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Errol Danziger
The uniqueness of construction lending ........................................................................1 Construction, and construction-related ..........................................................................3 Valuation........................................................................................................................3 Assembling the construction loan..................................................................................4 The construction lenders role .......................................................................................5 Balancing the construction loan.....................................................................................6 Risks of being a construction lender..............................................................................7 Controlling construction risk .........................................................................................8 Controlling take-out risk ..............................................................................................10 Controlling property risk..............................................................................................10 Controlling carry risk...................................................................................................10 Other reserves ..............................................................................................................11 Pre-sale and pre-leasing ...............................................................................................12 Stabilising the completed project.................................................................................12 Repaying the construction loan....................................................................................13 In the event of default .............................................................................................14 Permanent financing ....................................................................................................14 Lender as an investor ...................................................................................................15 Structuring the investment ...........................................................................................15 UK Taxation.................................................................................................................20 This publication reviews the process of investing in property through construction lending. It covers the role of the construction investor from site acquisition to making the construction loan to participating in completion project profit through a partnership or an equity interest in the property.
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In a commercial loan, the participants are lender and borrower. The participants in a construction project are the project developer, who sponsors the project, the builder who carries out the construction, the lender who funds the construction, and the letting agent or sales agent who markets the project after completion. Property construction is sponsored by a property developer. The developer is the borrower in the construction loan. The construction lender is a lending bank or other loan investor. Where construction is on leased land, the landowner may also be involved in the financial arrangements. Finally, a second bank, lender or investor, called a take-out financier, makes a permanent loan after the project has been completed. In a commercial loan, the loan principal remains unchanged during the loan term, except where the loan provides for periodic repayment of principal by way of amortization, or where the loan principal is prepaid - repaid early, before maturity by the borrower. But a construction loan has a principal amount that fluctuates, usually upwards, depending on the stage of construction of the project. The lender does not pay the principal amount of a construction loan over to the developer in a lump-sum at the start of building operations. It disburses the loan principal to the developer or makes it available in some other programmed way according to a draw schedule. The lender permits loan draws to be made, but draws are dependent on project progress. The lender monitors construction progress through on-site inspections which are coordinated with cash advances under the construction loan. Unlike many commercial loans that are long-term and are in place for up to several decades, a construction loan is a short-term loan. Its term is based on an estimate or expectation of how long it will take to complete the construction project. This may be months or several years. For a lender, a construction loan is riskier than other types of property-based lending. The reason for this is that the economic feasibility of a construction project is hard to assess beforehand. And for lenders that specialise in construction loans, construction projects concentrate credit risk (the risk that a loan will not be repaid) in a small number of developers who borrow large amounts. This is different to residential mortgage lending where the lenders risk is spread out over a portfolio consisting of a large number of residential mortgage loans made to homeowners who each borrow a small amount. There are many risks that are construction-related and linked to construction finance. Most projects are completed on time and on budget. But it is hard to estimate the value of a project that will only be completed in two years time or later. Property supply and demand conditions over that time scale are difficult to predict. Office buildings in particular have long preparation times. A two-year time horizon is standard in assessing the market. The construction lender tries to predict how the market will look over that period. What will be the vacancy rate in two years time; what will supply in demand look like in the market at that point?
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A pro forma cash flow forecast for the completed project is prepared before the construction loan is granted and construction commences,. This forecast predicts how the property is expected to perform after it has been stabilised. But before completion of construction, actual cash flow and forecasts of cash flow will be volatile and uncertain.
Valuation
The principal amount of a construction loan is directly linked to or based on the value of the project and the property that is being built. But the value of the underlying property asset fluctuates as the project progresses. This means that the property must be valued or revalued at several stages during the construction process. A construction project has four stages of value measurement: unimproved land value; project in progress value, project as completed value, and project as stabilised value. At the start of the construction project, the amount of the construction loan may be based solely on the value of the land. During the construction phase, the loan amount increases in tandem with the project progress. In the pre-stabilisation phase, when construction has been completed, but the completed property is not yet generating income, the value is the potential of the property to generate cash. In the stabilised phase of the completed project, the property is valued based on its current ability to generate cash in the future, by renting out space in the property in return for rental income.
