Over the past year or so, the real estate market has seen a number of forward funding transactions between developers and institutional investors. These were mainly in relation to projects where there were already substantial prelets in place.
There have also been one or two speculative fundings.
Under a forward funding arrangement:
• the fund acquires the land before the development commences;
• the developer builds the development, and the fund pays all the construction and ancillary development costs; and
• following practical completion and completion of the occupational leases, the developer receives a profit payment from the fund calculated on an agreed basis by reference to the value of the investment created.
Providing everything is properly addressed, forward funding agreements offer a great opportunity for institutional investors to add to their investment portfolio.
They also provide developers with a guaranteed exit route in terms of a buyer once the project has been built and let.
This article discusses some of the key issues which a fund will need to put in place and consider.
Pre-conditions
Before entering into a forward funding agreement, there are a number of issues which a fund needs to consider and make sure are addressed in the documentation.
A fund’s risk profile is increased in a forward funding arrangement because it is committed to the project from the outset, although the development will not have been built and may not have been let. A fund will therefore be looking for a considerable degree of control of what the developer does and over the project itself.
Prior to the fund acquiring the land, it should consider what pre-conditions need to be satisfied.
The key condition is normally the grant of a satisfactory planning permission (and the expiry of the relevant judicial review period without a third-party challenge). The fund will need to define carefully what amounts to an acceptable planning permission for its purposes. It is also important to ensure that this ties in with any agreement for lease where the nature of the planning permission has to be acceptable to the tenant as well.
Other pre-conditions will depend on the particular circumstances. For example, in the case of a city centre project, it may be resolution of any rights of light issues. Road closure orders may be a factor where there are public highways to be stopped up in order for the development to proceed. Obtaining vacant possession may be necessary where there are existing occupiers of the site.
Once the land has been acquired and works start on site, the fund will be reimbursing the construction costs as they are incurred. It will therefore need to ensure that there are the correct pre-conditions which need to be satisfied prior to the first drawdown.
For example, the building contractor and professional team need to provide warranties containing step-in rights so that, in the event that the fund has to take over the project, it can also take over the building contract and appointments. Evidence of compliance with pre-commencement planning conditions may also be a pre-condition to payment.
Costs
It will be important to the fund to control overall costs. This will be achieved by setting out in the forward funding agreement an aggregate limit for the various costs that will be reimbursed. However, the fund should also look at setting individual limits for different categories of costs.
For example, one limit could be set for monies payable to the contractor, another for monies payable to consultants. Once these limits are reached, or exceeded, it should be for the developer to pay any further monies in relation to those categories.
The fund will want to be certain that the monies being paid out on a month-by-month basis fairly reflect the value of the works that have been undertaken. The fund’s position will be protected by ensuring that the fund’s surveyor undertakes joint inspections with the quantity surveyor/employers agent employed by the developer, and approves all payments due to the contractor.
Design approval
Quite often at the time a forward funding agreement is entered into, the detailed design of the scheme will not have been worked up. There may only be planning drawings at that stage and/or an outline specification. A fund will need to insert the appropriate provisions into the agreement to ensure that the developer is responsible for working up the detailed design and obtaining the fund’s approval before works start on site.
In addition, the question of variations to the works during the building programme needs to be addressed. The developer will want some ability to vary the works (for example, as a result of statutory requirements or unavailability of materials). However, a fund will want to ensure that it is in a position to approve any material changes.
The parties also need to consider what should happen if a tenant wants to make variations to the proposed works. The fund will not want the tenant to be able to request any variations which have an impact on the rental or investment value without its approval.
Identifying tenants
Where a scheme has not already been fully prelet there will be detailed provisions dealing with the responsibilities of the developer and the fund in relation to identifying and agreeing terms with potential tenants and appointment of letting agents. Although the developer would normally take the lead in negotiating any agreement for lease (although the fund will also be a party because it will grant the occupational lease), because it is the developer that will be giving the development obligations, a fund would expect to control all lease negotiations.
More importantly, systems should be put in place for identifying acceptable tenants. It is common practice to impose some sort of financial test which a tenant has to satisfy (for example, net profit of X times the proposed rental level).
Lists of unacceptable tenants are also a way of ensuring that certain occupiers, which the fund does not want, are excluded. It is, however, important to retain some degree of flexibility because circumstances could change during the building programme.
Also, there will need to be very specific arrangements governing the financial terms of any letting – at the very least, a target rent or minimum rent. The fund will need to influence the financial incentives which can be offered to any potential tenant.
Profit payment conditions
The various provisions relating to the profit payment are key both to the developer and the fund. The profit payment will be based on the investment value created less the costs incurred. A fund will need to ensure that the lists of costs deductible is sufficiently wide so that it is not left out of pocket at any stage (for example, any holding costs such as insurance or security), and there will be an interest charge as well. The profit payment is a substantial incentive for the developer to perform.
It is normal practice to include further pre-conditions that must be satisfied prior to payment of the profit payment. The most obvious examples are completion of the relevant leases and practical completion of the works having occurred to the fund’s satisfaction. There can, however, be others – for example, provision of the health and safety file or sub contractor warranties.
Another pre-condition could be evidence of compliance with any planning conditions which need to be satisfied prior to occupation. In some cases, depending on the context, it may be more appropriate for outstanding issues to be dealt with by way of retentions from the profit payment rather than delaying the full profit payment.
Tenant insolvency
It is important for the fund to focus on what happens in the event of tenant insolvency during the building programme. This is particularly the case in relation to a bespoke building designed for one particular tenant.
The fund will be committed to the project, and may well have incurred substantial expenditure. How can the fund ensure that either the project is completed or that it gets its money back? If the building is not bespoke, and there is a reasonable chance of finding an alternative tenant, then similar provisions to those referred to above concerning lettings can be included.
On a bespoke building, the fund may want to consider having some form of “put option” which entitles it to require the developer to buy back the land subject to full reimbursement by the developer of all of the costs incurred (including the interest charge). Although this form of option may provide some comfort, its practical benefit will largely depend upon the covenant strength of the developer.
On a related point, the fund will also need to ensure that any termination arrangements in any agreement for lease, which entitle the tenant to determine the agreement, provide for prior notice to be given to the fund, and for the fund to have an opportunity to step in and take over the project.
Termination
Consideration should be given as to how the funding agreement can be terminated. The fund will have acquired the land at the outset, and is committed to the project. It will have also provided construction costs during the building programme. The fund will want the ability to take over the project in the event of material default or the insolvency of the developer. One of the more contentious issues is what then happens to the developer’s profit payment.
Were the developer to become insolvent right at the end of the project, the question is whether it should still receive part of the profit payment it would have been entitled to if it had not gone insolvent. There are a number of solutions.
For example, the developer could still receive a payout but instead of just deducting the development costs, 200% of those costs could be deducted. This means that the later into the building programme termination occurs, the more likely the developer will still receive some part of the profit payment.
Mark Heighton is head of the real estate group at CMS Cameron McKenna LLP
