After reading this week's material, consider, research and address the following: Please conduct independent Internet research on the most recent mortgage foreclosure crisis. This crisis impacted both

Introduction The purpose of this chapter is to discuss how funds flow to property. Who are the investors? Who are the intermediaries, and what mechanisms do they use to channelise funds from investors into property?

These mechanisms have evolved within the financial systems as a way to allocate risk associated with financing property to those who can assume them for returns in commensuration with the risk. Figure 3.1 shows the flow of funds to property, though it may be flagged here that property is only a small component of overall investment space. In a simplified scenario, domestic or foreign economic agents such as households, firms and government with surplus financial resources in present time (in terms of savings) can invest in those domestic or foreign opportunities (including property) that require these resources to carry out economic activities and earn risk-adjusted return on their investment in the future. These economic agents could invest directly in these opportunities (such as housing and office buildings for own use purposes) or channelise their savings into various opportunities through primary capital markets or through secondary financial sectors such as banks, pension funds and insurance companies for investment in income-generating properties.

The purpose of the financial system and financing mechanisms is to reduce impediments and create opportunities for the flow of funds from Financial Systems, Flow of Funds to Property and Innovations 3White, M., & Tiwari, P. (2014). Real estate finance in the new economy : Real estate finance in the new economy. Retrieved from http://ebookcentral.proquest.com Created from apus on 2020-05-21 07:42:44.

Real Estate Finance in the New Economy, FirstfiEdition. Piyush Tiwari and Michael White. © 2014 John Wiley & Sons, Ltd. Published 2014 by John Wiley & Sons, Ltd. 64 Real Estate Finance in the New Economy investors to investment opportunities. Property has its own specific charac- teristics. An objective of this chapter is to discuss how the financial system (and financing mechanisms) have evolved in response to the characteristics of property asset class and to what extent various mechanisms have been able to address the specificities of property.

Bank-based and market-based financial systems The mechanisms for financing assets that develop in a country depend on the regulatory and institutional environment within which financial system operates. There are two types of systems: (i) market-based and (ii) bank- based financing system. This does not mean that the mechanisms that would evolve in a country would conform only to one system or the other.

It means that one of these two systems would have predominant influence in the evolution of financial mechanisms through which resources would be mobilised and investments will take place. Mechanisms conforming to the other system will exist in a meaningful but to a lesser extent. The differences between the two financial systems arise from the way savings are mobilised; investments are identified, made and monitored; and risks are managed.

The other difference is from the legal perspective. In a bank-based econ- omy (Germany and Japan), laws governing financial systems are enacted and implemented by the government. These are based mainly on the civil law rather than the common law. Market-based financial systems are found most often in countries (the United States and the United Kingdom) that employ a common law legal system. Common law is less defined and can vary from case to case. Instead of government enacting and implementing the laws governing financial system, common law-based regulation is implemented through courts. Primary financial sectors Households Firms Government Secondary financial sectors such as banks, pension funds, insurance companies Primary securities market PropertyCore Residential CommercialIndustrial Non-coreHotelsWarehousingHealthcareOthers Savings Intermediaries Investment Figure 3.1 Flow of funds to property.White, M., & Tiwari, P. (2014). Real estate finance in the new economy : Real estate finance in the new economy. Retrieved from http://ebookcentral.proquest.com Created from apus on 2020-05-21 07:42:44.

Financial Systems, Flow of Funds to Property and Innovations 65 In a market-based system, primary securities markets play the dominant role. Banks in such a system are less dependent upon interest from loans and gain much of their revenue through fee-based services. In contrast, in a bank-based financial system, banks play a major role in channelising financial flows to investment opportunities through loans. Interests earned on loans form the major part of their income. In a market-based system, a number of non-banking sources for investments exist. Investments by private systems and government often compete with those of the bank.

In a pure bank-based system, banks mobilise capital, identify good projects, monitor managers and manage risk. The risk management, infor- mation dissemination, corporate control and capital allocation are all left to market forces in a market-based system. In a well-developed market, any information that is available is revealed quickly in the public markets, which reduces the transaction costs. Some view this as a shortcoming of market-based system as the incentives for individual investors to acquire information decline (Stiglitz, 1985). Standardisation becomes the key, and in this context, there may not be enough incentives to identify innovative investment opportunities. In a bank-based system, banks form long-run relationships with borrowers (firms), information is private, and investments are custom made.

There are other concerns which proponents of the bank-based system identify with the market-based system. Liquid markets create a myopic investor climate where investors have fewer incentives to exert rigorous corporate control (Bhide, 1993). However, powerful banks with close rela- tionships with firms can more effectively obtain information about firms and manage their loans/investments to these firms than markets. The view against bank-based system is that powerful banks can stifle innovation by extracting informational rents and protecting established firms with close bank–firm ties from competition (Rajan, 1992). Moreover, in the absence of appropriate regulatory restrictions, they may collude with firm managers against other creditors and impede efficient corporate governance (Wenger and Kaserer, 1998). Market-based systems will reduce these inherent inefficiencies associated with bank-based systems.

Levine (2001) minimises the importance of the bank-based versus market- based debate. He argues that financial arrangements comprising contracts, markets and intermediaries arise to ameliorate market imperfections and provide financial services. Financial arrangements emerge to assess potential investment opportunities, exert corporate control, facilitate risk management, enhance liquidity and ease savings mobilisation (Levine 2001). Finance is a set of contracts. These contracts are defined and made effective by legal rights and enforcement mechanisms. From this perspec- tive, a well-functioning legal system facilitates the operation of both market- and bank-based systems. While focusing on legal systems, it is not White, M., & Tiwari, P. (2014). Real estate finance in the new economy : Real estate finance in the new economy. Retrieved from http://ebookcentral.proquest.com Created from apus on 2020-05-21 07:42:44.

