways, but in this article we propose to focus specifically on a forward funded development, partially funded with debt from a third party lender. For the sake of simplicity we assume that the lender debt will be made available to a borrower and no additional third-party funding (outside of the borrower group) is present.
Before delving into the mechanics of a forward funding transaction, it is useful to set out what exactly forward funding is and how it differs from a traditional development financing.
A traditional real estate development structure will involve a corporate entity which acts in a dual capacity as both borrower and developer (these terms may therefore be used interchangeably when dealing with a traditional development but for ease we will refer to the borrower). To the extent that the borrower does not already own the relevant plot of land, it will borrow money to finance the acquisition of the land from a third party vendor. The borrower will then seek to borrow a percentage of the costs required to develop the land and construct a new property on it.
The borrower will usually employ a building contractor (by way of a building contract) and relevant professionals (either directly or through the building contractor) to design and construct the buildings on the plot. It will receive the benefit of any performance bond/parent company guarantee in connection with the building contract, as well as collateral warranties from the professional team.
A third party lender would usually look to take a complete security package over all development documents to which the borrower is a party, and have step-in rights should the borrower fail to perform its obligations under such documents.
Forward funding shares a number of similarities with a traditional development finance structure – a borrower desires to acquire land and ultimately wishes to construct a building. A third party lender is often part of the scenario, assisting the borrower to acquire the land and fund construction costs.
However, the duality of the borrower/developer role is a unique characteristic of forward funding. The borrower in a forward funding may not have the experience or ability, or simply may not wish to, develop the land itself. Instead, the borrower will purchase the land from a vendor/ developer entity and the developer will in turn contract with the borrower to carry out the development. Funds lent to the borrower will then be used by the borrower to pay development costs to the developer.
Forward funding therefore introduces the added complexity of a third-party developer which has an obvious impact on the key development documents, financing arrangements and security package granted to the lender.
“Forward funding” should be distinguished from “forward sales”. The expressions ‘forward funding’ and ‘forward sales’ are sometimes used interchangeably but it is incorrect to view such structures as synonymous. A forward sale transaction involves an investor (who is looking for an investment property) entering into an agreement with a developer to purchase and receive title to a newly developed property once the development is completed. Forward sales therefore retain similar characteristics to a traditional development, with the developer acting as a borrower and typically requiring a financier to directly fund it to construct the relevant project.
A forward sale is fundamentally different in its structure to a forward financing, will involve different payment mechanics and may give rise to substantially different tax implications. Care should therefore be taken at the outset to ensure that it is indeed a forward funding that is being envisaged by the parties.
Why choose to forward fund?
The Borrower may be able to obtain a greater return on its investment than it might otherwise have done had it purchased an already completed development (though the greater return recognises an implicitly higher risk profile given that the development has not yet been realised). Further savings can be made through reduced Stamp Duty Land Tax (SDLT).
SDLT is chargeable on the purchase price for land in England, Wales and Northern Ireland (at rates of up to 5 per cent. for commercial property). A similar land and buildings transaction tax applies in Scotland (at rates of up to 4.5 per cent. for commercial property). For the purposes of this article any commentary is limited to SDLT implications.
SDLT will generally be chargeable on the consideration given for the land acquired under the sale and purchase agreement. In a forward funding this may be limited to the land in its state at the time of completion of the sale (resulting in SDLT being payable only on the reduced price payable for the land in that state). By comparison, a conventional purchase of developed land or a forward sale would attract SDLT on the price for the developed land.
Care must be taken to ensure that SDLT is not charged on the full consideration given by the borrower, including amounts paid to the vendor/developer for the development works. This is discussed in more detail below.
There are potential cash flow benefits to a developer in using a forward funding structure, as it will generally receive cash for the sale of the land up front rather than having to wait until completion of the development and the ultimate disposal of the property.
The developer may also hope to receive a profit-related payment from the borrower after completion of the development. This payment is often calculated from the investment value of the completed development less the development costs incurred (although a properly advised borrower/lender should only permit such a payment once certain time periods have elapsed, and should ensure that the developer retains responsibility for dealing with third-party issues).
Core commercial documents
The usual core documents of a forward funding transaction are as follows:
- Forward Funding Agreement (FFA) (sometimes referred to as the Development Agreement or Development Finance Agreement)
- Facility Agreement
- Security Package
- Sale and Purchase Agreement (SPA)
- Building Contract and related consultant appointments
- Pre-let Agreement (or equivalent).
Other than the FFA, the documents listed will be familiar to lenders who lend into part-debt funded developments. Where these documents differ is in relation to the interplay between each of them, which is explored further below.
Forward Funding Agreement
The FFA is the core document that governs the relationship between the borrower and developer. It contains parameters around how the development is to proceed and the mechanics of how and when the borrower will make payments to the developer in respect of development costs. Typically, it will also cover the profit payment element of the development (to the extent there is one).
The borrower, and ultimately the lender, will be concerned to control cost overruns i.e. expenses exceeding the agreed projected costs schedule (also known as the developer’s appraisal). In a forward funding transaction, there are various options for funding cost overruns – either via the borrower; or the developer; or both, depending on how the deal is structured.
Where cost overruns are to be met by the borrower, and the developer is to receive a profit payment, the borrower will usually deduct overruns from any profit payment to be made to the developer after completion.
