Consequences of selected Basel III regulations for real estate developers

Table of Contents

Index of Illustrations

Index of Tables

Index of Appendices

Index of Abbreviations

1 Introduction
1.1 Problem Definition
1.2 Objective of the Thesis and Methodology

2 Real Estate Project Development - Business Model, Financing Instruments, German Market Conditions
2.1 The Business Model of Developers
2.1.1 Classification of Real Estate Developers
2.1.2 The Process
2.1.3 Sector Types
2.1.4 Real Estate Entities
2.2 Real Estate Development Financing
2.2.1 The Capital Stack
2.2.2 Alternative Capital Sources
2.2.2.1 Joint Venture
2.2.2.2 Closed Funds
2.2.2.3 Project Bonds
2.2.3 Project Valuation
2.2.4 Funding a Project
2.3 Real Estate Market Conditions in Germany

3 Basel III - Framework and Relevant Elements for Real Estate Developers
3.1 History of the Basel Capital Accord
3.2 Description of the Basel III Framework
3.3 New Elements in Basel III
3.3.1 Raising quality of capital base
3.3.2 Strengthening the Risk Coverage
3.3.3 Leverage Ratio
3.3.4 Capital conservation buffer
3.3.5 Countercyclical buffer
3.3.6 Systematically important financial institutions
3.3.7 Liquidity standards

4 Consequences of specific Basel III regulations on Real Estate Developers
4.1 Methodology of the Analysis
4.2 Analysis of the Consequences
4.2.1 Senior Loan
4.2.2 Equity Capital
4.2.3 Mezzanine
4.2.4 Joint Venture
4.2.5 Closed Funds
4.2.6 Project Bonds
4.3 Case Study - Project Financing of a Real Estate Developer
4.4 Recommendations

5 Conclusion and Outlook

Bibliography

Appendix
Appendix A: Questionnaire Loanees
Appendix B: Questionnaire Lenders

Index of Illustrations

Ill. 1: Return, Absorption, and Risk Characteristics of Real Estate Sectors

Ill. 2: Example of Leveraging for a Project

Ill. 3: Development Project Typical Sources of Investment Capital

Ill. 4: The Capital Stack

Ill. 5: Financing Structure with a Joint Venture Partner

Ill. 6: Development Project Phases: Typical Cumulative Capital Investment Profile and Investment Risk Regimes

Ill. 7: The Showing Rental Prices from 2006 to 2012

Ill. 8: Typical Yields Proceeding Up the Capital Stack with Increased Risk

Ill. 9: Financing components related to return, risk and control rights

Index of Tables

Table 1: Framework Data of Regentum

Table 2: Financing Costs of Construction Phase 1

Table 3: Total Investment Costs of Construction Phase 1

Table 4: Financing Costs of Construction Phase 2 with 20% Mezzanine

Table 5: Total Investment Costs of Construction Phase 2 with Mezzanine

Table 6: Financing Costs of Construction Phase 2 with 10% Mezzanine and 20% Joint Venture

Table 7: Total Investment Costs of Construction Phase 2 with Joint Venture

Table 8: Comparison of Scenarios

Index of Appendices

Appendix A

Appendix B

Index of Abbreviations

illustration not visible in this excerpt

1 Introduction

1.1 Problem Definition

The high leveraged American real estate investment market dominated by specula- tors, brought about a global financial crisis of epic proportions in 2008. The global financial recession, which followed, highlighted a gloomy rate of interdependence in the banking world. It exposed the tight interconnection of the American real estate market and the structures of the global financial market (Panagopoulos et al. 2009, 4).

In December 2010, the Basel Committee on Banking Supervision published the report ''Basel III: A Global Regulatory Framework for More Resilient Banks and Banking Systems'' which will be implemented gradually across the European Union (among others) between 2013 and 2019 and supplements the existing International Convergence of Capital Measurement Document (Basel II) which was implemented in 2008 (Basel Committee on Banking Supervision, 2013).