66 Real Estate Finance in the New Economy inconsistent with banks or markets playing an important role in the econ- omy. With financial innovations and their export that has accompanied globalisation, the coexistence of bank-based and market-based system has further got reinforced.

The mechanisms that develop for financing or investment in an asset take root in the efficiency of the market. Though a detailed discussion on market efficiency is out of the scope of the present book, it is important to mention the key elements of an efficient market. According to Fama (1970), an efficient financial market is one in which security prices always fully reflect the available information. This hypothesis rests on three arguments which progressively rely on weaker assumptions. First, investors are assumed to be rational and hence value securities rationally for its fundamental value. Any new information is quickly factored in the price. As a result, all available information is captured in the price. Second, to the extent that some investors are not rational, their trades are random and therefore cancel each other out without affecting prices. Third, to the extent that investors are irrational in similar ways, they are met in the market by arbitrageurs who eliminate their influence on prices (Shleifer, 2000).

Given the aforementioned definition of the efficient markets, property markets are not efficient. Trading on this asset is infrequent (one property does only few times during its life), transactions take time to materialise, and the transaction costs are high. Information on transaction price, rental and lease terms are highly private, and hence, third party valuation plays a key role in guiding buyers’ and sellers’ decisions. Participants in the market are few and most deals are negotiated deals. Property being local in nature, laws and local planning regulations play a very important role in determin- ing the value of the property. Importance to understand these local norms for the participants makes the market thin.

The role of financial system is to evolve mechanisms that can take into account characteristics of property asset class and create opportunities for investors to invest in this asset class. Hence, the question to ask in case of property investment is what bank-based and market-based mechanisms have evolved for channelising savings from the real economy for financing of property development and investment in property as an asset class. As would be discussed later, to a large extent, property is financed through debt instruments, mainly debt from commercial banks. In the last two to two and half decades, innovations in financial mechanisms have taken place to enhance the role of the market-based financing in the sector. Figure 3.2 presents the flow of funds to the property.

Though various mechanisms would be discussed in detail in the next sec- tion, it is important to observe here that both bank-based and market-based systems are operative in any economy. The extent to which an economy is able to use these mechanisms depends on the depth and maturity of its White, M., & Tiwari, P. (2014). Real estate finance in the new economy : Real estate finance in the new economy. Retrieved from http://ebookcentral.proquest.com Created from apus on 2020-05-21 07:42:44.

Financial Systems, Flow of Funds to Property and Innovations 67 banking system and primary markets as well as regulatory environment within which intermediaries and investors operate. It is also important to observe from the aforementioned figure that in a fully developed system, bank-based and market-based systems interact and innovate to provide mechanisms to fund property assets and new developments.

Property investors and intermediaries There are four major types of investors: institutional investors, unregulated investors, households and proprietors and corporations. Motives for invest- ment in property differ for different investors. Even for investors in the same type, as described earlier, motives could differ. There are those who invest in property for financial reasons, that is, they are looking for a return on their investment, and there are those whose intention is to invest in prop- erty for occupation purposes. Figure 3.3 presents the further breakdown of investors in each type.

Following are the two distinct and mutually exclusive investment objec- tives (Geltner et al. 2007): (i) the growth (savings) objective, which implies a relatively long time horizon with no immediate or likely intermediate need to use the cash being invested, and (ii) the income (current cash flow) objec- tive, which implies that the investor has short-term and ongoing cash requirements from his investments. There are other considerations that affect investors in the property markets. Risk is an important factor in the Households FirmsGovernment Primary securities market Primary sectors Secondary sectors Commercial banksMutual funds Savings institutionsInsurance companiesPension fundsGovernment Equity instruments Debt instruments Equity Equity Property asset market Existing properties Office RetailCommercial ResidentialIndustrialHotelsWarehousesOthers New property Development Loans Figure 3.2 Typical flow of funds to property.White, M., & Tiwari, P. (2014). Real estate finance in the new economy : Real estate finance in the new economy. Retrieved from http://ebookcentral.proquest.com Created from apus on 2020-05-21 07:42:44.

68 Real Estate Finance in the New Economy decision for investment in real estate. This arises from the concern that future investment performance may vary over time in a manner that is not entirely predictable at the time of investment. Time horizon, for which investor wants to stay invested, itself is a factor. Liquidity, that is, the ease with which the asset could be bought or sold at full value without much affecting the price of the asset, is another consideration. Investor expertise and management burden that investment in property pose determines the ability and desire of investor to invest in property. Minimum size of invest- ment required also determines the willingness and ability of an investor to invest in property.

Considering that investor space is heterogeneous, an elaborate invest- ment system with a number of intermediaries and mechanisms through which funds flow to property has emerged. While the investment mecha- nisms will be discussed in the next section, it is interesting to see the range of intermediaries that operates in the property investment markets (Figure 3.4). These intermediaries are the conduits between investors and investment, and the investment mechanisms are the products through which investment is made.

Investment mechanisms Figure 3.5 presents a highly simplified version of real estate investment sys- tem with main mechanisms depicted there. The figure does not cover investment mechanisms exhaustively, as given the range of possibilities that exists, it will be highly ambitious to attempt here.