Prior to the completion of the building works, both the borrower and lender will be exposed if the developer vastly exceeds its cost projections and becomes insolvent. Consequently, the borrower and lender are incentivised to monitor the developer and control cost overruns during the building phase. Typical protective provisions may include:
- A funding threshold, representing the borrower’s maximum overall cost commitment
- Notional compound interest on all sums drawn down by the developer, to be offset against the developer’s profits. Cost overruns will inflate this figure
- Borrower entitlements to suspend funding whenever the developer requests funding in excess of the amounts agreed in the developer’s appraisal. This is a type of default which may be ‘cured’ once the developer gets itself back on track and in line with the appraisal figures.
The FFA plays an important role as the nexus between the developer/building contractor and the borrower, and ultimately the lender, and it is vital that the FFA is consistent with the other core documents to the deal.
Careful consideration should be given as to how the facility agreement (between the borrower and lender) works with the FFA (between the borrower and developer). Most development finance loan agreements, including the LMA template for commercial real estate finance development transactions, are drafted on the basis that the borrower will also be the developer. Any standard template will therefore require tailoring to address the fact that the borrower will be contracting with a third party developer entity and it will be the developer who will in essence manage the development and maintain a direct contractual relationship with the building contractor. Below is a non-exhaustive list of some of the core areas often subject to negotiation:
- Drawdown mechanics – Account mechanics, conditions precedent and drawdown mechanics must work in sync with the FFA. It is important to ensure that relevant information is provided to the lender’s project monitor in sufficient time for it to sign off on development costs and for the lender to process payments to the borrower
- Development covenants – It is preferable that the borrower’s obligations in the development covenants in the Facility Agreement mirror the developer’s obligations in the FFA
- Representations and warranties – Consideration should be given to the extent to which the representations and warranties given by the borrower in the Facility Agreement should be extended to the developer in the FFA
- Events of default – Lenders should ensure that events of default in the Facility Agreement capture the developer, particularly the insolvency events of default. In addition, given the relationship between the Facility Agreement and FFA, careful thought should be given to the circumstances in which breaches of the FFA by either the borrower or developer will trigger an event of default under the Facility Agreement
- Cost overruns – As in a standard development transaction, the lender should look to address the situation where the developer exceeds the cap on development costs
Whether cost overruns are funded by the borrower or developer, typically the lender should not permit a drawdown where cost overruns (both actual or anticipated) remain unfunded. The lender will need to ensure at the outset that it is comfortable with the financial strength of the party funding any cost overruns and take additional protections, for instance in the form of a cost overrun guarantee, where necessary.
The security package is similar to that required on a typical development financing. However complexities can arise by virtue of the fact that there is no contractual nexus between the lender and the building contractor (appointed by the developer).
Attention should be given as to what collateral warranties are obtained and in favour of whom, given that the contractor (and any sub-contractor or entity forming part of the professional team) does not enter into a direct contractual relationship with the borrower, and therefore the lender, in comparison with a traditional development financing. Collateral warranties should be given by the building contractor to the lender.
Usually the lender will also look to the borrower for a collateral agreement or a direct agreement to ensure the contractual nexus between the lender and developer is in place. However, the lender may be satisfied with the usual warranties and security from the borrower combined with collateral warranties from the contractor and the professional team. Much depends on the bargaining position of the parties as the developer will also be concerned to ensure that its position as regards payment and liability is protected.
Where there is a profit payment, it is not uncommon in a forward funding for the developer to request protection of its profit payment from the borrower. This can be in the form of a guarantee or security. Most lenders would expect any security granted by the borrower to the developer to be second ranking and fully subordinated to any security granted by the borrower to the lender. However, depending on the structuring of the forward funding, the intercreditor arrangements between the lender and developer can remain a core area of negotiation between the parties.
The interaction between the FFA and the SPA can be critical to the determination of the SDLT tax liability (as discussed above). Where the agreements are so interlinked as to, in effect, amount to a consolidated bargain for the sale of a developed property, the SDLT may be chargeable on both the price payable under the SPA and any amounts payable for construction works under the FFA. For example, if the developer does not deliver the land or otherwise breaches its obligations under the FFA, the buyer is able to rescind the SPA and return the property (buildings) to the developer. In this instance the SPA and FFA will be so interlinked as to be treated as one bargain in substance. Specialist tax advice should always be sought in relation to the structuring and documentation of forward funding arrangements to mitigate this risk.
Where a Pre-Let Agreement is in place advisers should ensure cohesion between it and the FFA. Triggers for letting should coincide with triggers for final payments to the developer. If cohesion is lacking, this could result in a problematic ‘gap’ whereby the developer is entitled to step away from the development before the tenant is obliged to enter into the lease.
As with a traditional development transaction it is important to ensure tenant-specific provisions in any Pre-Let Agreement are tracked through to the FFA to ensure that the developer delivers a final product that matches the tenant’s requirements. At best, non-compliance by the developer could cause rent to be adjusted downwards; at worst, the tenant may not be obliged to enter into the lease, resulting in the borrower holding a vacant property built to the specifications of a particular tenant who will no longer be leasing the property.
Forward funding offers a solution to both borrowers and developers seeking an attractive return on a development property (albeit with a corresponding potential increase in risk to both parties). SDLT mitigation for the borrower can represent a huge cost saving. Achieving funding for the construction costs for the duration of the development as well as a profit payment on completion of the building will be very attractive to the developer. For lenders, an enhanced return on investment (in comparison with a traditional development financing) may well be available.
Whilst forward funding may appear more complicated when compared to a traditional development funding, the rewards, as set out above, can be greater for all parties involved.
This article originally appeared in the January 2017 edition of Butterworth’s Journal of International Banking & Financial Law.