Fund through transactions
Fund through transactions are becoming more common for Developers and Investors.
The rising demand for premium grade "flight to quality" commercial offices, large scale industrial estates, hotels and affordable childcare coupled with increased costs of capital and tightened access to traditional debt financing for these projects creates opportunities for experienced Investors and Developers to adopt the fund through model to deploy capital and experience into the Australian property market in an efficient and de-risked manner.
For Investors, the benefits include acquiring an asset early and efficiently (e.g. as regards transfer duty), de-risking the project delivery phase through appropriate conditions and participating in some aspects of the project (e.g. some leasing decisions). For Developers, the benefits include securing a take-out Investor early, locking in returns and having a secure source of funds to complete a project.
Additionally, fund through transactions provide an attractive risk position for Investors because at the point of the initial investment, market risk (e.g. tenant pre-commitments), planning risk (e.g. development approvals) and construction delivery risk (e.g. D&C contract) are mitigated. Further, the Developer is incentivised to manage these risks and complete the project on time because the Developer’s main returns are tied to project completion.
How does it work?
Typical fund through structures involve the Investor paying an up-front deposit to the Developer and the Developer either transfers the land to the Investor on payment of the up-front deposit (which is efficient for transfer duty purposes) or on practical completion of the project. The Investor will fund the costs incurred by the Developer in carrying out the project via regular payment claims made by the Developer, with supporting evidence (such as payment certificates from the Builder, where necessary certified by the Independent Certifier). In exchange for funding the project, the Developer will pay the Investor an agreed coupon on the aggregate funds invested by the Investor from time to time. The Developer (who usually owns the land itself or via a related entity) develops the land in accordance with the Project Brief. The project is usually underpinned by the
Developer securing a sufficient level of Tenant pre-commitment.
The Developer will provide security to the Investor for the performance of the Developer's obligations under the Development Agreement. The security is likely to be:
- a general security agreement (and associated registrations) granting security over assets of the Developer associated with the project; and
- a bank guarantee or other similar bond for an agreed sum that satisfies the Investor in relation to any residual exposure not otherwise covered by the in-built risk mitigators in the Development Agreement.
The Builder will provide usual security and retentions to the Developer under the D&C Contract. Any security provided by the Builder will also ultimately be available to the Investor on a pass-through basis. The usual Builder's 12-month defects liability period will be available to the Investor to enable rectification of defects to be appropriately managed.
Contrast this to a take out structure where:
- the Investor pays a deposit to the Developer when the Developer commences construction of the project;
- the Investor makes a final payment (either via debt, equity or a combination of both) for the land and developed improvements to the Developer when practical completion of the project occurs; and
- the Developer, rather than the Investor, funds the development.
The basic structure and typical agreements involved in a fund through model is set out below. Alternatively, a full copy of this article can be downloaded here.
Developer, Investor and Tenant
Provides detailed specifications on what the Developer must deliver.
Investor and Developer
Sets out the terms for the Developer delivering the project and the Investor paying the progress payments. The Development Management Agreement will typically:
- require the Developer to provide performance security to the Investor (either via a bank guarantee or a general security over the Developer’s assets (or both));
- insulate the Investor from cost overruns by including a maximum cap on construction and development costs;
- allow the Investor to step-in and replace the Developer if the Developer is in unremedied default of the Development Agreement;
- defer the Investor’s obligation to pay the development margin to the Developer until completion of the project;
- implement milestone targets for delivery of the project and mechanics for the Developer to extend those target as a result of delays outside the Developer’s reasonable control; and
- buy-back mechanisms requiring the Developer to buy-back the land from the Investor where the project is not delivered on time or the Developer fails to achieve the necessary Tenant pre-commitments.
Developer and Project Manager
If the Developer does not project manage the project in house, this document sets out the Project Managers roles and responsibilities for managing the project.
Developer and Builder
Provides for the Builder carrying out construction of the project. The Investor will typically have the ability to approve the Building Contract to ensure it aligns with the design and construction deliverables and timing under the Development Agreement.
Investor, Developer and Builder
Provides Investor with step in rights to the Building Contract in the event of the Developer’s default.
Developer and Investor
Gives the Investor security over the assets of the Developer.
Developer, Investor and Builder
Documents the duties and scope of the Independent Certifier in delivering certification services to the parties at different stages of the project.