Institutional Banks Savings and loan corporationsPension funds Insuranc e comp anies Fin ance and securitie s fi rms REIT s Pers onal trus t Government Unregulated investors Reli giou s organizatio ns Private and personal trusts Non-profit organizatio ns Households, Proprietors Pers ons Families Limited partnerships Sole proprietorship Corporation s Publicly tradedcompanies Priv ate comp anies Property investmen t Figure 3.3 Commercial real estate investors.White, M., & Tiwari, P. (2014). Real estate finance in the new economy : Real estate finance in the new economy. Retrieved from http://ebookcentral.proquest.com Created from apus on 2020-05-21 07:42:44.

Financial Systems, Flow of Funds to Property and Innovations 69 Private investment mechanisms Debt The private investment mechanisms (Figure 3.5) for debt and equity are the traditional ways of financing property during its development phase and later when it is an income-generating asset. These two together form the major share of investment flow in property. The finance for development is short term and takes the form of a loan or an overdraft facility. Since during the time the construction is on, there is no cash flow to repay the debt, the repayment is a bullet payment of accumulated interest and principal at the time of when the project development ends. In the United Mutual funds, real estate funds Commercial banks, specialized mortgage institutions Securities dealer s REIT companies, listed property funds Asset backed securities Savings institutio ns Insurance companies, pension companies Private equity, venture capitalists Governments, sovereign funds Figure 3.4 Intermediaries in the property investment market. Property in physical form (e.g. offices, retail, industrial, hotels) Limited partnerships/ property funds/privateREITs/sovereign wealthfunds: own equity in properties: LP shares privately held andprivately traded DirectinvestorsHigh net worthindividuals,developers,individuals Bank loans fordevelopment/ commercial mortgages/mortgage debentures:Senior (debt) claims – privatelyheld and traded REITsIssue publicly traded shares,may own underlying assets,LP units by UPREITs,mortgages, CMBS CMBSPublicly traded securitiesbased on a pool of mortgages Initial listing, rights issue,stock split Property derivatives Privateinvestmentmechanisms Traditional Publicinvestmentmechanisms InnovativePublicinvestmentmechanisms Bonds/commercialpapers issued byproperty companies Figure 3.5 Investment mechanisms.White, M., & Tiwari, P. (2014). Real estate finance in the new economy : Real estate finance in the new economy. Retrieved from http://ebookcentral.proquest.com Created from apus on 2020-05-21 07:42:44.

70 Real Estate Finance in the New Economy Kingdom, 30 years ago, the term of the loan coincided with the length of the construction period, but later, lenders have started to look at the loan period up to the first rent review (usually after 5 years of completion of project) as the expectation is that the property would have stabilised and a better value for refinancing or sale could be achieved for owners at this stage. The loan for development is provided by one bank or a syndicate of banks.

In the United Kingdom, which is a market-based system, during the prop- erty boom period of 1980s, property companies were able to assemble a panel of banks with the help of an underwriter who would compete on inter- est rates for an opportunity to lend. Property companies had the opportunity to raise debt finance on very competitive rates from different lenders up to an agreed limit (Lizieri et al., 2001). However, during the 1990s, when the property downturn began, the lending market became very conservative in their lending (Lizieri et al., 2001). These loans from banks are secured on company assets or development project assets and/or other fixed and float- ing charges that borrowers could provide. During 1970s, the interest rates used to be fixed but the interest rate risk for lenders was too high to assume, and hence, these were replaced by floating rates based on London Interbank Borrowing Rate (LIBOR) or some other floating rates plus a margin that banks charged to assume risks associated with the development and the bor- rower (Lizieri et al., 2001). In that sense from the risk perspective, each development project and borrower is different and the interest rates charged to them is different. This is where complication arises, and the importance of a bank-based system assumes importance as banks with relation with borrowers are supposedly able to assess their risks better.

Commercial mortgages represent the senior claim on any cash flow (called senior debt) that is generated by stabilised property (i.e. development is over and property has been let out and is receiving cash flows in the form of rent and other incomes) and provide lenders/investors (typically banks or insurance companies) with fixed tenured, contractually fixed cash flow streams.

Traditionally, the mortgage is a long-term loan (typically 15–25 years tenure) kept as a ‘whole loan’ on the balance sheet of investors to maturity, meaning that it is not broken into small homogeneous shares or units such as corporate bonds that are traded on stock exchanges. However, over the last three–four decades, a number of variants of mortgages have also emerged first in response to the low loan-to-value (LTV) ratio for property lending and the low valuation accorded to property for lending purposes (the practice is that the property is valued on the basis of ‘vacant possession’) and the second the comfort that banks have gained with property investment. As per the Basel Accord, commercial property lending carries full risk weighting, and hence, other types of mortgage instruments have emerged that combine the balance-sheet and off-balance-sheet lending. These mortgage instruments, more prevalent in the United States, take the form of profit sharing mortgages such as participating White, M., & Tiwari, P. (2014). Real estate finance in the new economy : Real estate finance in the new economy. Retrieved from http://ebookcentral.proquest.com Created from apus on 2020-05-21 07:42:44.

Financial Systems, Flow of Funds to Property and Innovations 71 or convertible mortgages. These mortgages are usually more prevalent during weaker markets to unlock more capital for borrowers.