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The value of a completed construction project is calculated by estimating the net cash flow that the project is predicted to generate, and to determine the present value of that cash flow by applying a capitalization or discount rate that is sustainable. Net cash flow from the project is taken to include rental generated by leases in place, plus rental generated by additional leases that are signed up until the time that the property is regarded as stabilised, so that there is an acceptably low level of vacancy and the assumed rentals are market-related. Expenses and capital expenditure are fixed at market levels, and are deducted from gross income to determine net cash flow. Some property-related expenses are deducted from the stabilised value of the property. These include rent losses, the cost of tenant improvements, leasing commissions, and free rent.
corporate loan to the developer, which the developer then uses to pay these fees. The developer uses the first draw on the construction loan to repay the corporate loan. A construction loan can be for an amount of up to 100 percent of the value of the completed project. If the project is sold for its appraised value after completion, and the construction loan has been repaid, the cash proceeds of the sale may have to cover interest and loan fees that were debited by the lender during the construction phase. Construction loans are risky for lenders. A lender has a choice. It can play the part of an arms length financier and accept the associated credit risk and other risks that a construction loan entails. Or it can try to reduce these risks by playing a closer role in the project, by taking an equity interest or quasi-equity interest in it. A lender that has acquired an interest in the residual profits of a project is said to have received an equity kicker. The lenders equity interest in the project can be structured in several ways. The lender may be given the right to receive a specific percentage of profits from the sale or rental of the completed project. This would clearly be an equity interest in the project. Or the lender could be entitled to receive interest at a rate that is considerably higher than the market interest rate, or loan fees that are higher than the fees customarily charged in the market. The lender would then have a profits interest in the profits of the project designed in a more subtle way but giving the lender a return similar to that of an equity interest. Or the lender could finance, in addition to the costs of construction, all loan fees and construction loan interest, in the expectation of being repaid out of the proceeds of the property or the cash flows generated by it. For the developer, these lender equity arrangements and contributions to costs would mean that, although the developer holds title to the project, it bears little or no risk of project failure, because it has no capital invested in the deal.
lenders interest in the project, to ensure that construction is going according to plan, and that loan funds are disbursed only for completed work. Where the lender has a substantial equity interest in the project, this could give it effective control of the project. If the lender is the only party at risk in the project, or the main party at risk, then only the lender stands to gain from the success of the project up until the developer repays the construction loan. To protect its stake in the project, the lender controls disbursement of the construction loan, and the progress and direction of the project. Where the developer does not receive any return until the project has been completed and starts to generate cash, the developer has an incentive to complete the project as quickly as possible. During the construction phase, the developer has nothing at stake, and only becomes interested in the project when it has been completed and starts to operate successfully. The lender must then exert control over the project to ensure that the developer does not give in the temptation to cut corners in building operations. This is specially important where the developer, or a project special purpose vehicle, is thinly capitalised and totally dependent on construction loan financing. This dependence increases the risk of defective construction. So the lender monitors construction operations, looking for errors in workmanship and design. As part of this monitoring, the lender can demand to review plans, inspect construction, approve construction methods, and supervise builders. In the pre-stabilisation phase, the lender may also participate in negotiation of leases.
event, than a project that is near completion with the majority of its costs already determined and attached to the ground. An out-of-balance event is most severe in the early stages of the construction phase. It is least severe towards the end of the construction phase, when the project can be completed for only a small additional outlay, when there will be little if any loss incurred on the construction loan. What can be done if the construction loan becomes unbalanced, and attempts to rebalance it are not successful? In extreme cases, the best course of action may be to liquidate the project, even if it is only part-completed. This could be the most practical choice where loan imbalance has been caused by systematic economy-wide factors. For example, where rental rates, vacancy rates, or interest rates have changed substantially from the rates prevailing at the time the loan was contracted, or the rates that were predicted at the commencement of the project. Or where the cost of construction inputs - materials or labour - have markedly increased. Where the construction lender is an investor and the loan becomes unbalanced, the investor is likely to complete the project with its own funds, because this may be the best way - and perhaps the only way - in which the investor can maximise its recovery on the part-completed project. When an out of balance event occurs and the lender does complete the construction, it adds the additional cost to the amount of the loan principal, as the property enters the pre-stabilisation phase.
