Some notions about the sources of real estate financing

Monday, 8 october 2018 | Redacción CEU

The real estate industry is characterized by the reduced access to financing it has when compared to other fields. Besides, its leeway has been limited due to the economic crisis' effects. Bank funding, which was once the most popular funding source in the industry, has declined substantially. This fact has contributed to the appearance and boost of new formulas which are alternatives to it. Debt funds, REITs or crowdfunding are options that are spreading rapidly in the sector. So, what aspects must be taken into account when choosing any of them?

On September 27, The CEU IAM Business School held an event about "Sources of financing for real estate projects". This meeting, which was conducted by Eugenio Molina, Executive Director of Frux Capital, provided attendees with an updated view of the different alternatives for financing this industry. Below, we offer those who could not attend the meeting a summary of the main points which were addressed in it.

What is the current situation of the real estate market?

Molina kicks off this event by highlighting the differences that exist between the stock market (which in 2016 had more than 54 million transactions) and the real estate market (which approximately collects 500,000 transactions at present). Broadly speaking, they are the following:

Stock Market

It has a high number of buyers and sellers, great transparency in information, low transaction costs and a high degree of efficiency

Real Estate Market

It has a low number of buyers and sellers, its information is deficient, has high transaction costs and is fragmented and inefficient compared to the stock market.

In spite of the above, Molina considers that between 1987 and 2007, the real estate market was growing with a very positive trend and even over the figures which were achieved by the IBEX index (only between 1998 and 2001, the IBEX registered higher indicators). In 2007, as expected, the market experienced a decline due to the crisis, but in recent years it has been recording another similar rise. <<The real estate industry is a market that in the long term has evolved more positively and more profitably than the stock exchange market (the IBEX)>>, says the executive director.

Another aspect to take into account is that the banking sector has undergone great changes in the last ten years. For example, although the number of Spanish financial entities was once 62, in 2017 there were only 11. Until recently, banks had been the main source of real estate financing, they had supposed almost 80% of the financing. Now, the scenario has changed. It is not surprising that this context has served as a breeding ground for Spain to open to different financing alternatives. In the industry new players are beginning to emerge that are increasingly concentrating more power: business angels, venture capital, private equity, business investment, share issue, corporate bonds issue, project bonds, crowdfunding, private debt financing, etc.

What are the peculiarities of real estate investment?

As in any type of investment, people who bet on real estate should take into account many aspects such as the relationship between risks and returns, the availability of different structures for different investor profiles, the returns in capital gains and cash flow and the fiscal incentives. Of course, it is also important for these investors to be aware of the particularities of the real estate industry, for example, the lower volatility of investments in variable incomes, their capacity for diversification, the relationship that investments have with inflation and that, as a rule, these operations are ensured by physical assets.

One of the key aspects when dealing with this type of investment is the appropriate reflection on the risk/return ratio. The risks associated with real estate investment are: those inherent to the business, financial risks, the ones that are relative to the nature of the assets and those that have to do with macroeconomics (such as inflation), team management, legislation and environmental issues. Among the sources of return on investment in this industry, we can find: the real estate assets, cash flows from the rental of assets, capital gains on the sale of assets, tax benefits, real estate debt, the payment of interest on the loan and repayment of the loan principal. The nature of this market itself, the fragmentation and a lower efficiency should not be taken lightly in this approach.

Molina makes a brief categorization of the different types of investors that exist in the real estate industry (in the video of the event, he explains what the different features in each of them are) in order to offer a context to the audience:

Private and based on capital: direct partners and private funds
Public and based on capital: companies that are listed on the market
Private and based on debt: direct lending and debt funds
Public and base on debt: listed debt instruments, corporate bonds and CMBS (Comercial Mortgage-Backed Securities)

The choice between equity and debt

At this point, it is important to highlight what is one of the main decisions that individuals must take into account when seeking funding: the choice between their own resources or somebody else's. In other words, betting on equity or debt. <<If the cost of their own resources is lower than those of the others, it will not make much sense to look for funding, except for diversifying risks>>, says in a conclusive way the Chief Executive of Frux Capital. According to Molina, there are two questions that the interested individuals can ask themselves: how much would they have to pay me to invest instead of saving up or spending? How much would they have to pay me to save up instead of investing or spending?

Equity

Equity is the own resources that shareholders invest in a real estate property, those which are inside the company itself. In this financing formula that represents the property of the real estate, the operational and financial risks that are derived from the property are shared, as well as the profits and losses caused by the real estate business and the capital gains of the sale.

This equity category encompasses: family members of managers and friends, pension funds, REITs and listed companies, foreign investors, insurance companies, sovereign wealth funds, private banks, private investors and real estate developers and the owners of real estate assets.

Debt

Debt in the real estate industry plays a role of intermediation, since it puts investors and lenders (savers) in contact with shareholders and developers (those who need capital). Market rules demand that this relationship is based on the premise of "higher risk, greater profitability". Whatever its typology is, this financing will always seek to maximize the return and will require relying on a previous detailed study.

Among the main sources of debt, we can find: commercial banking, CMBS (internationally), foreign investment, insurance companies, pension funds and credit companies.

This article serves only as a brief summary of the event organized by CEU IAM. In the video "Sources of Financing for Real Estate Projects" of our Youtube channel, you will find the complete recording of the meeting. Remember that our business school offers an Advanced Program in New Management of the Real Estate Business with which you will be able to expand your knowledge about this industry. If, on the other hand, you are more interested in developing your career within the finance, banking and investment world, do not hesitate to find out about our Executive Master's Degree in Finance.