Participation loans, also called equity participation loans, are a combina- tion of loan and equity that a lender take in a project. Though it is called equity participation, but the lender does not acquire ownership interest in the project. Lender’s interest is only limited to the participation in the cash flows, and this participation kicks in only after property has starting gener- ating cash flows (Brueggeman and Fisher, 2008). Lenders receive a percent- age of potential gross income or net operating income or cash flow after regular debt service, as may be agreed for their participation. In return for receiving participation, lenders charge lower interest rates on their loans.

Participations are highly negotiable between lenders and borrowers, and there is no standard way of structuring them (Brueggeman and Fisher, 2008).

A convertible mortgage gives lenders an option to purchase full or partial interest in the property at the end of some specified time period. This pur- chase option allows lenders to convert their mortgage to equity ownership.

Lenders may view this as a combination of mortgage loan and purchase of a call option, which gives them an option to acquire full or partial equity interest for a predetermined price on the option’s expiration date (Brueggeman and Fisher, 2008). Here again, lenders accept a lower interest rate in exchange for the conversion option.

Equity The source of equity capital for property development and asset investment is provided by two types of investors: those who want to actively involve in management and operation of underlying property asset such as property companies (e.g. developers, institutions and high net worth individuals) and others who want to invest in property to diversify their investment portfolios but do not want hands on involvement. A number of mechanisms have emerged to meet the needs of these investors with the needs for equity for property investment. Examples of these passive equity investment mechanisms are units in real estate equity funds such as real estate limited partnerships (RELPs), commingled real estate funds (CREFs) and private Real Estate Investment Trusts (REITs – whose units are not publicly traded); companies; and mutual funds, though passive equity investment mechanisms provide investors with an ownership interests in the underlying asset but give limited governance authority over the assets and are not traded in the liquid public exchanges.

The greater part of the pan-European market is concentrated in non- REIT form including limited partnerships, companies and mutual fund vehicles. REITs are quite popular in the United States. Partnerships are very popular as they allow even the most complex arrangements to be structured through a partnership agreement rather than under a company law (Brown, 2003). White, M., & Tiwari, P. (2014). Real estate finance in the new economy : Real estate finance in the new economy. Retrieved from http://ebookcentral.proquest.com Created from apus on 2020-05-21 07:42:44.

72 Real Estate Finance in the New Economy The fund sponsor for a real estate equity fund is usually an affiliate of a developer or professional investment organisation. The investors generally provide most, if not all, of the investment. The structure of the fund has at least one general partner and any number of limited partners. The general partners, who are the fund sponsors, provide ‘sweat equity’ and have the responsibility for management of partnership assets. They may have a small equity contribution. Limited partners are very restricted in management of a joint venture, and their personal liability is limited. However, limited partners insist on having approval rights over a variety of major decisions ranging from refinancings, sales, leases and budgets to insurance, service contracts and litigations (Larkin et al., 2003). Some funds also have invest- ment committees that include limited partners with role to provide advice to general partners on issues such as conflicts of interest and valuation of fund assets (Larkin et al., 2003).

The legal form of the fund is largely determined by the tax efficiency of the form chosen and familiarity of the fund structure to prospective inves- tors (Larkin et al., 2003). These funds though structured to be tax efficient, are not generally tax shelters, in that they do not attempt to accelerate tax deductions to shelter unrelated incomes (Larkin et al., 2003). The investment objectives of real estate private equity funds can be either capital apprecia- tion or income. The investment cycle varies depending on the strategy of the fund, target assets and needs of the investors. For example, while real estate opportunity funds typically have 2–3-year investment period, 1–2-year monitoring period, a fund organised for acquisition of a typical asset may just have duration of 2–3 years. These funds will typically leverage each real estate investment by borrowing money to finance a portion of the purchase price and securing the debt by granting direct lien on the property assets owned by the fund.

RELPs were popular in the United States prior to 1986 due to tax advan- tages associated with them. Passive investors could offset their other incomes with property (tax) loss from investment in limited partnerships.

With these advantages gone with the Tax Reform Act of 1986, their popularity has declined. Moreover, many of the funds in the United States were organ- ised under the laws of the State of Delaware or tax heavens like Cayman Islands. In Europe, though, there is no one jurisdiction of choice for real estate private equity funds, and the choice of jurisdiction depends on the nature of investors, tax residency of the investor and the likely jurisdiction of the property assets (Larkin et al., 2003).

Another important source of equity capital, in recent times, is the Sovereign Wealth Funds (SWFs). These funds are wholly owned government entities that invest nation’s surplus wealth in broad array of investments overseas. A number of governments, such as Abu Dhabi, Qatar, Kuwait, Norway, Singapore, Australia and China, have floated these funds. SWFs are White, M., & Tiwari, P. (2014). Real estate finance in the new economy : Real estate finance in the new economy. Retrieved from http://ebookcentral.proquest.com Created from apus on 2020-05-21 07:42:44.

Financial Systems, Flow of Funds to Property and Innovations 73 commonly active investors or passive asset managers. Though the asset holding of SWFs is not easily available, their property holdings are about 5–10%. A number of SWFs have taken controlling positions in large property assets (Langford et al., 2009).

