Current Tendencies and Challenges in Financing Property Development in Emerging Markets: Case Study of Ukraine

Dept of Real Estate and Construction Management Div of Building and Real Estate Economics Master of Science Thesis no. 383 Current Tendencies and Ch...
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Dept of Real Estate and Construction Management Div of Building and Real Estate Economics

Master of Science Thesis no. 383

Current Tendencies and Challenges in Financing Property Development in Emerging Markets: Case Study of Ukraine

Author: Tatyana Yurchenko

Supervisor: Hans Lind Stockholm 2007

Master of Science Thesis: Abstract Title Author Department

Master Thesis Number Supervisor Key words

Current Tendencies and Challenges in Financing Property Development in Emerging Markets: Case Study of Ukraine Tatyana Yurchenko Department of Real Estate and Construction Management, Devision of Building and Real Estate Economics, Royal Institute of Technology 383 Hans Lind Development finance, real estate, development process, Ukraine

Abstract Analysts generally agree that developing real estate is far riskier than simply purchasing real estate as stabilized fully leased assets. A speculative industry by nature, real estate development offers higher returns to compensate for the inherently higher risk. There are multiple steps that developers follow from the moment of conceiving the project. One of the most important is financing. There are many ways for developers to finance their projects. Because they are wealth constrained, they seek cheap significant outside capital. The typical source of this capital is mortgage debt. Lending market in Ukraine can not offer favourable terms for high leverage. Lending conditions are tight and constrained by strict regulatory oversight of bank, legal imperfections, and lack of long-term money in the market. Banks place a higher value on liquidity and transparency factors as indicators of asset quality. Therefore, the developers are looking for the external equity in order to finance their projects. This involves two parties: a local player (with the land and all planning permissions) and a partner investor (with cash for construction and further operation of real estate). The holding period is also considered as a key to decide appropriate type of financing. As results show, most of developers seek to sell property after leasing up period. Money raised from the sale is reinvested in other project. Consequently, there is a little need for additional debt.

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Acknowledgements The study reported in this monograph was made possible with the cooperation of many persons and institutions. To them, I would like to say my warmest thanks and express deep gratitude. First of all, I would like to thank my supervisor, Professor Hans Lind, for his support and interest in my study. His firm guidance, help and thoughtful comments have greatly benefited my work. Secondly, I express great thanks to Nick Cotton, the Director of DTZ in Kiev, for offering this topic and his contribution into this work. Due to him, I met many people devoted to work in real estate field in Ukraine. I want to acknowledge with gratitude support and assistance by A. Warsame, O. Netzell, R. Hungria-Garcia, Han-Suck Song who so readily took their time to give comments on my work through course papers, seminars and more informally. I also appreciate contribution of every teacher who provided firm foundation for my knowledge during the period of studies and especially to Peter Brokking, the program coordinator, without whose support many bureaucratic hurdles would have very much complicated my stay in Sweden. I thank each company and every person in Kiev which have been involved into the process of work for their great help in providing information and sharing their experience. I appreciate Your willingness to take part in this project a lot. I would like to thank also my friends in Sweden and colleagues in DTZ for their ideas, assistance and understanding. Without all of you this would not be possible. Finally, a word of thanks goes to my dearest parents for their patience and continuous support and encouragements.

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Table of Contents ABSTRACT........................................................................................................................................................... 2 ACKNOWLEDGEMENTS.................................................................................................................................. 3 TABLE OF CONTENTS...................................................................................................................................... 4 CHAPTER 1: GENERAL BACKGROUND ...................................................................................................... 6 1.1 1.2 1.3 1.4 1.5

INTRODUCTION ..................................................................................................................................... 6 AIMS AND OBJECTIVES .......................................................................................................................... 6 APPLIED METHOD ................................................................................................................................. 7 LIMITATIONS AND DELIMITATION ......................................................................................................... 7 ORGANIZATION OF THE STUDY ............................................................................................................. 8

CHAPTER 2: REAL ESTATE FINANCE DEVELOPMENT: THEORETICAL FOUNDATION ............. 9 2.1 2.2 2.3 2.4 2.4.1 2.4.2 2.4.3 2.5 2.5.1 2.5.2 2.5.3 2.5.4

MAIN CONCEPTS USED .......................................................................................................................... 9 DEVELOPMENT AND REAL ESTATE MARKET PECULIARITIES .................................................................10 DEVELOPMENT AND THE FINANCING CYCLE ........................................................................................11 FINANCING ALTERNATIVES: DEBT AND EQUITY MARKETS ...................................................................14 A look at debt market .....................................................................................................................14 Mezzanine debt...............................................................................................................................15 A look at equity market...................................................................................................................16 DEBATE ON CAPITAL STRUCTURE ........................................................................................................16 M & M propositions .......................................................................................................................16 Traditional capital structure and M&M proposition .....................................................................17 Trade-off theory .............................................................................................................................18 Pecking order theory ......................................................................................................................19

CHAPTER 3: REAL ESTATE MARKET IN UKRAINE: TENDENCIES AND CHALLENGES.............20 3.1 3.2 3.3 3.3.1 3.3.2 3.3.3 3.4

KEY CONSTRAINTS TO THE DEVELOPMENT OF THE REAL ESTATE MARKET ...........................................20 CURRENT SITUATION: AN ECONOMIC OVERVIEW .................................................................................22 RENTAL MARKET: OFFICE, RETAIL AND INDUSTRIAL ............................................................................22 Office market ..................................................................................................................................23 Retail market ..................................................................................................................................24 Industrial market and logistics.......................................................................................................25 INVESTMENT MARKET AND DEVELOPMENT ACTIVITY ..........................................................................25