unbalanced, or to come up with additional funds that might be needed to complete the project. The lender has risks, but they can be mitigated. Firstly, by ensuring that the developer makes an equity investment in the project. The investment can be in the form of cash or a contribution of the land on which the project is to be built. If the developer makes this investment, the lender is not financing the entire project on its own. The developer has some equity at risk, and will have an incentive to take steps to protect its investment, and if it does take those steps it protects the lenders interest at the same time. Secondly, by requiring the developer to give collateral. The collateral can be substantial, marketable assets with a determinable sale value, that are owned by the developer. The assets should not be encumbered in any way and should not already have been pledged as security for any other loan. Alternatively, the developer can give the lender an irrevocable letter of credit from a financially robust loan guarantor, that covers a substantial part of the construction loan over its entire term. The implication of the developer giving collateral is that the developer has something substantial to lose if the project fails, as well as a strong incentive to make the project succeed. For the lender, the best type of collateral a letter of credit because it covers interest, fees and loan principal for the full loan term. Thirdly, by a creditworthy outside financier giving a take-out commitment for the full amount of the construction loan. Such a commitment should be unconditional. If it is conditional, the conditions should be reasonable. If the take-out commitment will cash out the lender for the amount of the construction loan on completion of the project, then the outside financier rather than the construction lender - bears the risk that the project will fail. With the take-out commitment in place, the construction lenders only risk is that that the project will not be completed on schedule, and project value is no longer an issue because an outsider has agreed to effectively repay the construction loan, including all of its interest and fees, once the project has been satisfactorily completed. Fourthly, by arranging some other type of implied guarantee of the projects success. This guarantee can be in the form of sale agreements or lease agreements entered into with creditworthy independent outside investors or lessees. Arrangements like these substantially reduce the construction lenders risk. They generate the cash flow on completion of the project that is needed to repay principal and interest on the loan.
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Firstly, by the developer putting up project equity of its own. The developer contributes its own capital or assets to the project, in the form of cash or land. Secondly, by ensuring that the construction contract is a fixed-price contract, in which the developer or builder agrees to construct the project for a price that is firm and fixed before construction begins. But for this contractual feature to have value in reducing risk, the builder or developer must be reputable, experienced and creditworthy. Thirdly, by using a system of retentions. Instead of the construction lender paying out the full amount of the construction loan to the developer when construction starts, the lender pays the developer in stages and holds back part of the loan. Loan payments are made when specified project milestones are achieved. For example, a loan for the construction of a multi-storey office development may be disbursed to the developer in stages as and when specified number of floors of the building have been completed. This enables the lender to monitor the project and to reduce its risk by keeping back part of the loan and taking a wait-and-see approach to the project. Fourthly, by providing for budget contingencies. If the project budget has an overrun cushion built into it, then that cushion acts as a surplus amount that can be used if construction costs turn out to be greater than predicted. How much of cushion is needed depends on how complex the project is, and how long it will take to complete. Budget overruns are usually about 5 percent to 10 percent of the amount budgeted for the project. Fifthly, by arranging guarantees. Construction project guarantees come in three forms, all of them surety bonds performance bonds, payment bonds, and completion bonds. Performance bonds are guarantees that protect the construction lender if the contractor, developer or builder fail to complete the project. The surety is then obliged to take control of the project and complete it, or to make a payment to the lender or developer that can be used to hire a new builder to complete the project. The performance bond penalty should be the full amount of the cost of construction. Performance bonds are critical in reducing construction-related default on a construction loan. Construction loan losses then depend on the type of performance bond, the penalty that it imposes, the conditions under which it is payable, and who issued the bond. If the surety who issued the bond is financially strong and is obliged by the bond to complete the project, then potential losses on the construction loan during the construction period will be minimised. Performance bonds usually only require the surety to perform if the original contractor was obliged to perform, and then to the same extent as the original contractor. So if the original contractor is not liable to perform, then neither is the surety. This means that performance bonds are often hard to enforce. Also, not all construction-related problems are covered by performance bonds. Natural disasters, undisclosed or unknown conditions, such as land subsidence, are not covered. Payment bonds are guarantees given by a surety who guarantees that all third party suppliers of labour or materials to the project will be paid.
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Completion bonds are guarantees that a part-completed construction project will be completed, regardless of cost.