The reformed capital and liquidity requirements for banks, Basel III, is a response to the global financial crisis and represents a substantial step forward from its predecessor regime, Basel II which already based credit costs on the degree of risk. One of the most significant outcomes of Basel III will be the enormous rise in the banking industry's capital requirements and the rise in lending as well as borrowing costs (Basel Committee on Banking Supervision, 2013).

Real estate developers heavily depend on debt capital for their projects and partake usually only with a small amount of equity capital in a project. If the access to bank loans will be limited or restricted in the future, developers will have to adapt their fi- nancing model to the new market conditions and challenges posed by Basel III and take other financing alternatives into consideration in order to decrease dependence on bank loans (Drucker, 2012).

Other financing alternatives might also gain attraction if senior loans become more restricted or the securities or the equity required by the bank increase so much that the return on investment of real estate developers will make investments unprofitable or they might not able to provide these securities. They might not know how to pro- ceed and restructure their financing model adapting it to a lower amount of senior debt. The increased loan documentation due to Basel III might take so long that the developer will not be able to realize the project viably anymore due to fast changing market conditions (Drucker, 2012).

The purpose of this paper is hence to answer the question of: How some Basel III regulations might affect the traditional financing model of real estate developers and how real estate developers can respond and adapt to possible new financing condi- tions.

1.2 Objective of the Thesis and Methodology

The aim of this thesis is to find out which elements in the financing model of real es- tate developers are affected by selected Basel III regulations and how they might change and impact the capital structure of development projects in the future causing may be also the creation and consideration of alternative capital sources for real es- tate projects.

In order to achieve the aim of the thesis, I first clarify how real estate projects are currently financed and how the overall business model of real estate developers functions. My central questions therefore focuses on ''how are real estate projects currently financed and which components play a crucial role in it?'' The Basel Capital Accord is introduced strengthening the new elements in Basel III in order to determine which elements matter for project financing.

The analysis starts by determining which components in the current financing model of real estate projects will be impacted by some of the new elements in Basel III. The impact on these financing components will then be analyzed by looking at how a change in some components might influence the other components and how the other components possibly shift and might gain new importance and attraction. I will focus on questions like ''how do some elements in Basel III impact the financing model of real estate development projects?'' ''Which financing components will shift due to Basel III?'' and ''how can developers adapt their financing model to the new condi- tions?''

To clarify the current challenges, facing developers when financing projects, and possible solutions for it, a case study is presented assuming a reduction in senior loan. Recommendations regarding the economically best possible option available to developers nowadays are given. The aim is to answer the question of ''which alterna- tive options are available to a developer when the senior loan is reduced and has to be partly replaced by a financing alternative assuming that the developer is not able or willing to invest the enormous amount of equity required?'' Three different scenar- ios including different financing instruments are depicted and evaluated to determine the economically best solution for the developer. Hence, the question is ''which capi- tal structure with distinct financing instruments is the most attractive for the develop- er for this particular project?'' In the recommendations, I pursue giving general ad- vices for developers who are confronted with the problem of a reduction in senior loans anwering the question '' wich financing options are available to a developer and how should he proceed to find the best solution for financing a project?''

Six interviews with loaners and loanees were conducted in form of a qualitative re- search so that I can compare the theoretical findings from literature to practical expe- riences from these professionals. The results are integrated into the according para- graphs in order to strengthen my theoretical arguments with practical experiences from professionals.

This research paper follows a deductive approach. Following the introduction, the 2nd chapter introduces the real estate development business model including the three types of developers, the stages of the process of a project regarding cost, time, tasks and risks as well as the sector types of real estate and real estate entities. In the next part of this chapter, the financing structure of a development project is covered. The different capital sources ranging from senior loans to equity capital are dealt with and shown in the ''capital stack''. Alternative capital sources like joint venture, closed-funds and project bonds are explained. The valuation of a development pro- ject that ensures financial viability of the project is discoursed as well as project funding. Following, the market conditions for real estate development in Germany are examined regarding political, social and economic factors to determine in which environment developers are operating and which external influences should be con- sidered.