CHAPTER 4: FINANCIAL MARKET OVERVIEW: TENDENCIES AND CHALLENGES....................27 4.1 A LOOK AT THE DEBT MARKET.............................................................................................................27 4.1.1 Banking sector development...........................................................................................................27 4.1.2 Corporate debt market ...................................................................................................................29 4.2 A LOOK AT THE EQUITY MARKET .........................................................................................................29 4.2.1 Private and public investment funds...............................................................................................30 4.2.2 Pension funds .................................................................................................................................30 4.2.3 Insurance companies......................................................................................................................30 CHAPTER 5: RESULTS: DEVELOPING REAL ESTATE ...........................................................................31 5.1 5.2 5.3 5.4 5.5 5.5.1 5.5.2 5.5.3

MARKET PERCEPTION BY THE DEVELOPER COMPANIES ........................................................................31 CRITERIA FOR CHOOSING LAND PLOTS AND SCHEMES TO ENTER THE MARKET.....................................32 COMPANIES’ STRUCTURE .....................................................................................................................32 CATEGORIES OF RISK AND OTHER CONSTRAINS INFLUENCING DECISION MAKING PROCESS .................33 DEVELOPER’S STRATEGY AND FINANCING SCHEMES ...........................................................................34 Build to sell ....................................................................................................................................34 Build to manage .............................................................................................................................36 Sale or refinancing .........................................................................................................................37

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CHAPTER 6: RESULTS: FINANCING ALTERNATIVES ...........................................................................38 6.1 6.2 6.3

TYPES OF LOANS REGARDING REAL ESTATE .........................................................................................38 DEVELOPMENT LOAN: TERMS AND CONDITIONS ..................................................................................41 EQUITY FINANCING ..............................................................................................................................42

CHAPTER 7: ANALYSIS OF RESULTS IN RESPECT TO CAPITAL STRUCTURE .............................44 7.1 7.2

ANALYSIS OF DOMINATING FINANCING SCHEMES ................................................................................44 CAPITAL STRUCTURE: COMMON GROUND BETWEEN THEORY AND PRACTICE .......................................45

CHAPTER 8: CONCLUSIONS AND RECOMMENDATIONS FOR FURTHER RESEARCH................48 REFERENCES.....................................................................................................................................................50 APPENDIX 1 ........................................................................................................................................................52 APPENDIX 2 ........................................................................................................................................................55

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Chapter 1: General Background If you want to know the value of money, go and try to borrow some. Benjamin Franklin 1.1 Introduction With the collapse of the communist regime Ukraine started to introduce packages of changes towards democracy and market economy. The real estate industry began to develop very rapidly. In the following years of sustained growth, rental real estate market has been heating up with more institutional investors eyeing the sector. The demand for any kind of real estate has risen significantly with the supply lagged behind. This situation has called both local and foreign investors into play. With lack of investment instruments and immature capital market local investors have realized that investing in real estate brings high return on their capital. On the other hand, the competition for high-quality assets made foreign investors to undertake and fund new developments in transition economies. Against this backdrop, financial markets in Ukraine remain underdeveloped though the link between real estate and financial markets is considered as an essential one. The characteristics such as large scale investment, the long construction cycle, and the high unit value mean that real estate needs huge amount of funds. Moreover, be eager to expand the business, the fund raised becomes the most important for real estate developer. There are multiple ways of financing development in mature international markets. Because private commercial real investors are wealth-constrained, they seek cheap significant outside capital. Typically, it is the single source of mortgage debt. Should this not be the case for Ukraine as well? If expected rate of return is in excess of interest rate on debt, why do developers still prefer to use equity financing instead of debt? Lending institutions in Ukraine are mainly represented by the banking sector. But the supply for funds is restricted by a limit of credit to one borrower, legal regulation for commercial mortgages, etc. These constraints cause market imperfections and create arbitrage for investors. Stock market is becoming an important complement to the banking system and private equity industry is emerging. 1.2 Aims and objectives Project financing involves two major actors: developers and lenders. Developers present demand side and lenders present supply side. To reveal the interests of both sides is the main aim of the present thesis. The paper primarily tends to explore what financing schemes are used and preferred by both local and foreign developers in Ukraine and the constraints under which these schemes have occurred. Further the monograph examines what financing schemes the lenders are willing to offer and their lending terms. More specific objectives have been set in order to reach the aim: 1. To discuss the possible ways of financing in real estate; 2. To examine the used/preferred schemes of local and foreign developers for their projects; 3. On the other hand, to discuss if the lenders are willing to come up with more flexible ways to finance construction and property operation. If they are, on what terms. 4. To relate financing decisions to company capital structure.

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1.3 Applied method To accomplish the aim of the study, three complementary methods have been employed: 1) a review of the relevant available literature on finance development in real estate and capital structure; 2) an analysis of secondary data sources, and 3) questionnaires with interviews. A literature review gives us the possibility to see which theories and principles have been influential in shaping the study on possible project financing (Denscombe, 2000). This provides basis for understanding and discussing the processes on finance decision as well as challenge that different ways of financing and existing market confront. The main works that have been used and shaped a theory framework of the paper were: Real Estate. Principles and Practices by J. Dasso & A. Ring, Real Estate Finance by R. Melicher et. al, Real Estate Finance and Investment by W. Brueggeman & J. Fisher, Professional Real Estate Development by Peiser & Frej, Principles of Corporate Finance by Brealey & Miller, and the article Optimal Capital Structure and the Market for Outside Finance in Commercial Real Estate by T. Riddiough. An analysis of secondary source data is based on the available statistical data, relevant policy documents, legal documents, government and media publication, and scholarly research studies conducted on real estate finance. Data from reports and speeches from various conferences held during the period of thesis writing have been used as well as a secondary source of information. Empirical data has been gained through interviews with both local and foreign companies who are involved in development and construction. At the end of the interview questionnaires have been handled into the correspondent in order to cover more or less straightforward information on the financing ways of development project. They have been designed to collect both factual and opinion information. Seven developer companies have been interviewed. Among them are XXI century (PLC), Alacor, First Ukrainian Development, NCH Property Advisors, Ghelamco, Karavan Mega store, AISI Realty Capital. The results from three other companies (Seven Hills, Giffel, MLP) have been used as a secondary source information. The results from interviews are presented from such lending institutions as Reiffesen Bank Aval, EBRD (European Bank Reconstruction and Development), ING Investment Bank. The secondary source of information is presented by Starokievsky, OTP Bank, Diamant Bank and UkrSotsbank. 1.4 Limitations and delimitation Among the limitations that may have affected the present study are the following ones. First, the holistic nature of the study, dictated by the complexity of the real estate finance development subject, inevitably means that treatment of the issues concerned is relatively brief. Besides, development of real estate market in Ukraine is a process in flux and any judgments drawn in the study should be seen as tentative. Despite the effort of the author to examine the research problem based on relevant literature, empirical data, observation and stipulations made by competent experts and researchers, still the background and knowledge limitations of the author might have affected the study and limited it to a certain degree. The study is based on the answers that companies have given answering questionnaires and during the interviews. This implies that analysis and the conclusions are based on what the