Public investment mechanisms Property companies and developers access markets by issuing bonds and commercial paper for debt and through initial public offer (IPO) or rights issue or stock split for equity funding. The problem, however, is that given the risk perceived by the market (arising from concerns about true value of underlying property and cyclical nature of property markets) for investment in property, very few companies are able to issue unsecured debt paper that would obtain the highest ratings. The same problem is faced with the equity offers of property companies. The view is that the property companies are valued on the basis of discounted net asset value. Markets trade property securities at a heavy discount to net asset value (NAV) (due to reasons such as contingent capital gains tax liability, valuation uncertainty, hidden management cost, illiquidity of the underlying asset), which averaged 25% in the long run in the United Kingdom (Lizieri et al., 2001). Property stocks are usually considered as value stock and are also affected by the cyclicity of general stock markets. During the stock market downturn of the late 1990s in the United Kingdom, property stocks performed badly even compared to other value stocks, which led some public property companies (such as MEPC) to delist their stocks and others to buy back shares (Lizieri et al., 2001). A similar trend is observed in India, where large property company stocks (such as DLF, Unitech) are being traded at a heavy discount since 2007, which has led to the postponement of some property companies’ decision to raise equity capital from public markets.

other mechanisms There are some other mechanisms as well through which property is financed. One of them, sale and leaseback, is common and takes many forms. Many non-property companies, whose core business is not property, have owner-occupied properties for their use, enter in a sale and leaseback type of arrangement with property companies. Non-property companies sell the ownership interest in the property to a property company and take long- term lease on it. The reason for entering in such an arrangement is that it allows them to free up financial resources locked in property for their core business, trim down their balance sheet by reducing asset size and also gain from tax shield as lease payments are expenses for tax purposes. From the perspective of the market as well, non-property companies that hold too White, M., & Tiwari, P. (2014). Real estate finance in the new economy : Real estate finance in the new economy. Retrieved from http://ebookcentral.proquest.com Created from apus on 2020-05-21 07:42:44.

74 Real Estate Finance in the New Economy much of property assets face problems. The asset value of their properties may not be fully reflected in company’s market capitalisation. For a number of major retailers, a big problem is that their property assets are valued far in excess of the retailers’ market capitalisation, posing a threat of takeover and asset stripping. The problem is further complicated for companies whose required rate of return is higher than what property can (notionally) generate. These would motivate companies to unlock the capital from property assets.

Another form of sale and leaseback is where the property company sells the completed development to an institution and takes long-term lease. The company expects to gain from profit rent from subletting. The risk and profit sharing structure between the institution and the property company varies from a fixed rent to an agreed sharing of any rental uplift (Lizieri et al., 2001). Another type of financing arrangement that exists is the sale and leaseback of land. These are done to increase the proportion of financing in a development project. The land is sold to an investor and is leased back.

Here, the developer/investor owns the building and leases back the land from another investor. By doing this, 100% financing of land is obtained and the building is financing on usual lender’s property finance loan terms.

Innovations The major innovations have been around the development of public invest- ment vehicles for investment in property asset class. These have taken the form of asset-backed securities (ABS), commercial mortgage-backed securi- ties (CMBS), REITs and property derivatives. While ABS and CMBS are debt vehicles, REITs are equity investment vehicles.

In ABS or CMBS, the issuer, usually a special purpose vehicle, offers bonds or commercial paper to the capital markets. Cash flows from a single or a pool of property assets (such as rental income or loan repayments) is used to pay the coupon and capital redemption payment on the bonds or commercial paper. Some charge on underlying property assets provides security against default. The mechanism of CMBS is briefly discussed in Appendix 4.1.

There are several advantages to a lender from CMBS and to a firm from ABS. By securitising loans (in case of CMBS) or rental income and value streams (in case of ABS), the exposure to specific risk associated with prop- erty reduces. For lenders, the securitised loan portfolio moves off their balance sheet, thereby improving their capital adequacy and solvency ratios. For firms, ABS allows them to raise capital secured on value and income stream of their property assets while retaining the ownership.

Issuing ABS or CMBS on public markets allows firms and lenders to tap a new source of capital. In case of CMBS, there are also opportunities to earn White, M., & Tiwari, P. (2014). Real estate finance in the new economy : Real estate finance in the new economy. Retrieved from http://ebookcentral.proquest.com Created from apus on 2020-05-21 07:42:44.

Financial Systems, Flow of Funds to Property and Innovations 75 profits from arrangement and service fee and from the spread between the interest on loans and coupon payable on bond or commercial papers. For firms, ABS is a cheaper source of borrowing. The cost of these borrowing could further reduce as in case of tenanted properties, the rating of the bond depends on the tenant covenants rather than the rating of the firm issuing securities.

There are a number of advantages to investors too. They are able to gain exposure to a market that faces huge entry barriers and high transaction costs.

Investment in securities allows them to benefit from liquid and marketable nature of this asset. Moreover, since the underlying asset is a pool of loans or pool of properties, the specific risk to an investor reduces. It is also claimed that for ABS or CMBS, the transaction, monitoring and management costs for an investor are lower than those associated with investing in direct property.

These advantages, however, come at a cost. ABS or CMBS reduce the flex- ibility for the issuer in managing their securitised portfolio. There are also costs associated with arrangement, underwriting, rating and credit enhance- ment of a bond or commercial paper.

Lizieri et al. (2001) argue that asset-backed securitisation offers further potential for innovation, which could be explored. Underlying any lease, there are three sources of cash flows. The first is base rent, which given strong tenant covenants is a secure stream of income. The second is the possibility of a rental uplift at the time of rent review (in the United Kingdom where lease agreements specify upward-only rent revisions at the time of rent reviews, the possibility of rental uplift are far more secure compared to the United States where rent revisions are linked to the prevailing market conditions). This stream of income would appeal to certain investors who have larger appetite for risk but would require a higher return. The third class of cash flows arises from the fact that property has a residual value at the end of the lease which is still more speculative investment but would appeal to certain investors. These income streams could be sold to investors as income strips. The first, which is based on base rent, would attract institutional investors. There is a role for brokerage in the development of this market. Initial costs may be high due to costs involved in structuring these products and legal fees.

