Debt Finance in the Acquisition of Commercial Properties

Debt Finance is mainly used in the Acquisition of Commercial Properties . Commercial real estate  debt finance provides mortgage loans or other types of financing to companies to buy properties used for business purposes. Commercial real estate debt finance can be used to finance includes office buildings; retail sales buildings (such as shopping centers and malls); warehouse, storage, and manufacturing facilities; hospitals and other medical facilities; restaurants; recreation parks; and raw land.

Its important to note that Commercial Properties are properties that are not designed or used for residential purposes. These properties aren’t also for purposes associated with the primary industries such as agriculture and mining. The three main types of commercial properties are offices (single office buildings and business parks), retail (individual shops, shopping centres, and supermarkets) and industrial (factories, warehouses and distribution centers). Together these represent about 86% of the commercial property market. The remaining 14% comprises properties used for leisure (pubs, restaurants and hotels), sport, education, utilities, and healthcare.

Nigeria is rated among the top five African countries that have become the newest destination for real estate investments and debt finance is yet to take hold. Nigeria which has become Africa’s largest economy has seen an influx of companies limiting office space. It was discussed in the article The Next Phase Of Real Estate Financing In Africa that there is evidence to show that the African property market has evolved, and commercial debt finance would play a key role in Africa.

Who Buys Commercial Properties?

Occupiers

Owner-occupiers buy about one-third of all commercial properties. These are occupiers who need land and buildings from which to conduct their business. Some of these occupiers want to buy a freehold or long leasehold interest in the property. This is simply because they need certainty and complete freedom to deal with the property as the business dictates. Consequently tying a lot of capital in the building.

Besides that, other occupiers prefer to take a so-called ‘rack rent lease’, where the occupation cost is paid, usually quarterly. The payment is made over the period of the lease by way of rent, rather than all at the beginning. In recent years, particularly among the large food retailers, there has been a move away from freehold ownership through ‘sale and leaseback’. This is where the freehold interest in the property is sold to an investor (thus releasing capital for use in the operating part of the business) and the occupier takes a rack-rent lease instead.

Alternatively, shares can be bought or units in a company that invests in a range of commercial and residential property. Such as a real estate investment trust (REIT) or an offshore property unit trust (PUT). These indirect property investment vehicles offer opportunities for smaller levels of investment, some taxation advantages, less management responsibility and, arguably, greater flexibility. It may be easier to trade units than to sell a property. However, indirect property investment is beyond the scope of this book.

Developers

A developer can make a profit from commercial properties in Nigeria by buying a property that isn’t used to its full potential. Construct some new buildings on the site, let at least some of the new buildings to quality tenants. In doing this there is good income flow and then completed development can be sold to an occupier or investor at a price greater than the cost on the purchase and development of the property. Commercial property development experienced difficulties after the credit crunch of 2007. Developers experienced difficulties in obtaining loans to fund what is still seen as a risky activity. But in times of economic growth, when new buildings are in short supply, commercial property development returns.

Of course, the aims of occupation, investment and development are not mutually exclusive. For example, some larger investors develop the property themselves or participate in joint ventures with developers so as to spread the risks. Some potential occupiers, particularly those looking for prestige headquarters buildings, may prefer to develop their own building. However, they could work alongside a developer in order to achieve a high degree of customization.

Methods of  Debt Finance for Property Acquisition

One of the most common ways of raising finance is to borrow, usually from a bank or building society. Further, even if the buyer has sufficient cash to purchase the property without recourse to borrowing, the return it will get by investing the cash will often be higher than the rate of interest it will pay on a loan.

Term sheet

A term sheet is a document that sets out the principal terms on which the lender is prepared to lend. It is produced following initial negotiations between the lender and the borrower and is not usually intended to be legally binding as it is based on the limited information the lender has about the borrower and the property at this early stage. The term sheet will often be attached to a commitment letter or mandate letter which contains any terms which are intended to be legally binding at that stage, including provisions relating to the payment of the lender’s fees and expenses. Alternatively, it may be produced as a stand-alone document that clearly states that the parties do not intend the document to bind them legally, save in respect of the payment of fees.