In chapter 3 the Basel Capital Accord is explained putting an emphasis on Basel III and the new included elements.

In Chapter 4 some new regulations are selected and discussed regarding to what ex- tent they may influence the financing structure of real estate development projects. Possible new and current components in the financing model of real estate develop- ers, which were introduced in the second chapter, are analyzed as well as their future development and importance in the overall financing model of development projects.

The case study in chapter 4 shall demonstrate the arising difficulties that face real es- tate developers when financing with a bank in accordance with Basel II and Basel III. Therefore, some possible financing alternatives replacing partly the senior loan and internal equity capital are presented and the effect on the return on equity for the de- veloper is calculated. Recommendations and possible solutions for financial gaps in the capital structure of development projects are concluded and discussed. The re- sults from a qualitative research are integrated in the according paragraphs in chapter 4. The last chapter will include a conclusion and an outlook.

2 Real Estate Project Development - Business Model, Financing Instruments, German Market Conditions

2.1 The Business Model of Developers

Real estate development is a multifaceted business that requires various activities in order to convert an idea into a finished project. The completed project is the result of a process that involves all the stakeholders and the developer continuously pursuing equilibrium of joint objectives. As Graaskamp states: ''Real estate development is the common ground of developers, consumers, and communities: Equilibrium is reached through appreciation of joint objectives rather than confrontation and pursuit of total victory'' (Graaskamp, 1991).

A successful project development combines the factors of site, idea and capital in such a way that microeconomic competitive, job-creating and job-saving as well as macroeconomic socially compatible and environmentally sustainable real estate ob- jects can be created and used durably viable (Diederichs 2005, 5-6). But project de- velopment does not mean necessarily that a new building was created. It can also be an existing building that is revitalized, a so-called ''Re-Development'' (Schäfer et al. 2007, 123).

Most development projects can be characterized as either 'A use looking for a site' or 'a site looking for a use'. When the use is looking for a site, the developer has a par- ticular specialization like building shopping malls and has to find an adequate site for this use (Peiser et al. 2012, 9). It is also possible that the developer is working for a specific user like a big company and is in charge of building their new headquarter but has to find a site for the building. So the type of development is already known but the location to pursue the project has to be determined considering the question of the cost and the level of usage demand and competition at any given location. These projects are also called ''build-to-suit'' projects. They are often a crucial part of the business of retail firms, which tend to work with property developers who are specialized in retail development. If the site is looking for a use, the developer al- ready controls the site. But a highest and best use (HBU) study has to be conducted in order to find out what should be built on the site (Frej 2003, 7). It is also common that developers buy land when it is cheaper and wait until the site is ready for devel- opment (Geltner et al. 2010, 123-145).

2.1.1 Classification of Real Estate Developers

Real estate project developers can be classified into three different types with specific characteristics. There is the service, trader and investor developer.

The trader developer creates value by providing usable space over time aiming at selling a completed or redeveloped real estate project. He takes high risks since he is personally in charge of the project and invests own equity capital.

The service developer works on a service contract basis with institutional investors like real estate public companies, pension funds or insurance companies. They invest their capital but their core competence is not real estate development. So the institutional partner hires the service developer on a fee-for-service basis and keeps 100 percent of the profit when the project is completed.

The developer only provides his local expertise and project management know how. This revenue model is less lucrative than that of trader developers and it requires changing the style of operation but for undercapitalized developers it may be a solu- tion to stay in business. The investor developer starts a project in order to rent it after completion and to keep the property in his portfolio. He does not aim at selling the property in the end like a trader developer does (Miles et al. 2007, 8-10).

2.1.2 The Process

The development process demands increasing amounts of investment capital at risk over time but the investment risk decreases with the process of completion as the certainty of finishing the project successfully grows.