REITs, discussed briefly in Appendix 4.1, provide tax-efficient vehicles for equity investment in property. These allow subdivision of ownership of single property or developments.

The development in property derivatives has been slow partly due to lack of transparency and infrequent data. In the United Kingdom, over the last few years, property derivatives based on IPD income return and capital growth have emerged. These derivatives, one called Property Index Certificates and the other called Property Index Forwards, are synthetic investment vehicles offering opportunities for low-cost exposure to property market.White, M., & Tiwari, P. (2014). Real estate finance in the new economy : Real estate finance in the new economy. Retrieved from http://ebookcentral.proquest.com Created from apus on 2020-05-21 07:42:44.

76 Real Estate Finance in the New Economy Economic assessment of investment mechanisms The focus of this section is on the role that private and public innovative investment mechanisms such as sales and leaseback, asset and mortgage- backed securitisation and REITs have played in financing property. Chapter 4 shows that the flow of funds to property through public markets using securitisation and REITs has increased substantially over the last 20 years. A number of these innovations, though originated in the United States, have been exported to other economies. However, how well have these instruments been able to overcome the limitations of property asset class (namely, lumpy investment, inelastic supply in the space market, infrequent transactions, huge transaction cost, information asymmetry, a somewhat rigid valuation system that does not allow innovations such as in lease terms, huge specific risk associated with investment in direct property) that lead to inefficiencies in the market and create opportunities for investors and property companies and strike a balance between the risk and return for investors with the relatively lower-cost funding for property companies compared to traditional secured debt and equity needs to be examined. The efficient market hypothesis would suggest that if markets are efficient, then there are no opportunities for any abnormal gains. In that context, innovative mechanisms serve to rebalance the risk and return in any transaction or help in addressing sources of inefficiencies in the market, should they exist.

Lease financing The growth in lease financing instead of financing property ownership by companies has been phenomenal over the last four decades, and this has largely been due to tax shield that lease financing provides. Three arguments that are often put forward in favour of lease financing are that (i) it provides 100% financing of space, (ii) it ‘finances’ property asset off balance sheet and (iii) it is beneficial from the taxation point of view. Sale and leasebacks are special case of lease financing. With these oft-cited benefits, it is expected that lease financing allows companies to unlock value from property assets.

However, this may not always be possible.

The argument that the lease financing provides 100% financing for space required by the company is flawed. While it is true that the capital required for lease transaction is lower than required for ownership, the two transactions are not comparable. Rental payments are fixed only in the short term and at all time have higher claim on the cash flows of the company than some other expenses. This poses a significant risk if the lessee becomes financially constrained. Thus, the liability for rental payment for lessee is White, M., & Tiwari, P. (2014). Real estate finance in the new economy : Real estate finance in the new economy. Retrieved from http://ebookcentral.proquest.com Created from apus on 2020-05-21 07:42:44.

Financial Systems, Flow of Funds to Property and Innovations 77 equivalent to liability on a bond or debt (Lizieri et al., 2001). Moreover, when an investor buys a property, she acquires working space and an investment in performance of property market relative to her business performance. Besides claim on the future stream of rents, other sources of value accrue to the investor. These additional sources of value arise because property has reversionary value after the expiry of lease term and also has the option to redevelop before completion of lease attached to it (Lizieri et al., 2001). These options have value if the rents and yields are more variable, and these options would rise or fall in value depending on the relative performance of property market relative to tenant’s own business performance. However, given the risk of owning a building and its management, non-property occupiers may be less keen to finance the property than specialist property investors.

The second argument that leasing finances property assets off balance sheet needs more investigation. It is right that leasing does not appear on the balance sheet of a company as loan does, but does it have an impact on the value of the company is not clear. From the perspective of financial risk for a company, the higher the gearing (debt), the more is the equity risk.

However, if the company replaces debt (for purchase of property) by another expense that is not on the balance sheet and appears only on the profit and loss account (lease payments) but has a higher claim on cash flows, would it lower the risk of equity? A stream of research (see, e.g. Dhaliwal, 1986; Ely, 1995; quoted in Lizieri et al., 2001) has argued it otherwise. These operational leases are sticky and have the same effect as debt on equity risk. In fact, the equity risk is better estimated after taking into account the effect of operating leases, and the underlying market ‘true’ value of a company does not depend on whether or not the cost of space is disclosed in balance sheet or profit and loss accounts.

The tax advantage associated with leases is only marginally more than debt as the interest payment on debt is also an expense from tax point of view in the profit and loss statement. The level of gearing possible in a pur- chase of a building would, however, determine the extent to which interest can be claimed as an expense. This advantage loses its value if the company is a tax-exempt entity. There is though a demand side perspective. There are many institutional investors (such as pension funds, insurance companies) who seek asset with long duration of maturities and are constrained from investing in equities or other volatile securities (Lizieri et al., 2001). These investors would constitute the demand side for assets which could be long leased to companies.

If lease financing does not add value per se, then any value add from such deals would have to come from mispricing, which then would mean that some would gain and some would lose.White, M., & Tiwari, P. (2014). Real estate finance in the new economy : Real estate finance in the new economy. Retrieved from http://ebookcentral.proquest.com Created from apus on 2020-05-21 07:42:44.