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cash flow shortfalls. The carry reserve provides for the servicing of the loan from the construction period through the pre-stabilisation phase before the property is leased up to break-even point. The reserve is needed if at this time the property is not generating enough cash to service the construction loan, that is, to pay interest on the loan. The carry reserve is established and maintained so that it contains enough funds to cover construction loan interest. The reserve is then used to service the construction loan until the project reaches stabilisation, or at least until the cash flows that the project generates are able to satisfy debt servicing requirements. It ensures that interest on the construction loan is paid on time. What should the size of the carry reserve be, relative to the construction loan principal? Big enough to ensure that interest on the construction loan is paid on time, during the period in which the property is not generating enough cash flow to service the debt. A major complex construction project will have a big carry reserve buffer, a small project will have a minor reserve or some other form of provision for loan service. The carry reserve is treated as part of the construction budget. The reserve must be big enough to cover interest payments, as well as property tax and insurance, during the construction period and the pre-stabilisation leasing period. The existence and size of a carry reserve are important factors relating to the credit risk of the construction loan. The size of the carry reserve determines whether the loan needs other form of credit enhancement. The bigger the carry reserve, the lower the chance of default on the construction loan, and the smaller any loss that might be incurred on default will be. The reserve can also take the form of an insurance policy or a letter of credit that covers all payments due under the construction loan, until the project has achieved a debt service coverage ratio of 1:0, that is, until there is enough free cash flow being generated by the completed project to cover all payments that are due under the construction loan.
Other reserves
The lender should monitor the projects ability to generate enough cash to meet operating costs. The project should be able to cover operating costs from the date on which the loan is made by the lender, to the date on which the whole of the loan principal is repaid. Construction loan structures often have a modest buffer period built in, usually several months. Reserve are thus maintained to cover fixed operating costs, for example, property taxes, insurance, and security expenses. A delay cost reserve is used to cover expenses that might be incurred because completion or stabilisation of the project has not been completed on time. For example, payments may have to be made to compensate a key tenant that has leased space in the completed project but is unable to take possession of the leased premised, because the project has not yet been completed. Or a penalty may have to be paid to an anchor tenant, such as a supermarket chain, for late opening of a retail centre.
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Construction loans with extendible terms that run through the pre-stabilisation phase have stabilisation risk. The extend of that risk depends on the net cash flow from the property once it has stabilised and a loan-to-value ratio has been worked out.
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Permanent financing
A construction loan is a short-term loan that meets a specific need to pay the building costs of a construction project. It is a stop-gap between a land loan and a permanent property loan. A construction loan commences when the first sod is turned, and ends at the time when the construction is expected to be completed. At that time it is replaced by a permanent property loan. The maturity date of a construction loan is set at the date or slightly after the date on which the lender and the developer agree the completed project will become stabilised. The time between construction completion and the maturity date of the loan may be longer for big, complex projects, like major office developments, and shorter for small simple project, like industrial buildings. Once the project has been completed, the developer obtains permanent financing for the project. The permanent loan is a form of long-term financing that is repaid over the useful life of the completed project, which may be years or decades. This can take the form of a roll-over of the construction loan into a permanent loan. Or it can involve obtaining a new loan from another lender. Or the developer can sell the property once it has been completed, use the proceeds to repay the construction loan, and take any remaining surplus as its profit from the project. If the construction lender agrees to also make the permanent loan, then another loan commitment is made, and a new loan agreement is entered into. The lender is again paid a commitment fee and a loan origination fee. Here again, the developer may use a draw on the construction loan to pay this initial cost of obtaining the permanent loan. The permanent loan can include the lenders agreement to fund initial project operating deficits in the pre-stabilisation phase, up to a set limit, until the property has been fully leased. This gives the developer the cash that it needs to turn the newly constructed building into a profitable operation.
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Once a permanent loan is in place, the owner of the property uses cash flow that is generated by operation of the property to repay the permanent loan. Under the permanent loan, the property owner is required to make monthly or quarterly payments of principal and interest. Interest on the permanent loan is also calculated at a floating rate, at a fixed level above LIBOR, usually between a floor and an optional ceiling. The interest rate that is payable on the permanent loan is lower than the rate payable on the construction loan, because the risk to a lender on a newly-completed building is less than the risk on a building that is under construction. Not every construction loans is made with the intention that it will be replaced by permanent financing as soon as construction has been completed. Some construction loans have their terms extended and they continue through the stabilisation phase of the property, and are only replaced after the property has been leased and is generating a stable cash flow.