Typically a term sheet will include brief details of the following:

The borrower and the objectives stating the amount of the loan and the period during which the borrower can request the release of the loan monies.

The term sheet would also contain the purpose of the loan and the interest rate been offered as well as the date for repayment of the loan and the repayment schedule; There would also be provisions relating to repayment of the whole or part of the loan prior to the date for repayment (called prepayment);

An important part of the Term Sheet is the security required for the loan as this is a key conditions precedent which must be satisfied by the borrower prior to the loan being made. The Lenders would typically require representations and warranties which the borrower must make as to both its status and the property, many of which will be deemed repeated throughout the period of the loan;  the undertakings and financial covenants to be given by the borrower with which the borrower must comply throughout the period of the loan;

Due diligence

Prior to issuing the term sheet, the lender will have undertaken a certain amount of due diligence in respect of the borrower to assess the risk that the borrower will be unable to meet the payments due under the loan. Once the terms of the loan have been accepted by the borrower, by signing and returning either the commitment letter or the term sheet itself if it has been produced as a stand-alone document, the next phase of the due diligence process can commence. The lender will undertake a more detailed analysis of the borrower, its constitution and powers if it is a corporate borrower, and of the property to be purchased. At this stage the lender will also instruct its solicitors to prepare a first draft of the loan agreement, sometimes referred to as the facility agreement or credit agreement.

Loan Agreement

The term sheet and any commitment letter are the starting point for the negotiation of the loan agreement. It is not uncommon for the term sheet to use generic language such as ‘The Loan Agreement will contain the usual conditions precedent applicable to this type of facility. The loan agreement will incorporate the provisions outlined in the term sheet, but the brief outline of conditions precedent, representations and warranties, undertakings and financial covenants will become detailed provisions. The precise nature and number of these clauses will depend upon the nature of the borrower and its business, and the extent of any issues identified during the continuing due diligence process.

The borrower needs to consider the provisions in the loan agreement carefully, as it needs to be satisfied that it can comply with the provisions in order to obtain the loan and, further, that any repeating representations and warranties and any undertakings and financial covenants are not drafted in such a way that they restrict the borrower’s ability to run its business.

Part of the due diligence process to be undertaken at this stage will be the investigation of the title to the property. This will often result either in changes to the terms outlined in the term sheet or in additional terms.

For example, a satisfactory valuation of the property will generally be a condition precedent that must be satisfied prior to the release of the funds. The lender will have proposed a loan-to-value ratio when negotiating the terms of the loan. If the property is valued at less than anticipated, this can affect the proposed loan. Generally, the property is the principal security for the lender. The lender will need to be satisfied that a sale of the property by the lender as mortgagee, in the event of a default by the borrower, will achieve sufficient funds to repay the loan, any accrued interest, and the legal costs and charges incurred by the lender in recovering the loan. The loan-to-value ratio is intended to ensure that there is a margin by which the value of the property exceeds the loan. The margin should be sufficient to cover the accrued interest, etc, and to alleviate the possibility of the lender suffering a shortfall in recovering the loan either due to a decline in property values generally or due to the property simply being sold for less than anticipated. In order to meet the loan-to-value ratio, a lower valuation will result in a reduction in the amount the lender is willing to lend.

In addition to being concerned with the valuation of the property, the lender will also wish to be satisfied that the property has a good and marketable title. As mentioned above, on a default by the borrower the lender will wish to sell the property as mortgagee to repay the loan, interest, costs and charges. If there are any defects in the title this could cause a delay in the sale, thereby causing further interest to accrue, or enable a buyer to renegotiate the price. This increases the risk of the lender suffering a shortfall. For example, if the investigation of the title reveals a subsisting breach of covenant, the lender may require restrictive covenant indemnity insurance to be put in place prior to the release of funds. This would be added as a further condition precedent.

