7. Capital funding

This is part of a Series in eight parts. Here are the other posts.

1. On commercial Real estate
2. Defining project Value in CRE
3. Identifying Risks in RE
4. Sample table Project development
5. On Construction contracts
6. Essential types of project development
7. Capital funding
8. Components of project development

I am still working on the book of project development in RE from a few posts ago.

Opposing to classical investments, the RE Investments have a bigger share of foreign capital. In good years, you can get up to 100% foreign investment capital for your projects. In bad years, this number usually falls to 80-50%, which is still a good share. In crisis banks or investment funds want to see more collateral. For the credits are relevant interests (zinsen) and repayment rates (tilgung), usually in the form €/year.

If you invest in a project also with own capital, there will be a difference between total return and return on your investment. It is called a (positive) leverage effect. The positive leverage effect should be bigger after the taxes. The formula goes:

(return on Own Capital) rEK > rGK (return on Total Capital), also:

(R-i*FK)/EK > R/GK

R – Earnings before interests and taxes

i – foreign capital interest rate

FK – foreign capital

EK – own capital

GK (=EK+FK) – total capital

The important variables are:

A) Time duration:

• Short-term: in-front and in-between credits
• Mid-term: credits to start the project
• Long-term: credits to close the project

B) Repayment mode

• block credits
• in Repayment tranches and annuity credits
• business credits

C) Interest rates

• variable
• fixed
• capped

Following are some credit forms:

• pre- and in-between financing: many smaller credits, each one covering different development phases. Pre-financing is a short-term credit, which comes at a time when the final financing is not yet guaranteed. In-between financing is a mostly short-term credit, that takes place during the development, when the final financing is already guaranteed.
• post-delivery financing: a long-term loan, the payment of which often depends on certain conditions or charges in favor of the lender.
• leasing financing: the Lender owns the building and is slowly being repaid back.
• funds financing
• Fortfaitieering
• Shareholder loans

Credits have many advantages as, for example, you can develop many projects parallel. Also this way you can share risks. On the other side, working with external financing means more coordination and losing control over the project.

Financing

If a project is bad from the start, financing cannot turn it into a good project. Projects are usually funded via banks (credits) and are in Germany regulated via Kreditwesengesetz and Pfandbriefgesetz. Both define and limit the access to credits, rights and obligations. The banks usually give a lot of focus on:

• security of delivery costs
• ability to take credits
• creditworthiness (experience, security, etc.)

Taxes

There is a big range of possible taxation burden on construction projects. Historically, they are heavily taxed, from state to local levels, from materials and works, to land taxation. It is no easy to navigate this waters, but it has to be done. do not forget to analyse the whole investment cycle, from construction to the operation and demolition, when analysing the tax burden.

There are two types, direct and indirect taxes. Direct are:

• Earnings taxes: income tax, corporate tax, profit tax.
• Substance taxes: property tax, land tax, trade tax, inheritance tax.

Indirect are:

• Traffic taxes: value added tax, real estate transaction tax.
• Usage taxes: gasoline tax, tobacco tax, road usage taxes, spirits tax, coffee tax.

Types of taxes in Property are:

• Transfer of property to a third party -> income, either sales or renting. Exception are the open RE funds, where they count as capital.
• Basic groups are: Renting the property or using the property by yourself
• and the property is, in taxing sense, part of the company’s capital or private capital.

There are two typical scenarios:

• If the property is given to a third party against a compensation, then it is taxed according to income from letting and leasing. RE Funds are, of course, an exception.
• If you use the property for yourself (in the context of a source of income), the property is regularly taxed in such a way, that the expenses, associated with the building, are taken into account for tax purposes. The revenue here results from the saved rent expenses.

Taxing of real estate

The typical income taxing types in property are:

• short-term: Construction phase. Property tax, Value added tax, but the financing models can trigger some income tax brackets.
• long-term: Operating phase. Income tax, individually calculated, as a difference between income and costs.
• termination: A potential capital gain is taxed in the taxable business assets. Private assets have a tax exempt, if 10 Years passed between acquisition and disposition.

The substance taxes historically come before the general income taxes. Property transfer tax is, for example in Berlin, 4,5%. There are other aspects of real estate, like social and political. Especially politicians are very interested in the RE development and try to subsidize it. They can help lower the production costs to rise supply, or to rise demand with manipulating the property income tax. Other methods are subventions or state’s co-investing in projects, helping obtain better credits, or giving 0% loans. Some typical cases are:

• Higher amortisation for construction work on old buildings (<1996) to create new rental apartments.
• Higher amortisation on fixed assets (<1991), that serve for environmental protection.
• Higher amortisation for buildings in renovation areas and urban development areas.
• Higher amortisation for historical buildings.
• Other amortisation/writeoff for buildings in the special areas under development (Fördergebietsgesetz – FördG).