A development process can be separated into three stages of development. Each stage includes different tasks and risks. The predevelopment phase has the highest risk of loss and requires 5 to 15 percent of the project costs. During this phase the most important decisions are made in order to create a high value project. The devel- oper selects a site, conducts a feasibility study that considers time, costs, the project- ed sales value as well as the profit margins. If the property is viable he acquires the suitable piece of land, visualizes and designs what type of property and how many units can be constructed. He gets quotes from builders, secures financing commit- ments from lenders and investors and submits detailed plans to the local council to show that they conform to local council requirements and building regulations to ob- tain an approval of building permit. Marketing actions also start now in order to pre- let as much area as possible, which makes it easier to obtain a loan or find an inves- tor. The predevelopment stage shapes what occurs in later phases (Schäfer et al. 2007, 119).

The development phase requires the highest costs with 80 to 90 percent of the project costs for the construction. The success depends largely on the quality of the work done in the predevelopment phase. Once the construction phase has started, the pro- ject developer has to supervise, control and monitor the construction process. The role of the developer is to manage the entire real estate development process and to coordinate all participating actors like architects, engineers, investors, financial insti- tutions, public authorities, contractors and construction companies while always tak- ing into account the time and cost management (Frej 2003, 37-44).

As with any big financial investment, there is always a high risk associated with the task of real estate development. The aim of every real estate developer is to spread the risks and lower the impact as much as possible. Nevertheless many risks remain even after the construction phase has started.

The primary risk factors are the construction risk, capital market risk and pricing risk. The construction risk contains the risk that the cost of materials may change significantly from the original construction and also that the planned construction termination is not finished in time due to the weather or material delivery delays for example. The capital market risk is the risk that interest rates raise during the development process, which affects construction costs and the cost of financing. The pricing risk contains the risk that rental rates will be negatively affected by changes in market dynamics (Schäfer et al. 2007, 121-123).

The close-out phase takes place after the completion of the project and requires 5 to 8 percent of project costs. It includes tasks like marketing, selling and leasing. But the- se activities depend on the sector type, size and capital funding requirements of the particular project. Some projects have to be presold or preleased for capital funding sources while others can be build on speculation and marketed as a completed pro- ject. The close-out phase aims at minimizing the time and capital costs from con- struction completion to lease-up or sale by preleasing or presales before construction is finished. The most common exit strategy is selling the completed building to an- other so called end investor in order to make profit and to regain the equity capital invested to reinvest it in a new project. Only well capitalized developers are able to keep the real estate in the portfolio ensuring a stable cash flow from the rental reve- nues (Held 2010, 99-134).

2.1.3 Sector Types

The risks and returns of projects depend on the sector type of a project. A retail project for example requires usually preleasing commitments from major tenants before construction can start. After a certain prelease rate, investors are rather willing to invest in the project, as they perceive the risk to be reduced. Banks even demand a certain prelease rate for these projects.

These different risk profiles and absorption characteristics show that the capital for a project is invested for different periods of time at different levels of risk. Therefore, different real estate sectors have different return-on-investment parameters (Long 2011, 16).

Ill. 1: Return, Absorption, and Risk Characteristics of Real Estate Sectors (Long 2011)

2.1.4 Real Estate Entities

Real estate developers usually set up a project development entity in form of a lim- ited liability company (GmbH). Each project will be one entity so that the developer can sell one project as a GmbH to an end investor when the project is terminated and can realize the sales proceeds tax-free according to the tax reform in Germany in 2002. Taxes are one key factor that affects the way development entities are orga- nized. One primary concern is the avoidance of the double taxation of profits, which can occur when corporate profits are taxed, and the dividends to shareholders are al- so taxed. A GmbH has the advantage that it is a non-taxable entity. Another key fac- tor is the personal liability. A GmbH limits the recourse to the parent firm or firms. Usually the members and managers of a GmbH are not personally liable for caused debts and obligations. A member's liability is limited to the amount contributed. Creditors may therefore not be able to recover any amount of claim from a member's personal assets if the GmbH's assets are not enough to cover it. Additionally having a separate entity for a project is advantageous in case a joint venture partner partici- pates in this particular project. It has no restrictions on investors' participation in the management. A GmbH has also streamlined governance provisions (Müller et al. 2011, 155-158).

