Authors: Stuart Cormack, Peter Doyle, Spiro Papadolias, Nick Lazarou, James Frixou and Brent Thompson
The Australian Build-to-Rent (BtR) market is attracting significant levels of both foreign investment (especially from established UK Build-to-Rent and US “multi-family” developers and funds that are familiar with the sector) and significant investment locally from superannuation funds and other Build-to-Rent funds. Whilst Build-to-Rent projects tend to generate lower yields compared to other real estate assets such as commercial office buildings, there is growing institutional investor appetite for this asset class particularly amongst large global real estate funds who view it as a sustainable long-term market.
Up until recently, tax, duty and planning law hurdles have deterred many investors (especially foreign investors) from investing in Build-to-Rent assets rather than other real estate asset classes (such as commercial, industrial or retail assets). However, some positive change is in the wings on these matters.
In our series of articles to date, we have given an overview of the Build-to-Rent market, considered some of the key commercial issues in a Build-to-Rent project, looked at the structure of a Build-to-Rent project, considered the categories of fund investors and tax aspects of a Build-to-Rent project and examined the construction, real estate and planning considerations in a Build-to-Rent project.
In this final article in our 4 part series, we look at some of the key financing issues in a Build-to-Rent project, sources of finance and the impact of sustainable investing on the sector.
Key financing issues and financing terms in a Build-to-Rent project
Development funding and post completion funding
For Build-to-Rent developments that require debt funding to purchase the project land, develop and construct the building, refinance project debt and fund operating expense, the debt facilities will normally be structured / staged as an acquisition/ pre-construction loan facility; a construction and development loan facility (which often provides for short letting and stabilisation period post construction); and “conversion” of the above 2 facilities into an operating facility upon practical completion to refinance the above facilities and fund ongoing operating and maintenance expenses.
Ideally a project sponsor or developer (BtR Sponsor) will wish to enter into a single facility agreement with a financier covering all of the project across all of the stages of its lifecycle described above (including a 2-3 year stabilised operating period post “conversion” to reduce the risk that funding for a later stage is not available when required). Whilst a Build-to-Rent Sponsor will require such a “conversion” mechanism in its debt facilities, generally, we would expect Build-to-Rent Sponsors to re-test the debt market at practical completion of the project to see if debt financing can be obtained on the newly stabilised asset on more favourable terms than are available to it under the “converted” facility from the original financier.
Build-to-Rent financing vs Build-to-Sell financing
Whilst both Build-to-Rent and Build-to-Sell transactions involve the same broad asset class, from a credit underwriting perspective they are viewed very differently by a debt financier as there are a number of key tenets that typically underpin financing for Build-to-Sell residential developments that are not applicable to the Build-to-Rent model. These include the following:
- The financier’s comfort around being able to exit (i.e., have its debt repaid) in a Build-to-Sell project is derived from the sale proceeds of pre-sold lots immediately post-construction completion, backed by minimum qualifying pre-sale threshold requirements and extensive legal and commercial due diligence with respect to the qualifying pre-sale contracts. This means that if the borrower defaults, the financier’s exit strategy aligns with its pre-default strategy and provides a mechanism for quick realisation of the secured property to facilitate repayment of their debt. However, in a Build-to-Rent project, the financier will be reliant on the net rental income generated from the property over the tenor of the debt - if this does not meet expectations once the building is complete, then it may affect the borrower’s ability to refinance the project debt.
- In addition, in a Build-to-Rent financing, post-default a financier will likely need to step-in (or have its receiver step-in) to manage the asset for at least a short period. They will also need to identify a buyer in an enforcement sale for the entire building / project which is willing to operate and manage the asset (rather than selling off apartments individually, many of which are already under binding contracts of sales with purchasers, as would be the case in a Build-to-Sell project).
- In a Build-to-Sell project, the debt facilities are relatively short-term with market standard terms that are easily refinanced in buoyant markets. A Build-to-Rent project, on the other hand, requires a long term, cash-flow reliant, debt solution.
- A Build-to-Sell project is undertaken in a well understood tax and regulatory environment giving greater certainty to costings, project feasibility and valuations. The Build-to-Rent market by contrast is still very much in its infancy, and the tax and regulatory environment is continuing to develop as we have considered in detail in this series.
From a security perspective, a senior debt facility would typically be secured by a first-ranking all-asset security over the borrower’s assets (which may include first-ranking specific security over the cashflows or revenue streams which the borrower/SPV generates) and, to the extent applicable, a first-ranking real property mortgage over the project site itself. In this sense, real property is a well-understood asset class for financiers in the same way it is for investors.
Strong equity backing for Build-to-Rent projects
As Build-to-Rent projects do not benefit from proceeds from pre-sale contracts, the Build-to-Rent Sponsor will need to demonstrate that it has secured adequate levels of equity funding for the development, in terms of its investment at the outset, its contribution during the course of construction and any additional capital expenditure or sinking fund requirement during the operating phase of the project.