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companies have claimed. Those questionnaires that have been sent by email offer little opportunity to check the truthfulness of the answers given by respondents. And language limitations could have affected the study as well. 1.5 Organization of the study Overall, the thesis comprises eight chapters. The monograph is organized in the following way. Chapter 2 starts with the conceptual discussion on finance development and the logic behind real estate financing decisions. More specifically, the discussion goes in details concerning the possible ways to finance a project development in the context of international experience. Then, those schemes are viewed through the lens of the market conditions of a specific country. Chapter 3 provides a framework for the study. First, constraints that influence real estate market are discussed. Then, the chapter reviews situation on the rental real estate market by each segment, presents groups of investors who undertake development and explains their main incentives. Chapter 4 examines situation on the financial market in Ukraine particularly regarding debt and equity market and sources of financing. Chapters 5 and 6 reveal the empirical results gained from the questionnaires and interviews. The criteria affecting developer’s decision such as risk and return are discussed in chapter 5. Besides, the expectations by a developer are tied up to the financing strategies they choose. Chapter 6 presents common practice of financing development. Lending terms and conditions for different types of loan are examined. Chapter 7 draws conclusion based on the results and information in chapters 5 and 6. Moreover, it attempts to tie these results to the theories for capital structure and explain why most developers do not have debt in the company structure. Chapter 8 makes concluding remarks and sums up the monograph. It also reiterates the major implications and provides recommendations for further research.

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Chapter 2: Real Estate Finance Development: Theoretical Foundation This chapter introduces basic concepts that will be used further in the study. It also provides discussion on development and financing cycle of the project. The importance of real estate cycles can not be omitted since it is crucial to enter development selecting the right time. Moreover, interest rates that lenders charge depends to a large degree on the change of business cycles. The chapter also explores the institutional setting of real estate finance within debt and equity markets. Finally it concludes with the explanation using several theories on capital structure how debt financing affects both the actual return on equity and the riskness of that return. 2.1 Main concepts used Real estate is a piece of land, including all natural resources and permanent buildings on it (American heritage dictionary, 2006). The real estate commodity, according to Dasso & Ring (1989), is the elusive ‘property rights’. The real estate market therefore can be described as a business activity in which an exchange of property rights is carried out. Product characteristics mentioned bellow cause real estate market to differ from other assets markets as stocks and bonds in several ways (Hoesli & MacGregor, 2000). Among the distinct characteristics of the property are: • Uniqueness: each property has fixed location, distinct physical characteristics, large lot size, long holding periods, infrequent trading, and finally property is the only asset class that entails management costs. • High unit value: it is very costly to purchase a property, thus it is difficult for a small investor to invest in direct property and it is impossible for big institutions to completely diversify their property portfolio. This characteristic entails borrowing and mortgage in real estate investment. • Limited information available on transaction prices due to the absence of a central property market. • Illiquidity or infrequent trading. Real estate developers play a key role in determining the financial health of the cities and a developer is defined as ‘a person or firm that is actively involved in the development process and takes the risks and receives the rewards for development’ (Peiser & Frej, 2003: 16). Development is an interlinking and overlapping process that requires knowledge about prospective markets and marketing, patterns of urban growth, legal requirements, local regulations, public policy, elements of building design, site development, infrastructure, financing, risk control and time management (Miles et.al, 2003). There are multiple steps that developers follow from the moment of project conceiving. The sequence of steps to be taken changes very frequently. Especially it concerns financing methods that may change over time. According to EDFI’s definition (2006), ‘finance development is a specialized sector of the financial industry, and aims to bridge the gap between commercial investments and government development aid. Development finance aims to invest in both private and public development projects’.

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2.2 Development and real estate market peculiarities Due to specific property characteristics as an asset class, a real estate market is extremely sensitive to any local changes in demographic, economic, political and social forces. It acts much like the market of economic theory in response to changes in supply and demand. Imperfections such as lack of product standardization, long time for production of new supply, use of leverage, and tax shelters cause some deviation from the theory. Cyclical It is argued that commercial real estate has always been a cyclical activity (Lewis 2000, Renaud 1997). Real estate markets are cyclical as a result of lagged relationship between demand and supply for space. It is possible to distinguish four phases: recovery, expansion, oversupply and recession (see Exhibit 2.2). Exhibit 2.2: Physical real estate cycle characteristics