The project developer charges a monthly project management fee to each GmbH in order to cover his fix costs like salaries. These fees become part of the overall devel- opment costs.

The tax benefits, the flexibility, the limited liability, the streamlined governance and the owner’s participation in management make a GmbH very attractive for project developments (Frej 2003, 13).

2.2 Real Estate Development Financing

2.2.1 The Capital Stack

Real estate development financing contains two basic elements: debt and equity. Debt financing receives a return based on fees and an interest rate, which can be fixed or variable. It has a senior position in the financing ''capital stack'' to equity capital and is secured by the underlying real estate. The lender can foreclose on the property receiving ownership of the pledged real estate in case the owner fails to pay debt service. Lenders require underwriting criteria like a fixed loan-to-value (LTV), loan-to-cost (LTC), interest coverage (ICR), or a debt service coverage (DSCR) ra- tio. This limits the percentage of project cost that they will fund. These covenants in the lending contract require that the developer perform in an agreed way. In case the project stops performing well enough to pay its debt service, lenders can gain full ownership of the project including equity investor’s value (Peiser et al. 2012, 126- 128).

In a usual real estate development project, debt funds from 50 to 80 percent of pro- ject costs and equity provide the rest. Debt financing for a project occurs in two stag- es, construction loans and permanent loans. Construction loans are ''acquisition, de- velopment, and construction'' loans also called ADC loans. They are short-term and usually adjustable rate loans tied to the prime rate. They often demand guarantees se- cured by recourse to the developers' assets. ADC loans are mostly used for construc- tion and provided by banks on a percentage of project costs. Permanent loans repay outstanding construction loans based on the lender's underwriting criteria and have a fixed or adjustable rate. They are usually non-recourse and have only the property value as security (Long 2011, 41).

Senior loans by banks are letters of credit, which are recourse loans requiring collat- erals like personal guarantees from the developer and have tight covenants. They are rigid and have extremely structured amortization schedules with relatively short ma- turities like mostly up to three years for privately held companies. This is caused by the refinancing risk of banks. Besides the developer has to pay periodic interest payments. They create tax-benefits as they can be recorded as expenses on the income statement (Geltner 2006, 299-304). Bank loans are the least expensive capital with interest rates between four to seven percent without receiving any control rights in the project. There is no equity dilution (Long 2011, 30-42).

Equity financing receives a return based on project performance. It is subordinated to debt capital and participates on the projects profit, which is distributed hierarchically in a ''waterfall'' to the different equity investor ''pools''. Each ''pool'' has a different rate of return and position in the capital stack. Equity financing has a higher risk than debt financing but higher returns, which makes it also more expensive for the owner of the project. The equity layers have the biggest risk since payment comes only from project performance after the senior, junior and mezzanine debt is paid. So the cost of equity capital is higher due to the less secure position of the equity investor. Equity investments are not tax-deductible like debt capital interest rates (Peca 2009, 113-121).

There are two types of equity investors, preferred equity investors and common equi- ty investors. Preferred equity is structurally senior to the common equity of the fi- nancing vehicle but also junior to other debt capital. It is an unsecured, non-recourse loan, which means that foreclosure for example is not possible and no personal guar- antees from the developer are required. Preferred equity is very flexible in structuring the transaction because it can be structured in a multitude of ways with various de- fault triggers, repayment priorities and remedy mechanisms possible. It contains flex- ible covenants, due diligence, is patient in terms and long-term. During the term of debt, there is no return paid to the preferred equity investor, which allows the devel- oper to invest the increased cash flow into the project. The investor has no control rights but the right to reporting and transparency and receives a high return rate due to the high risk. He also participates on profit in form of an equity kicker. Preferred equity therefore has elements of debt and equity. It can also be structured more as a true equity investment or as a tantamount to a loan to strengthen the project's equity position (Peiser et al. 2012, 309).