78 Real Estate Finance in the New Economy Asset-backed securities The argument in favour of ABS is that these mechanisms, which are secu- red by income or value of the underlying portfolio of property assets, can (i) reduce the cost of borrowing for the company issuing these securities compared to secured debt because the rating of securities is on the strength of tenants occupying the property and not the corporate owning the assets, (ii) increase the leverage on property assets than the LTV that lenders would offer, (iii) allow investors to diversify into property without the need for taking full ownership of the property, (iv) offer better returns than an equivalent-rated corporate bond and (v) limit the exposure to single asset or borrower for an investor.

The clear advantage of securitisation is that it permits the risk to be spread over a range of investors, and the relatively low cost of each security permits investors to take exposure to a portfolio of property assets and hold it in their portfolio. Investors who would have faced market barriers in investing in property can gain exposure to property lending market. Since these inves- tors do not face specific risk associated with property, the required return from their investment in these securities is lower. This may put downward pressure on interest rates on ABS.

The advantage to a company that securitisation reduces the weighted average cost of capital as the coupon payment on securities is lower than the interest on a loan is debatable. The aforementioned claim is based on the argument that these securities receive ratings on the strength of ten- ants which are better than company’s itself and hence are rated higher.

This reduces the coupon demanded by investors. However, the impact of the price of securities on company’s valuation is not that straightforward.

Since these securities are traded in the secondary market, their price at any given point in time depends on the risk–return profile perceived by the market for holding these securities, which continually changes. From this perspective, issuing securities exposes the company far more to the scrutiny by the market, which has its own advantages and disadvantages.

Moreover, the debt that was secured on the company as a whole is assessed on the basis of the quality of the overall rental cash flow to cover interest payments and on the value of underlying property assets as security in the event of default. However, the creation of security ring fences certain good properties through mortgages and subsidiary structures for asset- backed securitisation, which undermines the quality of remaining cash flow for the company (Lizieri et al., 2001). Hence, the benefits for the company from claimed reduced cost of borrowings are not that straightforward.

On one hand, asset-backed securitisation may lead to financing flexibil- ity; on the other hand, it could lead to inflexibility in occupiers market. White, M., & Tiwari, P. (2014). Real estate finance in the new economy : Real estate finance in the new economy. Retrieved from http://ebookcentral.proquest.com Created from apus on 2020-05-21 07:42:44.

Financial Systems, Flow of Funds to Property and Innovations 79 Long leases, upward-only rent reviews as in the United Kingdom, senior claim on company’s assets, have has led to superior ratings for a number of issues but this has hampered the development of flexible occupier market with leases that are shorter and have break clauses and innovative rent fix- ing arrangements. There is a counter view too. In the United States, leases are short, there is flexibility in rent fixation, and leases are tenant favouring, but the growth of asset-based securitisation market is no less. In the United States, it is argued that investors also focus on the quality of buildings besides the strength of the lease.

While securitisation allows property companies to increase their gearing, it comes at a cost. With high leverage, equity investors demand higher returns as their risk increases. Moreover, securitisation poses constraints on company’s operations as securitised assets can be disposed off or their uses are changed easily.

Mortgage-backed securitisation Mortgage-backed securitisation allows originating banks to access new sources of capital. The risks which in traditional debt structure are borne by one lender are spread over a large number of investors. Another source of risk diversification happens due to the pooling of a large number of property loans in a CMBS structure, which reduces the specific risk associated with one property for investors. Investors can gain access to property markets which were previously subject to entry barriers, lack of information, illiquidity and high transaction costs. The rating agencies play the role of market makers as they rate mortgage-backed securities on the same risk parameters as they would for a corporate bond. The behaviour of rating agencies has, however, been criticised heavily after the subprime loan crisis in 2007 discussed in Chapter 6. A number of authors argue that rating agencies did not price the risk appropriately due to moral hazard problems, and others argue that risk was difficult to price as sufficient time series of data covering more than one property cycle was not available.

Given that mortgage-backed securities allow risk diversification, the cou- pon demanded by investors on these securities is lower than the interest charged on individual loans. Lenders being aware of securitisation would reduce the interest charged to borrowers. Kolari et al. (1998) estimate that for every 10% increase in securitisation as a proportion of origination, the spread on home loans declines by 0.2%. In case of CMBS, the spread over risk-free rate had contracted phenomenally until 2007. However, after the 2007 subprime crisis, the spread on CMBS rose sharply and delinquencies have increased substantially (Figure 3.6).White, M., & Tiwari, P. (2014). Real estate finance in the new economy : Real estate finance in the new economy. Retrieved from http://ebookcentral.proquest.com Created from apus on 2020-05-21 07:42:44.

80 Real Estate Finance in the New Economy REITs REITs have been able to channelise retail funds into property equity (see Appendix 4.1 for a brief description of REITs). The growth and acceptance of REITs worldwide indicates the potential of this mechanism in channelising funds for property investment. Since REITs are traded on public markets, any market information gets quickly reflected in the price of the security.