Tenant market

Landlord’s market

Rental growth slowing

Rents falling

Rents booming out

Rental growth accelerating

Each phase is characterized by different changes in vacancy and new construction as well as changes in rent. The position of property in the market also differs by property type and location. Real estate cycles create opportunities for financing and strong market demand in advance of a large supply. It is very important for a developer to find a suitable project within this window of time for which the market is favourable. If a developer can synchronize his development process with the cycle, he can improve his chances for success. Contrarily, Dasso & Ring (1989) argue that a developer might better look to current and likely monetary policy than to regular cycles in deciding whether to take on a new project (p.330). Further the analysis of the position of the property market within the real estate cycle will allow us to draw some conclusions on the developers’ preferences to finance a project. Perfect competitive? Markets range from perfect to imperfect in operation. In a perfect market all information concerning future risks and benefits for each commodity is available to all participants (Dasso & Ring, 1989: 331). Real estate markets are generally considered to be imperfect in that full 10

information is usually not readily available to all participants. For one thing, information costs money, time, and effort to collect and analyze. Large economic size and long economic life make real estate not divisible. Furthermore, fixed location of physical property is not transportable. Efficient? In efficient market changes in information about outlook for a given property are quickly reflected in the property’s probable selling price or value. As Dasso & Ring (1989) argue the real estate market can be regarded as inefficient for one thing – information is generally captured rather slowly in real estate market. But once information is known, the value expectation of participants is influenced. This suggests relative inefficiency in that those able to gain the greatest knowledge are also able to gain the greatest advantage in the market. This conclusion provides a strong reason to study and follow cause and reflected in market indicators. 2.3 Development and the financing cycle Development is also seen as an iterative process. This means that all stages in development overlap considerably (Exhibit 2.3). Within each stage a financial factor can be considered as a driving factor behind a project.

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Exhibit 2.3: The Go Decision Existing Site

Financial Constrains

Market Information

Context Constrains

Regulatory Constrains

Driving Factors

Symbiosis

Financial Analysis

Architectural Design

PRELIMINARY SCHEME Revision

Strategy

Documentation

Construction Cost Line Up Financing

Construction Financing

Last Check

Permanent Financing

Equity Financing

GO DECISION Commitment Working Drawings

Source: Peiser & Frej, 2003:19

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Myles, Berens and Weiss (2000) classify real estate finance according to the time the loans are made, in a sequence that begins with the acquisition of raw land and ends up with a fully developed property ready for use or sale. Land acquisition It is argued that financing land acquisition is characterized by the absence of institutional lenders ‘because lenders are concerned about the ability to service the debt, they generally consider risk to be taken in inverse proportion to the cash flow from the property’ (Myles et.al, 2000:75). Raw land generates no income and as a matter of legal restrictions or internal policy, land loans are frequently avoided or limited to a small percentage of most institutions’ portfolios. A common source of financing for land acquisitions is a purchase money mortgage – a loan taken back by the seller of the land. Land development Land development is process of preparing raw land for the construction and improvements. The major difference between the development of land and the development of income property is that land is usually subdivided and sold rapidly, whereas income property is held and operated over a period of years. Usually land development is financed by a short-term development or construction loan. Therefore, the interest charged is tied to the commercial bank’s prime lending rate. For land development, the construction lender relies on the developer’s ability to sell the finished lots within a certain frame of time. Construction This stage of development has high costs (materials, labour, overhead etc.). Therefore, commercial banks play a dominant role in this process. The real estate is primarily collateral for the loan, and sometimes it is required to post additional collateral, such as other securities, or third party guarantee. These loans usually run for six months to two years and are disbursed in stages as construction proceeds (the percents are drawn down when one of the stages is completed). It is argued (Myles et.al, 2000), that in this way the construction lender is assured that construction funds are being used for the intended purpose, and in the event of default, ‘the value of the property will have been increased in amount equal to disbursements on the construction loan’ (ibid., p.76). Typically, the developer pays an initial loan fee plus interest on the funds drawn down. The source of repayment of the construction is often the permanent loan. The construction lender, being a short-term lender, is unwilling to contemplate the possibility that no permanent financing may be available when the construction is complete. To protect himself, a construction lender requires developers to obtain a permanent loan commitment as a condition to obtain a construction loan. Permanent lending This stage in the real estate financing begins when the property is put to use by the owner or by the tenants who have leased space. At this point the permanent (long term) loan is funded. The developer need only provide the permanent lender with evidence of completion, and a loan is disbursed. Most or the entire loan is used to pay off the construction lender. Today, as the boarders between the countries erode permanent financing comes from a number of national as well as international sources. Sometimes the permanent loan commitment requires that a minimum level of rentals be achieved before the full amount of the permanent loan is funded. Over the life of the project, the permanent loan may be repaid in a number of ways such as amortization, refinancing, and prepayment.

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Amortization The loan may be gradually amortized during its term, eventually being paid in its entirely at maturity. In this case, the owner’s equity interest will be equal the full market value of the property. Refinancing Before the original mortgage matures, the owner may 1) renegotiate its terms with the original lender, 2) increase the loan amount, 3) pay off the existing mortgage and obtain a new one. Prepayment The owner of the property may sell it before the existing mortgage has been paid off. In this case, the lender may call the loan, or the new owner may wish to pay off the existing mortgage and arrange new financing. However, it is worth mentioning that financing methods and sequence of financing steps may change over time as it was in the case with high inflation in the 1980s. Moreover, loans on real estate income property can be constructed in a variety of ways to meet the needs of the borrower and lender. If we have a look at development finance from a different angle, it is possible to distinguish three general structures that are used. According to Brueggeman and Fisher (2005), the chosen structure depends on what the developer expects to do with the property after construction and leasing are completed. 1. The property may be sold upon completion to investors who want to own real estate but who do not want to bear the risk of development and initial leasing. 2. The developer may retain ownership with the expectation that she will continue to manage, operate and lease the property as an integral part of her business and therefore, maintain relationship with the tenants. In this case the developers look for longer-term financing structure. 3. A developer may consider the sale or refinancing of a property upon completion. This is an option that combines elements of strategies mentioned above. In this case, the developer may seek short-term construction financing or a commitment to extend financing for one or two years beyond the construction period. 2.4 Financing alternatives: debt and equity markets The financial markets are seen as aggregation of financial instruments, lenders, and investors using financial instruments to match those who need funds (demand side) with those who have the surplus of funds (supply side). The availability of money and the level of interest rates directly affect lending terms. Traditionally property financing were divided into equity and debt/loan. Today the structure of financing is much more complex than it was before. But still it seems reasonable to separate these two markets in order to understand financing mechanism and the nature of loans. 2.4.1 A look at debt market Like the overall financial markets, debt is serviced in two different markets - money market and capital market. Money market generally offers construction loans, because its pricing is based on short-term interest rate. Capital markets offer most permanent mortgages. The institutions involved in providing construction loans are mainly commercial banks. They usually prefer to lend money for a short term (from one to three years) through the