Common equity is the most expensive capital. It has neither securities like covenants nor guarantees and is non-recourse. The amortization is indefinite and capital is not paid back in form of periodic interest payments. The interest is accrued and not paid back which gives the developer the possibility to invest the increased cash flows into the project. The common equity investor becomes a co-owner of the project includ- ing his active involvement, which leads to a loss of control for the developer (Collier et al. 2008, 169-181). On the other hand, he might profit from the partners know-how who also shares tasks, provides staff and shares responsibilities as well as the related risks. The focus is on collaboration. The investor can enter in an early project phase when risks are high. This strengthens the equity position leading to a better rating, simplifies future raising of credit and does not debit the developer's line of credit. The amount of intern equity capital can be reduced resulting in higher leverage on the own equity capital. Nevertheless the profit has to be shared at the end with the common equity partner and only a small return remains for the developer due to the high cost of equity capital (Spore 2007, 27-29).

Therefore real estate developers aim at using as much debt capital as possible when financing a project. A higher debt percentage of the financing of a project means higher ''leverage'' resulting in lower financing costs on a greater percentage of project costs. This leads to profits producing higher returns to the developer and a smaller amount of capital required from equity investors after paying debt service. Therefore developers and equity investors tend to seek high leverage, which also increases the risk for the investors at the same time. As a consequence of the high risk, many equi- ty investors avoid high leverage and accept lower rates of return on equity. A devel- oper therefore tries to obtain as much debt as possible, which is called ''leveraging'' strategy. He aims at minimizing the at-risk equity investment so that profits provide return to a smaller investment. Higher leveraging leads to a higher return on equity because a bigger percentage of the project financed with debt signifies more of the capital stack carries a lower interest rate and a longer repayment period, leaving more cash flow available for equity investors (Peca 2009, 123-135).

The illustration shows how leverage impacts the return on equity. Projects costs are $10 million and values after two years $12 million, for a 20 percent cash-on-cash re- turn. The profit of $2 million generates an unleveraged annual rate of return of 95 percent. When 80 percent is leveraged in contrast to 60 percent, the return on equity is 31.1 percent and not 18.1 percent as with 60 percent. The advantage of leveraging is obvious (Long 2011, 40).

Ill. 2: Example of Leveraging for a Project (Long 2011)

When a for-sale project is completed, the debt and equity capital is repaid from sales proceeds whereas debt is repaid first. Equity investors receive a distribution of the remaining sales proceeds. If the project was not for sale but is an income-producing project, the permanent loan replaces the construction loan and is repaid in monthly installments. Equity investors receive their return from the revenues after these in- stallments and operating costs are paid. So after paying debt service to the lenders and all costs are paid, the annual cash flow remaining is called ''operating cash flow'' (OCF) or ''net cash flow''. This amount is available for distribution to investors and the developer.

If a project shall be viable, the OCF must be sufficient to provide a return of equity and a return on equity big enough to satisfy investors and the developer. It is then distributed in a waterfall. The first pool pays a high percentage of profit to the equity investor to repay principal (return of equity) and to pay an annual return on equity, which ranges usually from 9 to 15 percent (Long 2011, 138). When the developer co- invested with the equity investors, he receives a return on this amount. Developers usually also receive a fee apart from return which is part of the overall development costs (Broeggeman et al., 2005).