Equity contributions can be structured on an “all-in first” basis (i.e., the full amount of the minimum equity requirement must be funded prior to any debt being drawn under the debt facilities) or on a progressively drawn “side-by-side” basis, where equity is drawn in a proportionate amount to each debt drawdown. If a “side-by-side” progressive draw equity arrangement is agreed, financiers will require that this be supported by direct contractual obligations of the Build-to-Rent Sponsor to the financier to contribute such equity when required (and a requirement to contribute the full amount of committed equity on the occurrence of an event of default under the debt financing documents) and letters of credit to ensure the equity is in fact funded when required.
Project feasibility and business plan
The Build-to-Rent Sponsor will need to demonstrate to its financiers that the project will scale up, stabilise and become cashflow positive over the mid to long term during a defined period (which must extend well past the original term of the facilities to reduce refinancing risk to the lenders).
Market and commercial due diligence will be key to the financiers in making this assessment, and will almost certainly be a condition precedent to the financiers providing their debt financing.
The development and operational costs of the project will need to be captured and clearly set out in the budget which will be monitored and required to be certified to the financiers (i.e., no cost overruns and the cost to complete test being satisfied) at each drawing by an independent certifier. The financier will also test the developer’s rental assumptions against comparable market data and due diligence.
Debt sizing metrics and financial covenants
Initial debt sizing for a Build-to-Rent project in the commercial debt market is usually set as the lower of (i) a set $ amount; (ii) a Loan to Gross Development Value test (calculated on Total Commitments against the market Valuation of the Property based on the special assumptions that construction has been completed and rentals have stabilised) – which is normally set at 60% - 65%; (iii) a forward looking Debt Yield test (calculated on the Total Commitments against the Valuer’s projections of rental – this is normally set at 8% - 9%) or Interest Cover Ratio (normally set at 1.25x stepping up to 2.0x following ramp up); and (iv) a maximum Loan to Cost ratio set at the financier’s comfort level.
Note that Gross Development Value is set prior to Financial Close on the basis of the Initial Valuation (which can be speculative) and projected rental will be based on the Initial Valuation, which may be subject to changes in rental market before Practical Completion. The debt sizing criteria are normally tested as a condition to each drawdown at the same levels as initial debt sizing, with failure to meet the criteria being a drawstop.
Ongoing financial covenants may be imposed by debt documentation as follows:
- Development period: This would normally be limited to a Loan to Cost ratio. However, a Loan to Value covenant can sometimes apply (with Value determined off the most recently provided Valuation – on the basis of the property ‘as is’ with no special assumptions). Borrowers generally resist this (successfully), or if they accept it, will restrict the ability of financiers to call for an updated Valuation unless a Default has occurred.
- Operating period: Once Practical Completion occurs, there will usually be a Loan to Value covenant (on the basis of drawn, outstanding Loans + capitalised interest against the value in the most recent Valuation, to be provided at least annually) and either a Debt Yield (on basis of drawn, outstanding Loans + capitalised interest and rental income over the last 12 months) or an Interest Cover Ratio (as described below). These would apply both as Events of Default and distribution lock up at an appropriate headroom over base case.
- Historical / Projected Interest Cover Ratio / Debt Service Cover Ratio (on basis of interest expense and rental income over the last 12 months, or projected over the next 12 months) may also apply in place of Debt Yield covenants in the debt sizing, drawdown and ongoing covenants considered above.
Debt financing documentation tends to be bespoke and there is no standard form precedent or structure for such arrangements.
There are a number of key terms and conditions that financiers are likely to request in order to agreeing to provide finance to a Build-to-Rent project many of which are based on project financing principles and mechanics (e.g. an independent certifier appointed on behalf of financiers to sign off on drawdowns for construction purposes, including that the drawdown is budgeted, validly invoiced and for the permitted construction purpose) and to provide / review regular construction reporting for the benefit of financiers and a drawstop to the extent that either the Loan to Cost ratio or the Loan to Value ratio (based on valuation at the time of drawdown) exceeds an agreed level or the Cost to Complete test is not satisfied)).
There will also usually be detailed bank account undertakings including a “blocked” (i.e., lender controlled) Deposit Account for other amounts received (e.g., Build-to-Rent Sponsor funding of Cost Overruns, and certain other amounts required to be prepaid) and an “unblocked” (i.e., borrower controlled) Construction Account into which (among other things) the proceeds of the Construction Facility are paid and out of which construction costs are paid.
In addition to any equity support arrangements with the Build-to-Rent Sponsor (e.g., subscription agreement and supporting bonding) supporting letters of credit / bank guarantee bonding will be required if the equity is not fully funded up front and in some cases, a capped Parent Cost Overrun Guarantee.