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construction and leasing period at which time the permanent lender pays off the construction lender (Peiser & Frej, 2003: 53). The short-term nature of bank assets means both their costs of funds and their return on the investment are tied to money market interest rates. Market money interest rates fluctuate for two reasons: 1) changes in businesses’ supply of and demand for short term funds; 2) Central National bank policies. Changes in the supply and demand are primarily the result of the business cycle. During the short-term loan, the interest rate changes on agreed upon money market index (Myles et.al., 2000:72). The most common index is the prime interest rate, which is the rate the banks charge their most creditworthy clients. Because the developments involve higher risk, the rate paid is above prime. The second determinant of money market interest rate is the actions of Central National Bank. This institute is commonly known as a responsible for formulating and implementing the national monetary policy and using as one of the tools changing the rates banks must pay to borrow from the a Central Bank. Several institutions manage a large amount of capital and make permanent loans. Among them are: 1. The Savings and Loan institutions were a prime source of real estate financing before crisis in the late 1980s. They were willing to participate in joint ventures with developers, but no longer are allowed to do so. They make primarily home loans and apartment loans. 2. Insurance companies are primarily considered as income-property lenders and fund large projects with long-term loans. Life insurance companies find that long-term mortgage assets closely match with their long-term liabilities. These types of loans are tied to capital market and loans typically have fixed rates, unlike those from most construction lenders. 3. Pension funds are considered a major source of financing for real estate. First of all, because of large amounts of money to infuse. Secondly, because pension funds seek to diversify their investments and property could be a good diversifier having less risk and lower return than stocks and higher risk and higher return than bonds. 4. Foreign investors and foreign banks have been important sources of development of the capital, primarily for the large firms. And one of the reasons to enter the other country market is also to diversify their investments. Additionally, commercial banks provide this type of loans as well. Unlike short-term interest rates, permanent mortgages have maturities that exceeds one year, carry a fixed interest rate that is competitive with other capital markets to attract the necessary funds to the real estate market. Interest on permanent loans reflects the risk-free interest rate plus various risk premiums. The longer the term of the loan, the greater the premium, as lenders must forgo other investment opportunities during that period. Lenders also want to make sure they retain the purchasing power of money they lend, so they seek the compensation for unexpected inflation. A business risk premium is also added, that is, a compensation of possible default. Finally, marketability risk remains a major category for today’s commercial loans. 2.4.2 Mezzanine debt According to Peiser & Frej (2003), mezzanine debt has been established as intermediate mechanism that supplements the equity investment and first mortgage since 1980s. Deals with mezzanine debt are structured with a 70 percent mortgage, 5 to 25 percent mezzanine debt, and the remainder from the developer’s equity. Unlike a mortgage, a partnership interest is assigned in case the developer defaults on the loan. These loans are typically short-term, loans

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rates were running 3 to 5 percent higher than prime. Although interest rates are significantly higher than construction and permanent loan rates, they take the place of equity, thereby reducing the most expensive money that a developer has to raise. 2.4.3 A look at equity market Dasso & Ring (1989) define equity funds as sources that come from the personal resources of individuals or money accumulated by institutional investors. For an institution, acquiring an equity position it is expected to share the profits and risks of property operations in the same way as other equity investors (pp. 216-217). Categories of private equity investors may be all institutions mentioned above plus Real Estate Investment Funds (REITs), private investors, and joint ventures. 1. Real Estate Investment Trusts (REITs) is a public or private company that combines capital of many investors to acquire (or provide finance) and manage income generating properties (Dasso & Ring, 1989: 95). Public REITs have shares freely traded on the stock exchange and can be used for raising equity capital and mortgage financing for development projects. 2. Private investors are the individuals or organization that put up the personal savings as equity funds to gain undivided ownership of a property. 3. Joint ventures may be structured in a variety of legal forms, including general partnership, limited partnership, etc. Joint ventures also may be created by loan agreements. The most important points of negotiation for distributing of cash flow from the venture are: preferred return on equity, priorities of payback of equity, fees to the developer, cash flows from the venture, and split of the profit (Pejser & Frej, 2003:10). 2.5 Debate on capital structure Deciding how the business will be financed requires a decision as to what combination of debt and equity is best in order to achieve the investor’s goals. The financing decision is commonly known as capital structure decision. There are some theories that shape a debate on capital structure. These theories disagree with each other in many aspects. But their contribution to economic discourse is obvious and useful to discuss. 2.5.1 M & M propositions According to Modigliani and Miller (henceforth named M&M, 1958), the capital structure of the firm does not matter in perfect capital market. Their famous Proposition I states that the value of the firm is unaffected by its choice of capital structure. Therefore, borrowing increases the expected rate of return on shareholders’ investments. But it increases the risk of the firm’s shares as well (Brealey & Myers, 2003: 482). However, formal proofs of Proposition I depends on the assumption of perfect capital markets. The M&M Proposition II says that: the expected rate of return on the common stock of a levered firm increases in proportion to debt-to-equity ration (D/E), expressed in market value. The rate of increase depends on the spread between ra, the expected rate of return of all firm’s securities, and rd, the expected return on the debt (Brealey & Myers, 2003: 473). The M&M proposition says that if the debt is risk free, the expected return on the equity will increase linearly. re=ra+D/E(ra-rd) That is why you often can hear in commercial real estate - the debt is cheaper than the equity or use as much debt as possible. The effect is illustrated in terms of supply and demand for

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outside capital to finance commercial real estate, where quantity of outside capital that is demanded by property owner is related to the risk adjusted return that is supplied by the lender. Exhibit 2.5.1: Market equilibrium for outside finance in perfect capital markets RiskAdjusted Return (r)

rf

S&D

0

Quantity of Outside Finance (Q)