Ill. 3: Development Project Typical Sources of Investment Capital (Geltner 2006)

Projects can also include an intermediate category of capital between debt and equity capital. This is called ''gap financing'', ''subordinated debt'', ''junior debt'' or ''mezza- nine debt''. It covers a gap that neither the primary debt nor equity fills. It finances usually a component of project costs that arise from a change in future project value caused by a fundamental conversion of the project (Virtual 2012, 16). Mezzanine investing is a concept of investing in debt, equity, or hybrid debt/equity positions, which are subordinate to the first mortgage and senior or higher to the property owners’ equity (Ballard et al. 2000, 2). It is apparent therefore that mezza- nine investors are less secure in terms of risk undertaken compared to the first mort- gage holders, however are more secure than property owners. Depending on the de- gree of leverage and the risk perceived by the investors, returns to mezzanine debt are very different. As mezzanine debt lenders are in a lower position in priority of payment than primary debt lenders, they can expect rates of return to be between those of debt and equity. Usually they are between 12 to 15 percent depending on the perceived risk (Long 2011, 41-44). So the low-cost debt layers are secured by the ability to foreclose on the property if debt is not paid and fund the lowest risk com- ponent. After debt, the mezzanine levels charge therefore a higher interest rate, re- flecting the higher risk of a lower priority of payment subordinated to senior debt. The amount of debt that a project can obtain depends on the financial viability, the financial strength of the developer and capital market conditions (Malizia, 1992).

Mezzanine financing is often described as a comfort flexible buffer between the senior debt and the equity. Mezzanine debt can appear as ''junior debt'' that raises leverage and receives only an interest rate return to the lender. But mezzanine debt can also combine characteristics of debt and equity and receives an interest rate return and a return based on project performance, which is described as preferred equity and often also called ''mezzanine equity'' (Bowman, 2008).

If mezzanine debt receives only an interest rate, it requires flexible covenants like a LTC ratio for example, has a flexible coupon structure and no collateral is demanded but warrants are given instead. The lending is rather based on the company's cash flows versus fixed asset-based lending. This is advantageous during periods of eco- nomic downturn when collateral-based lending tends to discount sources of collateral like accounts receivable, inventories or fixed assets. The payment terms are flexible, patient, less stringent and mezzanine financing has long-term maturities. The pay- ment in kind (PIK) interest is accrued and paid on maturity (Virtual 2012, 17-20). Additionally, it is non-amortizing which puts less pressure on the project's cash flows. Cash can be invested into the project for a longer period of time, so that debt amortization is reduced while the maturity of debt is extended. Besides it can be raised quickly and tailored to a particular financial situation. As mezzanine debt capi- tal is no equity on the balance sheet, it can improve the balance sheet structure and help to increase the return on investment since it strengthens the company's econom- ic equity ratio. A better access to additional loans can be achieved because the confi- dence of a mezzanine provider improves the image of the company and it can help developers to get better credit terms and conditions. Furthermore developers do not rely solely on bank loans anymore. The mezzanine debt interest rates can be recorded as expenses creating tax benefits by decreasing the after-tax cost of capital. The lender does not receive any control rights but reporting and transparency. There is no loss of control for the developer (Fater 2010, 84-86).

This type of investment is not new to real estate development projects. In the past, investors have utilized various structures and percentages of debt and equity to fund a real estate project. “This was evident in the 1980’s, when first mortgage lenders would provide higher leverage mortgage debt to tax motivated investors, so as to limit the need for mezzanine level investment structures”. Widely practiced in the capital hungry “Wall Street”, this type of investment came about in the 1990’s when the need for real estate capital increased and so did the need to find an alternative to traditional means of financing. The trend grew in popularity in the last decade as property prices soared all across the world and the sophistication of mezzanine struc- tures improved significantly (Ballard et al. 2000, 4). It was further helped by a signif- icant improvement in risk management practices all over the world (Gatti, 2012).

''Mezzanine financing has been described as a range of risks rather than a vehicle or structure. Accordingly, many in the industry have defined the different types of mez- zanine investing by the level of risks undertaken, as measured by loan-to-value and loan-to-cost ratios'' (Ballard et al. 2000, 8). The need for alternative financial instru- ments to supplement the ambitions of real estate developers and their projects has grown significantly in the last decade. The considerable strain and fears of saturation in the more traditional financial houses have brought about the need to find alterna- tives, albeit with investors being exposed to higher risks like mezzanine instruments (Peca 2009, 173).