Lender as an investor
A construction lender has a choice. It can make the construction loan, be repaid after completion of the project, and withdraw from the project. Or it can take an ownership role in the construction project and morph into an investor in property through careful structuring of its role as a construction lender. Where the investor takes an ownership role in the project, the transaction structure differs from that of a standard construction loan. Giving the investor an equity interest in the project can change the nature of the transaction from construction loan to joint venture or partnership between developer and investor, or into an investment by the investor in the developer. To determine whether the nature of the transaction has changed, questions are asked. How much risk is the lender taking? Does the lender have an interest in the projects profits? Will the lender earn an amount over and above the regular arms length interest and loan fees that a construction lender normally earns? Construction lenders are not usually liable for defects in the projects that they finance, but a lender who is a partner, joint venturer or investor could become liable, possibly jointly with the developer for project defects.
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incremental cash flow, gross income, refinancing and sales proceeds, or some other measure for determining the investors profit from its equity participation. The effect of structuring the investment as debt, not equity, is that neither the investors current profit share nor its claim for repayment of its investment are subordinated to any equity claim. The investors claim to a share of profits is treated as contingent interest, so that the investors equity participation return is distributed to it as interest. Advantages of the structure for the investor are firstly, the structure gives the investor the foreclosure rights of a debtholder, secondly, the investor does not have to recognise partnership losses for accounting purposes. Other project participants also benefit from treating the investors participation as debt: debt treatment increases the partners cost bases in their partnership interests, and interest payments (both fixed minimum interest and contingent interest) are deductible as interest by the partners, and taxable as interest in the hands of the investor. Disadvantages of the structure include assumption by the investor of the risk that the loan will not be repaid, which would mean that the investor would lose its equity claim to share in future profits. Tax benefits could be lost by the investor if the developer and other partners claim all of the tax losses (including capital allowances), on the ground that because the investors participation is structured as a loan, the investor is not entitled to have any losses allocated to it. Further, if the contingent interest arrangement awards the investor a substantial participation percentage, say 50 percent or more of incremental benefits, it may be anomalous enough for HMRC to claim that it is not interest for either the partnership as debtor, or for the investor as creditor. Or HMRC may try to recharacterise the contingent interest into another type of income or participation, for example, rental income or a share of partnership income from partnership assets producing rental income, which could result on the investor being taxed on trading income rather than interest income. Interest is the amount paid as compensation for the use of borrowed money. For interest payments to be tax deductible by the borrower, it is not necessary that the lender limited the interest charge to a percentage of the loan principal, or that the interest is computed at a fixed stated rate. All that is required is that an amount that is definitely ascertainable is paid for the use of borrowed money, pursuant to an agreement between lender and borrower. Where the lender is a creditor with the right to the repayment of the loan principal and fixed interest as well as the right to share in appreciation in the value of the property, the question arises whether a payment made under the right to share would be a liquidation of the lenders equity in the borrower. In other words, the issue of contingent interest (or other equity participation) involves the issue of debt versus equity. Should the lender be regarded as a partner in the borrowing partnership? What is the effect where the conversion privilege or other equity kicker remains payable after the loan has been repaid? These issues should be kept in mind by the investor. In a ground lease with leasehold mortgage loan structure, the investor purchases the land earmarked for the project, and leases it back to the partnership under a longterm ground lease that provides for a fixed minimum rent, and additional rent based on a percentage participation in the gross revenues of the project, or other equity
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participation measure. The investor makes a construction loan to the partnership secured by a leasehold mortgage, either fixed return or participating. The investors purchase and leaseback means that the investors rights are not subordinated to any equity claim, and that the investor has foreclosure rights in the event of non-payment of ground rent or debt service on the leasehold mortgage. The investors equity profit participation is treated as contingent rent, so the investors equity participation return is distributed to it as rent. Advantages of this structure are that the investor has good legal security rights, secondly, that it avoids having to recognise partnership losses for accounting purposes, and thirdly, benefits to the partnership and maybe also to the investor from the treatment of the participation as rent: the rent payments both the fixed minimum rent and the contingent rent are deductible by the partners as rental