The problem, however, is that the NAV or the underlying portfolio is deter- mined through conventional valuation in the direct property market. 0 1 2 3 4Percent 5 6 7 8 9 Jan-99 Jan-00 Jul-99 Jul-00 Jan-01 Jul-01 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Figure 3.6 US CMBS 2004–2008 vintage delinquencies. Source: Reproduced by permission of RREEF (2010). 1996 1998 Premium/discount to NA V 2000 2002 2004 2006 2008 2010* 1990 –60 –40 –20 0 20 40 1992 (Percent) 1994 Figure 3.7 REIT premium or discount to NAV in the United States. * indicates estimate. Source: Reproduced by permission of RREEF (2010).White, M., & Tiwari, P. (2014). Real estate finance in the new economy : Real estate finance in the new economy. Retrieved from http://ebookcentral.proquest.com Created from apus on 2020-05-21 07:42:44.

Financial Systems, Flow of Funds to Property and Innovations 81 A number of studies indicate that the indirect property market (securities traded on the public markets) leads the direct property market. The result is that REIT securities are traded either at a premium or discount (Figure 3.7).

The disagreement on value between the direct and indirect market also offers opportunities for arbitrage.

Impact of new investment mechanisms on business culture and practices Arms length (market) versus relationship (bank based) One of the major criticisms of public investment mechanisms is that they are arms-length deals. They shift the responsibility of monitoring and management of asset cash flows to the market. The financing is done by the market, and banks are merely conduits between investors and inves- tees. Investors in the public market have rather short-term perspective than those who invest in direct property. In public markets, credit rating agencies play a crucial role. However, the experience of 2007 subprime crisis indicates that failure could happen on part of credit rating agencies (Chapter 6).

One major risk with property is the large lot size of most commercial property assets, which, along with property heterogeneity, exposes lenders to high level of specific risk. Loan syndication though allows for sharing of risks among lenders, reduced monitoring and due diligence costs but also exposes them to another risk, counterparty risk. This risk arises because of the reduced level of due diligence that banks in a syndicate undertake, each assuming that others would have done detailed loan appraisal and risk anal- ysis. During strong markets, the tendency to do detailed risk analysis by participating banks in a syndicate is far more less.

Caution in lending has led to cyclical trends in property lending. During strong markets, competition among banks leads to compression in interest rates, high LTVs on already inflated valuations and lax due diligence.

Precisely, the reverse happens during weak markets.

Cultural impediments The new market-based mechanisms for investment in property may conflict with the business culture. For example, the first asset securitisation in Japan was in 1994. Three years after, in an attempt to encourage securitisation, regulators in Japan amended trust and special purpose corporation laws that addressed tax and commercial code hurdles.

These changes cleared the way for establishment of privately placed bonds backed by property and for debt collateralised by property (Feder and Kim, 2002). Despite these changes, the development of securitisation market in White, M., & Tiwari, P. (2014). Real estate finance in the new economy : Real estate finance in the new economy. Retrieved from http://ebookcentral.proquest.com Created from apus on 2020-05-21 07:42:44.

82 Real Estate Finance in the New Economy Japan has been slow. A major reason for slow development of securitisation market is the cultural impediments that prevent financial institutions from fully embracing securitisation. Japanese law requires that obligators be notified of loan assignments (Feder and Kim, 2002). However, financial institutions are unwilling to notify debtors that their loans have been assigned since they believe that this would embarrass their clients and would also damage the banking relationships.

The due diligence process that goes with new mechanisms also faces cul- tural barriers. Loans and customers verification on phone or face-to-face meetings as in the United States is seen as an invasion of privacy in Japan.

Bankruptcy and dealing with it is also viewed differently in Asia (Feder and Kim, 2002). Culturally, Asians view bankruptcy as a personal failure, which causes problems in taking corrective actions. Instead of letting the bankrupt entity fail, governments and courts in Asia have tried to keep them alive, often by asking banks to restructure loans rather than foreclose, at the cost of economic recovery.

Another cultural impediment that comes in the way of mechanisms such as sale and leaseback, particularly in Asia, is that companies are reluc- tant to sell their property assets as this is viewed as a sign of weakness or even failure.

Valuation practices Valuation practices prevalent in different markets cause impediments for the development and adoption of new mechanisms. As has been discussed earlier, valuation practices have hindered innovations in lease structures. There are differences across markets as well. For example, while valuers in Western countries value assets on the basis of discounted cash flow method, that is, the return rate generated from properties, the valuation approach used in many Asian markets is very different. In Japan, there is a practice of government notifying official land values, which is used in valuation by banks and landlords (Feder and Kim, 2002). This leads to substantial differences in the valuation arrived at by using discounted cash flow methods and alternate practices used in some markets.

Conclusions To summarise, the chapter presented a nontechnical overview of the mechanisms through which property is financed. The evolution of these mechanisms, either bank based or market based, depends on the inves- tor requirements as well as the institutional and regulatory framework within which financial systems operate. In any economy, both bank-based White, M., & Tiwari, P. (2014). Real estate finance in the new economy : Real estate finance in the new economy. Retrieved from http://ebookcentral.proquest.com Created from apus on 2020-05-21 07:42:44.

Financial Systems, Flow of Funds to Property and Innovations 83 and market-based mechanisms are available to channelise funds from investors to property asset class. A range of investors (households, institutional investors, corporations, unregulated investors) through intermediaries (mutual funds, security dealers, banks, ABS, REITs, private equity, sovereign funds) and various investment mechanisms invest in property.

The innovation in property investment has been in the lease financing and development of public markets for property asset through ABS, CMBS and REITs. In addition, property derivatives have also come up recently. The discussion in the chapter suggests that some of the oft-cited advantages of these mechanisms are unfounded. The contribution of these mechanisms though has been in widening the space of investment in property. Advantages to investors associated with innovative mechanisms depend on their individual circumstances.

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