Source: Riddiough, 2004: 5

It can easily be observed that supply (S) and demand (D) curves coincide in perfect markets for financial capital. The risk adjusted returns1 in this case is the risk free rate of interest (R f), which is constant regardless of quantity of outside finance demanded and supplied. This consequently means that lenders are willing to supply as much capital as needed at a constant risk-adjusted return to property owners for investment property. 2.5.2 Traditional capital structure and M&M proposition M&M’s opponents, the ‘traditionalists’, argue that market imperfections make personal borrowing costly, risky, and inconvenient. Most importantly, property owners are equity capital constrained (Riddiough, 2004). The property owner is willing and able to pay relatively high costs for outside capital because the market for real estate is imperfect, in the sense that real investment profit opportunities allow property owners to pay a premium for outside finance. This means that demand for outside capital will be downward sloping and particularly inelastic at low amount of borrowing. At higher levels of debt the demand curve will begin to flatten (become more elastic) because the property owner is willing to substitute inside equity if outside capital costs are too high (ibid., 2004: 6). When equity investors borrow in attempt to chase higher returns, they assume the cost of greater variability in those returns – higher risk. In addition to creating more risk, borrowing also entails various direct costs (Myles et.al, 2000) and conflicts between the property owner and outside debt financier (Riddiough, 2004). The financial institutions allocating funds to equity investors charge fees for their service, and the charges are generally paid by the

1

In this context, risk adjusted return means the return on capital after subtracting expected credit losses and other ‘standard’ compensated risks (Riddiough, 2004:5)

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borrower. As the LTV ratio increases, the lender’s exposure increases. In response, lenders raise the interest rate’ (Myles et al., 2000: 82). Exhibit 2.5.2: Market equilibrium for outside debt: traditional standpoint Risk-Adjusted Return (r)

S

r*

D

rf

0

Q*

Quantity of Outside Finance (Q)

Source: Riddiough, 2004: 6

Scheme 2.5.2 illustrates the traditional market for outside capital in commercial real estate. According to traditional standpoint, the equilibrium quantity of debt at the time of issuance: 1) represent approximately 70 – 85% percent of asset value; 2) is supplied by a single source as mortgage debt; and 3) does not require a high premium on the capital above the risk-adjusted rate (Riddiough, 2004:7). However, market forces can change the equilibrium relation between property owners and traditional outside capital providers. A particularly interesting and relevant change is when lending conditions tighten, which can cause financing gaps to emerge. This in turn can provide market opportunities for non-traditional suppliers of debt. 2.5.3 Trade-off theory The trade-off theory is based on traditional position about market imperfections and emphasizes that taxes as well as financial distress costs influence the decision on the firm’s capital structure. Financial distress occurs when promises to creditors are broken or honoured with difficulty (Brealey & Myers, 2003: 497). Sometimes financial distress can lead to bankruptcy. The more debt to be added to the firm the more risk to be born. The lenders will require higher interest to compensate the risk of increasing debt. The likelihood of occurring bankrupt costs will lower the value of the firm as D/E increase. The capital structure of the company also includes taxes that go to the state authorities. The firm’s objective is to arrange its capital structure in such way to maximize after-tax income. Borrowing gives a firm a possibility to do so. Increasing D/E ration decreases the taxes, therefore, increasing the value of the firm (See exhibit 2.5.3).

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Exhibit 2.5.3: Costs of financial distress

The value of the firm is equal to its value if all-equity financed plus PV (costs of financial distress). According to the trade-off theory of capital structure, the manager should choose the debt ratio that maximizes firm value. Source: Brealey & Myers, 2003: 479

The trade-off balances the tax advantages of borrowing against the cost of financial distress. Corporations are supposed to pick up a target capital structure that maximizes firm value. This theory explains many industry differences in capital structure, but it does not explain why the most profitable firms within an industry have the most conservative capital structure. Under the trade-off theory, high profitability should mean high debt capacity and a strong corporate tax incentive to use that capacity. 2.5.4 Pecking order theory Pecking-order theory is a consequence of asymmetric information2. Asymmetric information affects the choice between internal and external financing and between new issues of debt and equity securities. This leads to a pecking order, in which investments financed first with internal funds (reinvesting earnings), then by new issues of debt; and finally, with new securities. New equity issues are the last resort when the company runs out of debt capacity (Brealey & Myers, 2003: 511). The pecking order theory says that equity will be issued only when debt capacity is running out and financial distress threatens a firm. Investors understand this, and interpret a decision to issue shares as bad news. That explains why stock price falls, when a stock issue is announced. However, there are many examples of equity issued by the companies that could easily have borrowed (Brealey & Myers, 2003). This is something that a pecking order fails to explain. Apart from these theories, according to Myles (2000), loan-to-value ratios are not solely the result of owner’s decision. Prospective lenders must also be convinced that a new development will support the level of debt requested by the equity investor. Two criteria dominate financing decision from their prospect: 1) the property value must provide adequate collateral to cover the loan, with cushion of value are shown in the loan-to value ratio; 2) the property must have an expected income to service the loan, with cushion of income measured by the debt service coverage ratio. Finally, Clauretie and Sirmans (2003) argue that regardless of theoretical arguments on the existence of an optimal capital structure, the existence of more practical considerations such as limited equity market for real estate, tax rules, property risk, and legal enforcement of debt agreements have driven the use of debt in real estate finance. 2

Asymmetric information is when managers know more about their companies’ prospects, risks, and values than outside investors. Therefore, they may use their knowledge in persuading own purposes.