There are a number of residential tenancy specific provisions which are often required to be included in finance documents to account for the underlying properties / residential tenancies, including controls on letting, property management undertakings, capex controls (both minimum and maximum), restrictions on lease minimum terms, and a requirement that new minimum term leases be entered into with a defined period prior to expiry of the current leases (rather than letting them move to a month to month basis) and review events and/or events of default if occupancy falls below a minimum level.
In terms of bank account undertakings during the operations phase, the “blocked” Deposit Account will remain, and a Rent Account will be required to be opened for receiving rent from tenants (which may be “blocked” subject to a regularly run payments waterfall, or “unblocked”. Additional accounts to hold retention or capital expenditure amounts may be negotiated on a transaction by transaction basis.
Given the large number of smaller value leases in Build-to-Rent structures (which are harder for financiers to vet), a template residential tenancy lease may be agreed between the financier and borrower with minimum parameters - the borrower must use this template lease with its tenants (i.e., to give some uniformity to the rights against tenants). In addition, sometimes (though not universally) there may be a requirement to set the rent at levels no lower than a percentage of what the Valuer has most recently opined is the market rent.
Other funding sources: The expanding role of NHFIC in the Australian Build-to-Rent sector and collaboration with commercial banks
The ability of NHFIC to offer concessional interest rate loans and to provide significant long-term financing is an essential ingredient in the ongoing development of the stock of social and affordable housing in Australia including Build-to-Rent.
Subject to the requirements noted below, a project which comprises at least 50% affordable housing can qualify for NHFIC funding. A recent example of this was announced in May this year when AXA Investment Managers, a large international real estate fund manager, launched its Build-to-Rent strategy in Australia by way of its strategic partnership with St George Community Housing (a Tier 1 registered CHP) for the delivery of circa 400 affordable dwellings in Western Sydney with long-term funding provided by NHFIC. This was a landmark transaction in this sector (which Gilbert + Tobin was proud to have been involved in) and a perfect example of how the sector can bring NHFIC together with a commercial bank to implement an innovative and lower long term cost debt structure to facilitate institutional investment in this sector and create more homes for key workers in that area.
Two of NHFIC’s main activities are:
- provision of loans at a concessional interest rate to registered community housing providers (CHPs) funded out of bond issuances under the AHBA (see sections 16 -21 of the NHFIC Investment Mandate). Through its bond aggregator function, NHFIC is able to raise debt at a spread (determined by market conditions) over and above the Australian Government’s cost of borrowing. NHFIC passes the resulting cost savings on to CHPs alleviating the need for CHPs to pay commercial rates of interest thereby ultimately enabling CHPs to reinvest more funds back into social and affordable housing; and
- provision of loans at a concessional interest rate to qualifying applicants out of the NHIF (which is a separate pool of funds to the AHBA) (see sections 21A – 24 of the NHFIC Investment Mandate) – loans can now be made out of the NHIF for both a housing enabling infrastructure project or a social or affordable housing project.
NHFIC also has access to a line of credit from Commonwealth Treasury which it can utilise as a short term funding measure pending issuance of bonds under the AHBA.
For a Build-to-Rent project, an important factor to bear in mind is that if a project proponent is considering a new housing development and wants to raise finance from NHFIC, it will be necessary to set up a registered CHP - under the NHFIC Investment Mandate, NHFIC can only provide AHBA backed loans to registered CHPs. This involves dealing with state based bodies such as the NSW Housing Registrar (or the equivalent regulator in the relevant state or territory) and meeting the regulator’s requirements particularly around financial strength, reporting, governance and the distribution of housing assets upon insolvency or winding-up. It will also involve dealing with the Australian Charities and Not-for-profits Commission (the national regulator of charities) to obtain status as a registered charity and with the Australian Taxation Office to obtain the relevant tax exemptions available to charities.
The Commonwealth together with the states and territories have established the national Regulatory System for Community Housing (NRSCH). Registered CHPs in all states (except Victoria) are subject to the National Regulatory Code for the NRSCH which sets out the performance requirements that registered housing providers must comply with in providing community housing under the National Law. Community housing providers must demonstrate their capacity to comply with the National Regulatory Code on application and once registered, must demonstrate ongoing compliance with the Code. NRSCH policies provide guidelines for Housing Registrars to achieve a consistent approach in the exercise of their regulatory functions. Policies are agreed and adopted by all jurisdictions participating in the NRSCH.
