When arranging debt with a bank the borrower will discover that the bank will impose rules that are based on ratios comparing the debt with either the earnings from or the value of the scheme. The loan will first be subject to a loan to value ratio, which ensures that the loan is adequately covered by the value of the investment to be created. Typically this figure will be up to 70%.
The bank may also wish to see that interest repayments are well covered by rental income and indeed that the total capital and interest repayments are covered by the total rent roll. For a multi-let development, such as a shopping centre, the lender will also be interested to know at what point of occupancy the debt payments are covered by rental income.
Although the conventional residual appraisal used in some of the examples given later assumes that a developer is 100% debt financed this can never be the case. Any developer who has no equity would be unable to run a viable business. The appraisal is, however, theoretically correct as the opportunity cost of equity would be the short-term rate of interest. In practice, developers respond to market signals and if development appears viable they will seek finance and commence schemes (RICS/University of Aberdeen 1994). As explained earlier, various types of finance will be required. If a developer uses the equity already existing from earnings within the company or raises equity finance through perhaps a rights issue the risk accepted is a great deal less than that involved with debt finance.
A developer’s incentive to increase the ratio of debt finance to equity finance in a project is that as the ratio increases so the return to the developer’s equity will also increase so long as the interest rate on the debt is less than the return from the scheme per annum. Where the long-term funding vehicle is a sale and leaseback viability is tested by the adequacy of the developer’s share of the occupational rent after the fund has taken its return. With long-term debt finance such as a long-term mortgage, it is important that the percentage rate that applies to the developer’s long-term debt is less than the percentage return from the property investment created. Example 6.1 illustrates this position. Four scenarios are considered. In Scenario 1, the purchase is relatively lowly geared and the interest rate is assumed to be 6.25% per annum. The same interest rate is used in Scenario 2, but the purchase is less highly geared. In Scenario 3, it is assumed that the interest rate available to the investor has risen to 10% per annum and the purchase is again relatively highly geared. In Scenario 4, the same interest rate is used (10%) but the purchase is assumed to be less highly geared.
Chapter6
Example 6.1 Debt and equity
A property developer is about to develop a site at a cost of £5m including all on costs and incidentals. The net annual rent from the property will be £400 000 per annum. The predicted initial net return is therefore 8% per annum.
Scenario 1
Assume rate of interest on money borrowed is 6.25%
Development funded by 80% debt and 20% equity
Debt £5m× 0.8 = £4m
Equity £5m× 0.2 = £1m
Yearly interest payment
£4m× 0.0625 = £0.25m pa
Net income
£0.4m–0.25m = £0.15m pa
Initial return to equity
£0.15m
£1m = 15%
Scenario 2
Same rate on interest 6.25% but development less highly leveraged Development funded by 50% debt and 50% equity
Debt £5m× 0.5 = £2.5m
Equity £5m× 0.5 = £2.5m
Yearly interest payment
£2.5m× 0.0625 = £0.1563m pa
Net income
£0.4m− £0.1563m = £0.2437m pa
Initial return to equity
£0.2437m
£2.5m = 9.74%
Scenario 3
Assume that the rate of interest available to the investor rises to 10% per annum
Development funded by 80% debt and 20% equity
Debt £5m× 0.8 = £4m
Equity £5m× 0.2 = £1m
Chapter6 Property Funding Partnerships 147
Example 6.1 Debt and equity (Continued)
Yearly interest payment
£4m× 0.10 = £0.04m pa
Net income
£0.4− £0.4m = Nil
Project makes nil return
Scenario 4
Assume that rate of interest available to the developer rises to 10% but is less highly leveraged
Development funded by 50% debt and 50% equity
Debt £5m× 0.5 = £2.5m
Equity £5m× 0.5 = £2.5m
Yearly interest payment
£2.5m× 0.10 = £0.250m pa
Net income
£0.4m− £0.025m = £0.15m pa
Initial return to equity
£0.15m
£2.5m = 6% pa
No account is taken of the need to repay capital as well as interest in the example given here. If this is included, the difference in the results would be less stark but nevertheless the example shows the reality behind the relationship of developer and bank. In Scenario 1, the developer’s bold decision to fund the purchase primarily by risky debt finance has paid off with a healthy return to equity of 15%. Scenario 2 shows how a risk-averse developer using a 50/50 arrangement of the bank and equity finance cuts the return to equity to 9.74%. When interest rates rise, the risk-averse developer makes 6% return to equity (Scenario 3) whereas the developer who chooses a highly geared arrangement makes no return at all with all the rent being eaten up by debt repayment. It is a matter for the developer and the bank to negotiate the terms upon which lending will take place. If a developer is confident that rental growth will be good and there are few inflationary pressures in the economy that might cause a rise in interest rates, a highly geared arrangement will be preferred. This is also the case with private finance initiative (PFI) schemes where a typical arrangement is 90% gearing (HM Treasury).
Chapter6