expenditure, and taxable as rental income in the hands of the investor. If the investors participation includes a share of proceeds from the sale of the completed project, then that profit will reflect its gain on disposal of the land owned by it. This profit should qualify for capital gains treatment in the hands of the investor. Disadvantages of this structure do not include the possible loss of the investors equity claim on future profits at the instance of the partnership, unless the partnership has an option to purchase the land from the investor. But the other partners will be claiming all of the tax losses including capital allowances, because the investors participation has been structured as a ground lease and loan that are not entitled to any allocation of losses. In a straight equity structure, the construction project is owned by a partnership and the investor, the developer and other partners in the project fund the construction costs in exchange for an equity interest in the partnership. The investors partnership interest may be a pro rata interest, or it may grant priority and preference to the investor with respect to current project cash flow, sale proceeds, or refinancing proceeds. Because the investors participation is structured as equity, both the current yield on the investment and any residual profit share will be subordinated to any future debt financing, even if the investors partnership interest entitles it to priority or preference or even to guaranteed payments, and the investor will have no foreclosure rights against the developer or against any other participants in the project. In a combined equity and mortgage loan structure, the investor funds the project by making a construction loan that is secured by a mortgage, and in addition it receives a partnership interest in the project. Increases in the partners cost bases in their partnership interests attributable to the partnerships mortgage loan liability may facilitate the tax-free distribution to the partners of cash provided by the investor. Interest payable on the mortgage loan is deductible by the partners including the investor - as interest. For the investor, the advantage of the straight equity and the combined equity and mortgage loan structures is the opportunity to share with the other partners in the tax losses from the property, including capital allowances. But if partnership accounting
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losses have to be taken into account for accounting purposes, this could have a detrimental effect on the investors earnings per share. Depending on the terms of the arrangement and on the debt-equity mix, these structures may be the least vulnerable to recharacterisation by HMRC. But there can still be an imaginative allocation of tax benefits: depending on the respective claims of the partners on cash flow, refinancing proceed, and sales proceeds, and on the investors preferences, priorities and any guaranteed payments, it should be possible to allocate tax losses to all the partners in the desired proportions. Disadvantages of the straight equity and the combined equity plus mortgage loan structures for the developer and for other parties, are firstly, the inability to buy out the investor through a refinancing of its interest, and secondly, the inability to claim a disproportionate allocation of tax benefits. In a deferred equity take-out structure, the investor looks for the assurance that it will receive an ultimate or deferred participation percentage in the projects cash flow, refinancing and sales proceeds, and other non-tax benefits, while initially limiting itself to a lesser role. The object is to maximise the allocation of early year tax losses and other tax benefits to the developer and other partners. The initial structure can involve the investor receiving, in exchange for funding the project with a construction loan, a convertible participating or non-participation mortgage loan which will be convertible at a later date into an equity partnership interest. Or, the investors initial interest may be a convertible preferred equity partnership interest, that provides it with a fixed yield guaranteed or non-guaranteed payment, and a priority or preferred claim against liquidation, sale or refinancing proceeds, together with a nominal residual allocation percentage interest. Later the investor will convert its preferred equity partnership interest into a full ordinary partnership interest that provides for a large residual allocation percentage. For example, the investor might contribute a nominal amount to the partnership capital, and in exchange for additional capital for the project, it will receive either a convertible mortgage loan or a convertible preferred partnership interest that would be similar to a preference share. The mortgage loan or preferred partnership interest would eventually be converted into an ordinary partnership interest, that would share fully in the current and residual values of the partnership. After conversion, the investor could even own the majority of the ordinary partnership interests. Because the investors additional percentage of ordinary partnership interest would not materialise until he converts his convertible mortgage loan or preferred partnership interest into an ordinary interest, the ordinary or residual profit and loss sharing percentages during the pre-conversion period would be received by the other partners. Instead of using either a convertible mortgage loan or a convertible preferred partnership interest, the mortgage loan or preferred partnership interest received by the investor could be coupled with an option or warrant to acquire an ordinary equity partnership interest in the partnership at a later date for a specified exercise price. The exercise price could be equivalent to the value of the equity interest at the date of grant of the option.