A registered CHP will invariably be established as a company limited by guarantee and therefore will have no share capital as such but simply one or more members. This is important to bear in mind as “equity” like funding from third party investors seeking a commercial return cannot be contributed as share capital but rather must be contributed to the CHP in the form of subordinated debt – this debt will rank behind, and be subordinated to, any senior debt funding from NHFIC or commercial banks (i.e. it will be treated as deeply subordinated akin to traditional equity in the form of share capital). Capital can also be contributed to a registered CHP by way of donation or gift. When considering how to structure any subordinated debt instruments, the requirements of section 16(2) of the NHFIC Investment Mandate must be borne in mind – this provides that NHFIC may provide a loan in relation to a mixed tenure development only if it is satisfied that any profits from the development will be applied to support affordable housing outcome.
Finally, as a Commonwealth Government statutory corporation, NHFIC is subject to the Federal Safety Commissioner Act 2022 (Cth) (FSC Act) which means that it can only provide funding to a Build-to-Rent Sponsor who proposes to engage a builder accredited under the FSC Act. In that regard:
- section 43(4) of the FSC Act provides that the Commonwealth or a corporate Commonwealth entity must not fund building work unless contracts for the building work will be entered into with builders who are accredited persons; and at the time of the funding, the Commonwealth or corporate Commonwealth entity takes appropriate steps to ensure that builders will be accredited persons when they carry out the building work; and
- section 43(5) of the FSC Act provides that for the purposes of section 43(4), the Commonwealth or a corporate Commonwealth entity funds building work if it pays for, or otherwise funds or finances, the building work (whether directly or indirectly) or facilitates the carrying out of the building work by entering into, or otherwise funding or financing (whether directly or indirectly), a pre‑construction agreement that relates to the building work.
The role of sustainable finance in the Build-to-Rent sector
Any Build-to-Rent development will need to be affordable, sustainable and community-focused while offering a high standard of on-site management services in order to encourage tenants to reside in the development for longer tenancy periods.
Particularly in the higher end Build-to-Rent market and larger scale social affordable housing projects, borrowers are often utilising funding structures comprising of “sustainability linked loans”, “green loans” and “social loans” which present an opportunity for borrowers to access funding at a lower cost. The more sophisticated borrowers have developed robust sustainability finance frameworks in accordance with the Loan Market Association, Asia Pacific Loan Market Association and Loan Syndications & Trading Association Green Loan Principles and Social Loan Principles.
Achieving strong green rating credentials (such as Green Star, NatHERS and NABERS ratings) have become a particular focus for borrowers aiming to utilise lower cost funding structures. Achieving a strong green star rating also benefits the marketability and long term returns of the project. Given the long term investment horizon, many investors are now concerned to ensure that their buildings will be future proofed against minimum consumer expectations in relation to energy efficiency and other sustainability metrics to avoid impacting the demand for such building as those metrics improve in other buildings over the medium to long term.
As a result, green rating metrics, amenity maintenance and upgrade programs should be incorporated into Build-to-Rent building and O&M contracts to ensure that the required standards are achieved and maintained throughout the life of the asset. For those social affordable housing projects procured by the government under a PPP, typically sustainability requirements are documented in the underlying project deed and are passed through to the D&C contractor and services contractor (as applicable).
Innovative funding structures and thinking outside the box
For many Build-to-Rent projects which seek to provide social and affordable housing, often an initial hurdle is to ensure that the investment return and economics of any deal are appropriate to facilitate the investment of private/institutional capital (including superannuation funds) into community housing. For example, a subordinated debt instrument which assumes equity-like risk in an investment capital structure (including development, construction and operational risk), will need to be afforded a return which is at a market rate commensurate with the risk assumed by that subordinated financier (or more favourable that market if a charity is involved in the financing structure).
In order to help bridge any such investment barriers and ensure that Build-to-Rent projects are economically viable, Build-to-Rent Sponsors will need to consider innovative financing structures (including charities, strategic partnerships with CHPs, NHFIC funding) in order to help mobilise institutional investment and deliver much needed affordable housing at scale. Often when multiple funding sources are required to help fund a Build-to-Rent project, this can sometimes require customary security and intercreditor/subordination arrangements to be entered into between various financiers (including senior financiers such as NHFIC), construction financiers and any subordinated investors. Whilst basic investment principles will apply in agreeing these intercreditor arrangements, innovative solutions in any payments or distributions waterfall can be key to ensuring all stakeholders are properly incentivised. The ability to capitalise some or all of the interest (both for senior debt and subordinated debt) during construction phase and certain covenant lite options during operational ramp-up phase may be considered as ways to help the viability of a Build-to-Rent project.
Leveraging and appropriately incentivising all forms of capital (including domestic and foreign private/institutional capital and superannuation funds) will require a collaboration between the private and government sectors. A balanced housing portfolio between at market housing (Build-to-Rent and/or Build-to-Sell) and social/affordable housing is often required in order to ensure that Build-to-Rent projects remain financially viable.
Grants (whether from government and/or philanthropic) and other contributions of value may also be part of the funding arrangements of any project.