The loan agreement will also include the detail of provisions such as events of default. If a borrower breaches a term of the loan agreement, the lender will want the ability to terminate the loan and demand repayment of all outstanding principal and interest (known as ‘acceleration’). The most common events of default are  (a) failure to pay any capital, interest, fees or expenses; (b) breach of any representation or warranty, undertaking or covenant in the loan agreement or the security documents; (c) the insolvency of the borrower (d) the borrower becoming involved in any litigation or similar proceedings (e) it becomes unlawful for the borrower to continue to perform its obligations under the loan agreement (f) a material adverse change in the borrower’s position or circumstances (g) cross-default if the borrower defaults under another contract, ie another loan agreement in favour of this or any other lender.

Each of the above may be an indication that the borrower is, or may soon be, in some financial difficulty and unable to comply with its obligations under the loan agreement. Once an event of default has occurred, depending on the seriousness of the breach, the lender may decide to accelerate the loan. Alternatively, if the breach is minor or technical in nature, the lender may permit the loan to continue but may take this opportunity to renegotiate the terms of the loan, for example increasing the interest rate to compensate the lender for any increased risk the lender perceives in continuing.

Methods Of  Equity Finance for Property Acquisition

One of the first considerations for any buyer of commercial property, whether the buyer is a developer, an institutional investor or simply a company looking to acquire premises from which to operate, is how to fund the acquisition. Even the largest commercial organisation is unlikely to have sufficient funds to buy the property without recourse to outside funding; and even if it does have the funds readily available, it may not make financial sense to use them. There may be tax advantages to borrowing the necessary funds. There are a number of ways in which a company may finance an acquisition and/or development.

These are considered below.

Institutional investors such as pension and life insurance funds have substantial sums of money at their disposal for investment

Share Capital

Where the buyer is a company, it may consider issuing further shares to raise additional capital to invest in property. This method of raising funds may not be popular with the current shareholders of the company. Depending on the method used, a new issue of shares may result in reduced dividends as a current shareholder’s percentage shareholding may be diluted, which will also affect the voting power and capital rights. Further, if the company is a publicly listed company there will be additional regulations to consider before any such fundraising may be considered. Details of these regulations are dealt with in Public Companies and Equity Finance.

Forward funding and equity funding

Institutional investors such as pension and life insurance funds have substantial sums of money at their disposal for investment. These investors will usually invest in property in addition to shares and bonds, in order to maintain a balanced investment portfolio. This investment may take the form of a simple purchase of an established commercial property (an office block or shopping center) that has been let. The investor will receive the rental income stream from the tenants, and it will also hope that, over time, the capital value of the property will increase. As an alternative to purchasing a property that has already been let, such investors may also take an active part in the development of the suitable property. Examples of ways of doing this are discussed below.

Forward funding

In this instance, the institutional investor finances the development from the outset, acquiring the land and paying all the construction costs, including architects’ fees, etc. The developer is paid a fee for its work and, once the development has been completed and let, is paid a profit share. The developer may be prepared to accept a lower profit because there is less risk to the developer than if it had developed the property using its own funds. The investor will hope to have paid less for the completed and let property than if it had waited to buy the property until after the developer had built and let it.

Equity funding

In the case of equity funding, an investor and a developer will form a Joint Venture company to acquire the development site and undertake the development. The investor takes preference shares in order to be assured of a priority return on its investment. This way, the investor is participating in the profits and losses of the development.

Sale and leaseback

It is possible for the owner-occupier of freehold property to raise funds against the value of its property and remain in occupation by entering into a sale and leaseback arrangement. The freehold interest in the property is sold; immediately following completion of the sale, the buyer leases it back to the seller/former owner, usually at a market rent. In this way the former owner can raise capital for whatever purpose it requires, eg working capital to acquire further premises for investment or development, etc. The buyer will see a return on its capital investment in the form of the rent paid by the former owner.