A cold shower and what’s next?

Investors are suffering the effects of the cold front that recently crossed the atlantic.
the cost of credit has risen from 1 to 2 pct.
The question is: is it worth looking around for other sources of finance for real estate projects?

S

ome investment decisions have been put on hold in recent months, with investors taking a closer look at project profitability, and renegotiating finalized contracts. The widening of banking profit margins in Europe has not generated any rise in interest to finance investment from other sources. The reason for this is that there is a lack of money throughout the entire banking and financial system.

The issue is what is needed and where

The financing of a development must fit the project, its location, the investor’s financial status and the designation of the land in local development plans. Commercial investments are financed in a similar way throughout Europe, with the sources of capital usually being the investor’s own equity and loans.

Paweł Ruszczak, financial director of the Orco Property Group in Poland, stresses that: “The percentage of an investor’s own capital required for commercial investment, for example in office
buildings, depends on many factors, such as location and the tenancy contracts that have been signed; but the average own capital required,
amounts to around 30 pct of the total. An investment’s location is therefore of no great importance, since banks finance projects with similar terms and conditions throughout the whole of Europe.”

It is only in the residential market that geographical differences start to appear. In Poland, the final customers are the principle source of finance, which means an investor does not require 100 pct investment security. In the West, where the home buyer pays only when the home physically exists, a developer must guarantee the entirety of the financing through its own capital and loans. This costs more than joint-financing by future owners, but is also less risky.

Risk factor included in the cost

Experts and market players in our part of Europe have yet to start panicking, as the influence of the US market on our countries is relatively weak. Admittedly, there has been a slow-down in the growth rate and financing has become more expensive, but it is still possible to make a profit.

Martin Danko, spokesperson of the Penta Investments Czech-Slovak investment fund, goes into more details: “The US credit crunch harms everyone, even major investors. The financial lever has become more expensive. This should not affect Slovakia however, due to the stiff competition between banks, and this is even stronger in the Czech Republic. However, I fear that the market turbulence could have a greater impact on property financing in the next six months, as the mother companies of international banks are suffering such substantial losses, that they will want to be reimbursed.”

As regards to investment financing, Ukrainian companies are similar to their Western European counterparts, employing the same instruments, financial loans, bonds and own finance, when building. Ruslan Ejnes, finance director of TKS-Management, one of the largest developers on the Ukrainian market, comments: “Luckily, our banking is not closely integrated with the world system, this explains why the collapse of the American mortgage market has had no great impact here. Banks continue to grant loans for our investments – this being the major source of our finance.”

Ruslan Ejnes claims that the risk in property investment is no greater than the usual levels. Companies that perform well, experience no problems in cooperating with the banks. The TKS company has taken credit from twelve different Ukrainian and foreign banks. However, the increase of 1 to 2 pct in credit costs since the middle of last year, is now being felt. Ruslan Ejnes explains that: “In the summer of 2007, we planned to acquire additional finance through a bond issue, but our bank consultants advised us to wait for the situation to settle down.”

Overprotective mothers
– the inter-bank market

The reason why the costs of loans is growing is not entirely down to the American sub prime credit crunch, but is also the effect of a more cautious policy for lending money in the inter-bank market. In Poland, for instance, there is less money in circulation at the moment. In 2007, the amount of finance loaned in 2007 exceeded bank savings deposits – a fact which also contributed to a rise in inflation.

But banks have become more astute. In 2007, property investment was treated in Poland as almost risk-free. Loans were freely given out, and credit analysts did not bother to examine investments in any great detail, which meant financing costs were not exorbitant. Yet the Polish real estate market continues to grow today in much the same way for investors.

Paweł Ruszczak highlights that: “It is mainly credit committee analysts in mother-banks, not acquainted with Polish conditions, who express anxiety. They ask far more questions and exhibit the greatest mistrust. It is small developers without much experience who have problems in obtaining credit. As far as I am concerned, the greatest changes are the lengthening amount of time it takes to obtain loans – by approximately 2 weeks – and the increase in the cost of this credit by about 0.5 pct in real terms since 2007.”

Who’s going to help if not the banks?

Now that credit is becoming more difficult to come by, developers’ own capital is perhaps going to be more important. One way to substitute and spread the risk is through real estate funds. For the Orco Property Group, which set up the Orco Endurance Fund several years ago, it is a way of expanding activity: financial engineering substitutes part of their own capital with that of the fund, of which it is the joint owner. Has the situation on the world’s financial markets influenced investment funds? Paweł Welo, director of AKJ Investment TFI property fund, admits that: “Indeed it has. Several firms have pulled out of issuing certificates; others are taking a long time to come to a decision – which has been a very cold shower for the industry in the past few months. But from the beginning of the year, confidence in real estate funds has been growing once again, with investors wanting to diversify their portfolios.” AKJ Capital is confident that the market has substantial potential, and is planning to introduce in mid-2008 a closed real estate fund, addressed to institutional and large private investors.

More or less transparent

Mezzanine funds, which are now becoming more widely known in Poland, are a similar source of capital for real estate investment. As regards the rate of return and risk, they are situated between bank credit and own capital, but are willing to assume much greater risk than banks – at a greater cost of course. The advantage is that they can become an exit strategy for small developers who experience financing problems. Mezzanine, that is a fund’s contribution, acts like one’s own capital – being entirely frozen and paid only once when the contract terminates. As a debt instrument, interest has to be paid on this. Mezzanine funds can also serve as a way to spread risk. Usually it is not the answer for stock exchange-listed companies which, in principle, must be transparent and secure.

Leasing source

Leasing is another method of securing finance – and not only for property investment. Market operators whose performance has been worse than those in Western Europe have been rolling up their sleeves, and last year registered respectable results, leasing properties with a value of PLN 3 bln, compared with PLN 2 bln in 2006. Magdalena Włodarska, strategic client manager for Pekao Leasing, observes that: “We are not yet feeling the slightest slow-down of the market. The volume of transactions is steadily growing, and our real estate investments have not become more risky. I am sure we would face a problem if property prices were to drop, but demand is still high and yields are not rising.”

How much slow-down is what matters

The collapse of the American sub-prime loans market influenced European banks in differing degrees. Much depended on the size of the interbank loans that allow institutions to acquire money. Interbank loans act as a linking mechanism that is felt by companies even though they are not directly connected with the American financial system.

According to Rashid Khan-Gandapur, director of Corporate Business Centre of Bank Zachodni WBK: “Banks are currently publishing their financial reports for 2007 and revealing the losses they have incurred. These depend on loans from other banks, some of which are off-setting their losses from customer deposits. The rise of financing costs will gradually be translated into higher prices for customers. Having said that, the potential of Central and East Europe and its local economy will continue to be the main factor determining market growth.” n

Emil Górecki