by Michael Brett
Categories of finance
Having looked briefly at some of the principles of property financing and the way in which property company accounts are structured, we need to examine in more detail the different types of finance available. In the process we will be categorising property finance on a number of different criteria. Perhaps we should define these at the outset.
- Debt or equity. This is the most basic distinction of all. Is the money being borrowed, or is it put up on a risk-sharing and reward-sharing basis? Borrowed money — debt — has to be repaid at some point and interest (or the equivalent of interest) has to be paid on it until the debt is repaid. With equity, the return for the person who puts up the money is determined by the success of the enterprise. He shares in the profits and if there are no profits he gets no return.
The most obvious form of equity is money subscribed as ordinary share capital of a company. But there are many other equity financing arrangements. The provider of finance for a particular development may, for example, be entitled to a share of the profits even though the money is not put up in the form of share capital. And there are deferred forms of equity, like the convertible loan. This starts off as debt, paying a fixed rate of interest. Later it may be converted into shares of the company, at which point it is transmuted into equity.
- Loan or traded security. Borrowed money may be a simple loan. You borrow, say, £1m as an overdraft from the bank. You pay interest on the loan and at some point you pay back the £1m to the bank. Or you might instead borrow £1m (in practice it would only be worthwhile for larger sums) by inviting investors to subscribe for a bond of one sort or another. This is a form of IOU (I owe you) note, and is a security rather than a straight loan. In return for providing the £1m, the investors get a piece of paper entitling them to receive such-and-such an amount of interest each year, and to have the money they put up repaid at a specific date. But they do not have to wait until this repayment date to get their money back. If they need the money sooner they can sell the piece of paper to other investors, who then become entitled to receive the interest and the eventual repayment. Securities of this kind are normally bought and sold on the stock market.
- Secured or unsecured. Lenders normally want security for the money they provide. In other words, they want a charge on specific assets of the business or on the assets of the business as a whole. What this means is that, if the borrower fails to pay interest or make capital repayments on the due date, the lender can put a receiver into the enterprise whose job is to sell the assets that have been charged and repay the loan from the proceeds. A loan secured in this way is clearly safer than an unsecured loan. But well-established companies may be able to raise unsecured loans because the safeguard for the lender is the company’s established profit record, out of which the interest can comfortably be paid. Most borrowings in the euromarkets (see below) are unsecured, as are borrowings in the commercial paper market. The company’s name and standing are the main guarantees.
- Fixed-rate or variable-rate (floating-rate) interest. With some borrowings the rate of interest is agreed at the outset and remains unchanged over the life of the loan. With others, the interest rate will change according to movements in interest rates in the economy at large. For large-scale floating-rate borrowings the most common yardstick of interest rates is the London Interbank Offered Rate, or LIBOR. This is the rate of interest at which the banks themselves are prepared to lend to each other. It is agreed at the outset, say, that the company should pay 1.5 percentage points (or 150 basis points, which is the same thing) over LIBOR. So if, over a particular period, the average LIBOR rate is 10%, the company pays 11.5% for that period. If LIBOR averages 11% over the next period, the company pays 12.5%, and so on.
Short-term borrowings are most likely to be at a floating rate of interest. Long-term borrowings such as mortgage debentures are more likely to be at a fixed rate.
But there is another complication that we will meet. A company may make a one-off payment to buy a “cap” for a floating-rate borrowing. This is a form of insurance policy which means that, whatever happens to interest rates in general, a maximum limit is set to the interest rate that the borrower will have to pay.
- Long term or short term. You can borrow money for a year or you can borrow it for 30 years (if you are well enough established). One year is clearly short term and 30 years is clearly long term. In between, there are medium-term borrowings. Where does the dividing line fall? How long is a piece of string? But we have seen that, in company accounts, borrowings for less than a year are categorised separately from other borrowings.
However, we have to be a little careful in using these terms. An overdraft is technically repayable on demand, so it has to be categorised as a very short-term borrowing. But in practice many companies have an overdraft outstanding almost indefinitely. Likewise, under a multi-option facility (MOF) a company might technically be borrowing for three months at a time. But when the three months are up it simply repays the original loans and takes out new ones for another three months. If the facility runs for five years, effectively it has the use of five-year money via this “rolling over” arrangement.
- Project finance or corporate finance. A smallish or young company undertaking a property development probably does not have a great deal of security to offer other than the development itself. So it borrows money on the strength of this development. This is project finance. A longer and larger established company may be able to borrow on the strength of the company itself rather than its individual projects. This will be corporate finance. Interest rates will generally be rather lower for corporate loans than for project loans.
But even some quite large companies are undertaking developments of such a size that they dwarf the company’s own resources. In this case each development may need to be financed separately on a project finance basis and may well be “off balance sheet” (see below).
- Recourse, non-recourse or limited-recourse loans. If the loan for a particular project or for a particular subsidiary company is guaranteed by the parent, the lender has recourse to the parent (can require it to stump up) if the project itself gets into trouble. But if the only security for the lender is the project itself, and the parent company has given no guarantees, the loan is “non-recourse’. In practice, many loans are “limited recourse”. The parent may, say, have guaranteed interest payments but is under no obligation to repay the loan itself. Because the parent company has no liability or a very limited liability, non-recourse or limited-recourse loans often do not appear on the parent company’s balance sheet. They are “off balance sheet”.
- Domestic or euro finance. Finally, loans may be in sterling or in other currencies, and they may be raised through the domestic markets or the euromarket. The euromarket is the international market in “stateless” money, which is centred on London but is not part of the domestic British financial system. Borrowings in the euromarket, which can be made in most major currencies including sterling, tap the very large deposits of different currencies held in banks worldwide. But companies generally need to be large and internationally recognised to follow the euro route.