The Investor's design and delivery risk position is adequately mitigated because the Independent Certifier:
- certifies the works the subject of a payment claim by the Builder have in fact been performed; and
- will also certify that the cost to complete the remaining works is appropriate, ensuring the Investor is protected against cost overruns.
The Agreement for Lease with a major tenant will also contain a sign-off process that the Developer and Builder must follow to achieve practical completion under the Agreement for Lease. Satisfying this Agreement for Lease process will be a condition to the Developer achieving completion under the Development Agreement.
Investor and a lender
Investor uses land as security to obtain finance. This is only available if the land is transferred to the Investor on exchange. The lender may require additional documents such as tripartite deed with the Developer allowing the lender to step-in in the event of the Investor’s default under the Development Management Agreement.
Developer (and Investor as the Developer’s nominee) and Tenant
Secures Tenant pre-commitment to Lease the project. The Agreement to Lease would trigger a Lease of the premises after practical completion occurs.
Benefits and challenges
Fund through developments can benefit both Developers and Investors but there are challenges. These benefits and challenges are summarised below.
- Liquidity: The Investor pays a series of progress payments rather than a large one-off lump sum improving Investor cash-flow and retained capital.
- Pricing: The price the Investor pays for the project is usually lower than the price it would pay for a take out structure because the Developer does not need to obtain finance for the project (i.e. because the Investor is financing the project).
- Tax: Transfer duty may be limited to the land value rather than the value of the completed development if the land is acquired by the Investor at the point of initial investment.
- De-risking: At the point of the initial investment, market risk (e.g. tenant pre-commitments), planning risk (e.g. planning approvals) and construction delivery risk (e.g. D&C contract) are removed or mitigated. The Developer is incentivised to manage these risks as the Developer’s main returns are tied to project completion.
- Income guarantee: Depending on the level of the initial pre-commitment, the Developer may provide an income guarantee to the Investor (effectively guaranteeing a rental stream from practical completion). The income guarantee would not apply if the Developer is able to secure sufficient pre-commitments prior to practical completion.
- Cost overruns: Usually, the D&C Contract would be a lump sum or guaranteed maximum price D&C Contract. To protect the Investor against cost overruns, the Development Agreement will make the Developer responsible for cost overruns from the Builder.
- Liquidity: The Investor must have existing pools of deployable capital given the challenges it may face obtaining finance (see below).
- Step-in: The Investor assumes the risk of having to complete the project in the event the Developer is insolvent or is in default of the Development Agreement.
- Finance: If the land is transferred to the Investor on practical completion rather than on exchange, then sourcing traditional mortgage-backed finance will be a challenge. If the land is transferred to the Investor on exchange then the land value alone may not be sufficient to support sufficient finance to fund the project.
- Certainty: The project is "pre-sold" to the Investor giving the Developer a higher level of certainty on receiving its returns for the project.
- Liquidity: The costs of the project are funded by the Investor (excluding cost overruns) alleviating the need to obtain debt finance to fund the cost of the project opening up new sources of project financing.
- Security: In a take out structure, the Developer’s only security from the Investor is the Deposit which is usually insufficient to cover the Developer’s project risk. In a fund through structure the Developer has the benefit of the deposit and regular progress payments offering better security.
- Builder defaults: The Developer is exposed to defaults by the builder. If, for example, the builder causes delay in achieving practical completion and the Development Agreement does not allow the Developer to extend practical completion back-to-back with extensions under the D&C Contract then the Developer will be liable to the Investor for failing to achieve practical completion on time.
- Cost overruns: Typically, the Development Agreement requires the Developer to pay any cost overruns. Given labour and material shortages and a move away from the just in time logistics approach to sourcing materials the Developer will need to carefully consider the project brief and pricing of the project.
- Inflexibility: Depending on the sophistication and level of detail in the Project Brief, the Developer may lack flexibility in the delivery of the project.
- Certification: Failing to achieve certifications from the Independent Certifier may cause payment delays
Where to from here?
Fund through models are complex and require a balance to be struck between the Investor’s required level of return, the costs of the development and the Developer’s obligation to deliver.
Despite its complexity, in today’s world of soaring inflation, increased capital costs, labour and materials shortage and disruptions to traditional logistics networks, the fund through model provides opportunities for investors and developers to deliver large-scale projects in a cost efficient and de-risked way.
If you have any questions regarding the content of this article or if you’re interested in exploring these topics further for yourself or your business, please reach out to Harry Stone.