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Because ordinary partnership equity ranks in priority behind a non-convertible mortgage loan or non-convertible preferred partnership interest, its value at the date of formation of the partnership would reflect both its subordinated claim on capital in the event of immediate liquidation, and its claim to receive unlimited future rentals (if any). Such value could turn out to be a fraction of the actual value of the equity interest at the time the warrant or option is exercised. In either case, the aim of the participants would be firstly, to defer the stepping up of the investors residual equity percentage interest in the partnership until the early-year tax losses had been allocated to the developer and other partners, while secondly preserving the participation of the investor in the potential economic upside of the project. The disadvantages of the deferred equity take-out include a potential tax issue for the developer because of the change in partnership percentages either at the date of conversion or the date on which the option is exercised. If the cost bases of the developer or of the other partners in their partnership interests have been reduced by losses or cash distributions that were effectively been financing with partnership debt, then a further reduction of their cost bases resulting from the change in partnership percentages could result in taxable capital gain for the partners. The object would be to ensure that the investor would not earn income on the conversion of its convertible mortgage loan or convertible preferred partnership interest, or on exercise of its option to acquire a full equity interest (the option initially acquired as part of an investment package consisting of both the option and either a mortgage loan or a preferred partnership interest). The value of the partnership equity interest received at the time of the conversion in exchange for the mortgage loan or preferred partnership interest (either of which would have limited potential for appreciation because of their fixed face amount or redemption amount, other than the conversion feature) could exceed the investors cost base in the debt or preferred partnership interest that it had exchanged for the partnership interest. The same applies to the exercise of an option to acquire a partnership equity interest, because although the exercise price of the option would have been fixed, the value of the equity interest may have appreciated before it was received. It is unlikely that the transfer of a partnership liability, a preferred partnership interest, or cash, in exchange for an ordinary partnership interest, would have corporation tax consequences for the parties. On the contrary, the acquisition of a partnership interest in exchange for cash or property, and the restructuring of a partnerships capital interests are not taxable transactions. Thus, the exchange of partnership debt or a preferred partnership interest for an ordinary equity interest in the partnership should be a tax-free exchange or conversion. The exercise of an option resulting in the payment of cash in exchange for an ordinary partnership interest is a non-taxable purchase of the interest. Where the investor is both a loan creditor of the partnership as well as the holder of a deferred equity take-out interest in the partnership, that is, where the investor has made a loan, such as a convertible mortgage loan, or a mortgage loan with an option to acquire either an ordinary partnership interest at a fixed price or a convertible preferred partnership interest (or option coupled with a preferred partnership interest), that is recharacterised as debt, and the interest rate on the debt is more favourable to
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the partnership than it would have been but for the equity kicker, then the equity kicker is effectively an economic substitute for interest paid as consideration of the cost of the use of money. In the developer fee structure, the investor purchases in its own name the land earmarked for construction. It then makes a construction loan to the developer. The developer builds the project, using the construction loan funds. Interest on the construction loan accrues monthly, and the interest rate is adjusted whenever market rates fluctuate. But the developer is not required to make any payments of interest or loan principal until the project has been completed, so that interest that accrues during the construction period is added to the loan principal. The developer completes the project, and receives a developers fee equal to a percentage of the construction loan. Ownership of the project remains with the investor. Finally, in a land warehousing structure, the developer earmarks land for construction. At the instance of the developer, the investor purchases the land and takes title to it, and grants an option to the developer to purchase the land. The investor holds the land warehouses it - until the developer is ready to start building, at which time the developer exercises the option and acquires the land from the investor. The option price is higher than the cost of the land to the investor, so that the investor realises a gain from purchasing the land and reselling it to the developer under the option. This gain is treated by the investor as a capital gain.
UK Taxation
A range of capital allowance are available to UK developers and property investors for UK construction projects. These include enhanced capital allowances, plant and machinery allowances, and integral features allowances. The following allowances are granted for construction projects: Office 20% - 40%; hotel 30% - 50%; industrial building 5% - 10%; retail (shopping centre) 5% - 20%; retail (fitting out) 50% to 75%; and office (fitting out) 55% - 80%. An enhanced capital allowance is available for low-carbon technologies (water saving technology, including water saving taps and urinals, and rain harvesting equipment) and for energy saving equipment (heat pumps, chillers, lighting, pipe insulation, controls, combined heat and power, and uninterruptible power supplies) at the rate of 100 percent of cost in the first year. Plant and machinery allowances are granted at the rate of 20 percent per annum on a reducing balance basis, thereby spreading the benefit of the allowance over a number of years. Construction project items that qualify for these allowances include fitted furniture, sanitary appliances, and fire alarms. The integral feature allowance covers items such as electrical systems, cold water systems, space or water heating systems, powered ventilation systems, air cooling or air purification systems and floors or ceilings comprised in such systems, lifts, escalators, and moving walkways, and external solar shading.
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Land remediation relief is a tax allowance that is granted to any company that owns a major interest in land, such as either a freehold interest or a leasehold interest for a lease period exceeding seven years. The allowance covers expenditure incurred on the decontamination of brownfield land that was previously used for an industrial activity, provided that the company was not involved with the original contamination. The allowance is a 150 percent deduction in respect of remediation costs, or alternatively, a 16 percent tax rebate.
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