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Chapter 3: Real Estate Market in Ukraine: Tendencies and Challenges This chapter starts with factors that constrained the development of both real estate and financial markets. Further a general overview of commercial real estate markets (office, retail and industrial) is presented. The discussion is tied to the investment climate and presents the main players in the market. 3.1 Key constraints to the development of the real estate market Before we start to discuss the current situation in both real estate and financial markets, it is important to understand that the development of real estate markets has been constrained by a wide range of factors. The constraints in many cases are a complex product of the recent history of the country and the ways in which economy have been managed. These constraints are interrelated and therefore make it difficult to tackle each in isolation. According to Adlington et al. (2000), the constraints fall into five main groups (the table 3.1 presents some reflection and consequences for the real estate development): 1. Cultural, political and socio-economic framework 2. Legal framework 3. Government and administrative framework 4. Financial and banking system 5. Private sector services All these factors affect the real estate development to a large degree and make it very different from common practice of Western Europe, though it has a lot of similarities with other Eastern European countries. These specific characteristics also help to understand the sources of risk once one is willing to undertake a project development or investment.

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Table 3.1: Summary of constraints to the development of real estate market Group Constraint Consequence Cultural, political and socio- - deep seated sense of - long held belief that land economic framework communal ownership of land cannot be privately owned - differentiation between - the land’s capital value ownership of buildings and may not be properly ownership of land considered in the development of policy and - government opposed to legislation reform or lacking - no consistent legislation, so commitment towards no land market granting private rights Legal framework

- fundamental and juridical misconceptions about titles and the powers of owners to transfer them - no workable mortgage law (relate to juridical registers) to securitize real estate

- ill developed legislation on planning and development control - slow move to official adoption of international accounting and valuation standards

Governmental and administrative framework

Financial and banking system

- inadequate provisions for enforcement of real estate market - government constrained to implement adopted land reform policies by bureaucratic oppositions and /or lack of understanding - bureaucracy perform real estate transactions at their own pace and price - lack of capital - ill developed banking and financial system

- uncertainty for purchaser about the nature of rights purchased and the legal ability to hold them - prospective borrowers unable to mobilize land based capital, prospective lenders perceive high-risk and may not lend - uncertain basis for valuation of real estate - very widespread distortion in every aspect of the real estate market and its reporting of financial information, esp. to shareholders and tax authorities - Real estate market may be perceived as high risk investment - bureaucracy prevents real estate transactions by (sometimes deliberate) misinterpretation of law - market is not transparent, transaction price and costs are distorted - limited activity in real estate market - very high interest rates

Source: Adopted from Adlington, Grover et al. (2000), pp. 6-8

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3.2 Current situation: an economic overview It was discussed earlier that real estate market development follows the business cycles. General economic indicators, such as unemployment rates, and business failures provide information on general economic conditions. National conditions determine fluctuation in interest rates and credit availability for real estate. DTZ (2006) notices that the country has great potential due to growth of steel industry and rapid development of mechanical engineering and chemical industry. Although Jones Lang LaSalle (2006) admits that Ukraine’s political and economic prognoses even over the short term remain uncertain. After economic growth slow-down in 2005, the economy is now recovering and further improvement is expected. Despite downward revisions, Ukraine’s economic growth remain among the highest in Europe at an average 5.3% per year (ibid., 2006). Nevertheless, analysts agree that political instability, lack of clear judicial regulation and stable taxation system make Ukraine far from offering attractive commercial environment. Exhibit 3.1: Key economic indicators for Ukraine 2000 – 2007 30

18 16 14 12 10 8 6 4 2 0

25 20 15 10 5 0 -5 2000 GDP

2001

2002

2003

Industrial Output

2004

2005

2006 2007*

Unemployment

Inflation

Source: DTZ Kiev, 2007

An increased demand for labour force has stimulated a decrease in the number of unemployed: unemployment decreased by 0.2% to 3.4% (Colliers International, 2006). Increase in employment is usually associated with an increase of demand for office space and decrease in vacancy rates. When companies productivity increases employment will reach the significant level, vacant spaces will be filled. Also, an increase in real wages is associated with strong consumption power by households and provides strong incentives for expansion in retail sector. As for the inflation rate, for the first time in four years, the high inflation was a threat for country economy and remains close to 12%. The inflationary pressure, as Colliers International explains, comes from growing wages and increased in social expenditure. It is likely to fall in the coming year though. 3.3 Rental market: office, retail and industrial In general, a rental market in Ukraine can be characterized as: • Poorly transparent; • Experiencing a shortage of quality space; • Landlord market with relatively low vacancy and upward moving rents • Experiencing delays with delivery of existing pipelines and new construction. 22

Demand for each property type is expected to increase due to several factors mentioned bellow, while absorption will remain restricted by existing supply. Key factors are observed in demand expansion: 1) further expansion of services and manufacturing businesses, 2) new entry of international companies and organizations, 3) influx of Russian business in Ukraine; 4) continued growth of national turnover in retail. Johns Lang LaSalle (2006) provides the benchmark data for rental market in Ukraine (Table 3.2). Table 3.3: Benchmark values Monthly office grade A rents (US/sq.m) 50-55 Monthly retail rents (US/sq.m ), boutique units 60-150 Industrial rents (US/sq.m ) 7-11 Prime national yields (%) 10 – 11 % Source: Johns Lang LaSalle, 2006, p. 9

In a broader context Ukraine can be found in the expansion phase within the real estate cycle that characterise Landlord’s market with rental growth slowing down as shown bellow. Exhibit 3.3: Real estate cycle in Europe, 2006

Tenant market

Landlord’s market Moscow

Kiev Rents falling

Frankfurt

Rents booming out

Rental growth slowing

Rental growth accelerating Oslo

Berlin, Milan Amsterdam, Rome

Stockholm, London West End London City Copenhagen, Paris, Helsinki, Hamburg

Prague, Lisbon Luxemburg,Athens,Brussels,Warsaw,Barcelona

Source: Johns Lang LaSalle, 2006, p. 9

3.3.1 Office market The office market fundamentals are showing signs of more sustained improvements. Demand for office premises is expected to increase year on year (because of increase in office based employment) while absorption remains restricted by the existing supply. Demand for offices, especially of large size, come primarily from the foreign companies, although the share of Ukrainian office users has been growing gradually (Colliers International, 2005). A small proportion of local users continue to purchase rather than lease. And one of the main factors that motivate local tenants in doing this, according to Colliers International, is the growth of prices on the real estate market, making a new office as an investment opportunity.