Ill. 4: The Capital Stack (Own Illustration)

2.2.2 Alternative Capital Sources

2.2.2.1 Joint Venture

Joint ventures are of the most popular types of strategic alliance, which is widely recognized and approved legally all over the world. It is a business agreement be- tween two or more parties, for a pre decided period of time to develop a new entity with new distinct assets, by contributing equity. This practice is globally practiced and the alliance aims at improving the future of the partnership rather than immediate returns. Both parties can profit from each other’s know-how, share tasks, provide staff and share the risks. The financing means go directly to the new project entity and the project's cash flow serves as a security, which has the advantage that the de- veloper’s credit rating is not determining for the senior loan. It helps getting good credit conditions by improving the equity position. As the investor becomes a co- owner of the project, the developer looses control and has to share the project's profit in the end. As the joint venture partner contributes to common equity, the character- istics are already explained in detail in the common equity part of the capital stack (Spore 2007, 28-31).

Ill. 5: Financing Structure with a Joint Venture Partner (Own Illustration)

2.2.2.2 Closed Funds

A closed-end fund is a financial security that is often traded on the stock market. But it does not have to be traded on the stock market. In most cases a GmbH as an own entity is set up and shareholders receive partial ownership of an underlying portfolio of real estate projects depending on the amount they invested (Müller et al., 2011).

Closed funds do not demand securities and are non-recourse, which lower the risk for the developer. The maturity ends when construction is completed. Closed funds are very expensive due to high administration costs and only profitable for big projects. The investors do not have any control rights and receive no performance participa- tion. The fund is called closed because once the initial shares are issued, it is closed for new investors who wish to invest in the project. Nevertheless new investors can buy shares from initial investors who wish to sell shares. But it is traded at its market price, which often differs from its net asset value. An investment manager actively manages the fund. The fund can help reducing the equity portion when the bank per- ceives the risk as reduced by the involvement of a fund. Closed-end funds often bor- row money to leverage their portfolios trying to improve distribution levels and boost performance for shareholders under certain conditions. As long as the short-term interest rates paid to lenders are lower than the long-term rates earned by the project, the shareholders will earn higher returns than they would have without leverage (Anderson et al. 2012, 13-15).

2.2.2.3 Project Bonds

Project bonds are flexible and have a long maturity providing a long certainty of funding. Nevertheless new challenges will evolve for project financiers as bondhold- ers would have to accept the construction risk in the early phases of a project and al- so bondholder voting complicates the whole decision process. Bondholders take a passive role but are hard to organize which may lead to less project interference (Drucker, 2012). There might evolve a ''bondholders' agent'' concept and an electron- ic voting system for bondholders that simplifies processes while increasing efficien- cy. Project bonds have light covenants and little discretion. Besides they are non- recourse, which means that no personal guarantees are demanded. The interest rates are paid at maturity and usually fixed. Nevertheless bonds are very expensive due to the significant preparatory costs such as obtaining a credit rating for the bond, pre- paring bond placement documentation and marketing costs (Bradley 2012, 5-6).

A rating from a credit rating agency should be made for a bond in order to enhance its marketability. It is also necessary to create a prospectus which describes the product, the collaterisation, the payment mechanism and the involved risks. The issuer's liability is limited this way. If the investors are private and not institutional with a maximum investment of 200.000 euros, issuing a prospectus is a legal requirement in Germany due to German Securities Prospectus Act and has to be approved by the Federal Financial Supervisory Authority (Brückner et al. 2010, 2).

Legal costs can also be high when the bond is publicly listed. On the other hand, pro- ject bonds can strengthen the equity position improving the return on own equity capital invested. The return to the developer is low though due to the high costs (Bradley 2012, 7).

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