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Low vacancy rate (2.6 %) on the office market is the result of the shortage of quality space. Generally, the office market can be characterized by high percentage of buildings refurbished from old industrial or administrative premises into B and C grade offices (DTZ, 2006). Traditionally, all major schemes are located in the CBD areas in main industrial cities in Ukraine. Typically for a traditional ‘landlord market’, property owners are not expected to offer a price reductions. Rather, in response to tight conditions on the office market, rental rates have experienced an upward movement during 2006 (DTZ, 2006). Interestingly, the most rental increases were seen in categories B and C, while category A buildings enjoyed stable pricing (Colliers International, 2006:12). According to DTZ, Colliers International forecasts, existing tightness on the market is likely to continue until large office projects come in stream in 2007-2008. This should enable rental rates to hold stable or with slight increase in the short-term with consistently outgrowing demand over supply levels. In the likely event that there is a limited number of office schemes will be completed in 2006, there is a good reason to believe that a vacancy level will remain low. At the lack of high quality supply in the tight market, this situation will give an opportunity for office property development that may enjoy quick leasing and relatively high rental rates. 3.3.2 Retail market The strong household demand for consumption goods and scarcity of retail premises make the retail sector the most attractive for investors and developers. With several international developers planning to deliver modern shopping centers, it is believed, that the retail market will show the signs of accelerated development. Together with IKEA’s shopping mall MEGA in Kiev, large scale projects with food and entertainment zones (such as Olympic Plaza, Europeiskaya Ploshchad, Lybid Plaza) are scheduled to open next three years. However, experiences show that only 15 – 20 % of the projects are get built, due to the planning permit and project financing (Johns Lang LaSalle, 2006). Many international retailers are planning a rapid expansion in the supermarket sectors. Among them: German retailer Metro, Russian – Paterson, Pyaterochka, Portuguese – Geronimo Martins, Turkish - Migros Turks, etc. Red tape remains a barrier for the retailers to enter into the retail market. While some of the retailers overcome this difficulty in building the own building, other decide to purchase existing stores. Despite difficulties foreign retailers are keen to invest in Ukraine. It also interesting to note, that according to Kearney’s Global Development Index, Ukraine has been ranked the third best market in the world in terms of retail opportunities after India and Russia (Johns Lang LaSalle, 2006). On the other hand, the increased consuming power by the population is connected with inability to save and invest money elsewhere. In general, rental growth has been seen as stable in all retail sectors and this growth is expected to continue. Commercial development has gradually spread from the capital to other Ukraine’s regional centers. Apart from increase in disposable income of households, a number of factors affect retail rent growth in different regions. Rents in the cities depend on quality and popularity of the retail centre, tenant’s brand, size of retail unit and its location within the centre.

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3.3.3 Industrial market and logistics According to John Lang LaSalle and DTZ’s view (2006), the logistic and industrial market remains underdeveloped mainly due to the lack of the industrially zoned construction plots, as well as a lack of research that could provide information on feasibility of industrial development. The situation may change as both local and international players are getting more active in the market. The development of industrial and logistics sector is expected to follow a decentralized pattern (not only around the capital but around the other strong secondary markets) as in CEE countries. As well as in office market, there is a shortage of good quality warehousing space in the big cities and in the capital. Major western corporations are willing to pay high prices and have been conducting their own renovation and settling the warehouse space. However, as DTZ notices, ‘Some started to construct actively logistics, expecting the rent increase for those premises, but nobody estimates correctly the demand. There is a certain sum viable to pay for this type of premises’. 3.4 Investment market and development activity It is argued (Adlington, Grover et al., 2000) that a mature real estate market can act as a store of wealth by providing opportunities for investment in property assets (p.3). A real estate is one of the number competing investment vehicles. An opportunity to invest in it permits increased opportunities for diversification portfolios. Moreover, as some investment funds have active management strategy with the anticipation to outperform the market, the part of value-added strategy is to identify something that is desirable in product located in a particular market, but does not exist, and then deliver. Both DTZ (2006) and Johns Lang LaSalle (2006) point out that the market for commercial institutional property is immature. Nevertheless, there is a considerable investor interest in both real estate development and secondary investment opportunities. Colliers international identifies two main kinds of investors: 1) those who are interested in acquisition of high quality investment, and 2) those plan to undertake development. Among the latter category is a mix of local and opportunistic international groups, with the former category entirely represented by foreign investors, mostly from Israel, US, United Kingdom, Austria and Russia. It should be admitted that local investors have somehow different interests to real estate than international investors. Local investors are more prone to look at acquisition and redevelopment of inactive industrial or administrative buildings in locations that are favourable for development of commercial real estate. International investors are increasingly interested in purchasing or development of joint ventures It was mentioned already that the real estate market in Ukraine is characterized by the shortage of quality space. Therefore, investors merely have limited possibilities to buy and hold high quality premises. However, this situation has created an opportunity for the local developers to be more active in delivering new products to the market and cooperate with international groups. Most of international developers are already active in CEE and Russian markets. At the same time, the current availability of capital sources (mostly represented by private equity funds) poses a significant obstacle to investment transactions on the market, and despite significant demand, sluggish development activity within commercial real estate is the concern of many market players. Other problems with development include the lack of

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available land parcels and difficulties with acquisition of existing structures for brownfield, especially in the city centre, and cumbersome approval process. Poor transparency in the real estate market does not enable many details on the number of projects that are in the pipeline as well as those planned or under construction. Experience suggests (articles overview on IKEA’s development project) that many developments remain on paper pending financing and/or approval, or arrive much later, missing construction deadlines. On the other hand, there can be observed another trend. As professional western developers consider entering the market, the local developers adopt new standards. Better quality of new office stock will drive refurbishment of the today’s premises in order to stay competitive. Another key decision making factor that attracts investors are high yields for commercial real estate (see table below). Despite persistent, significant interest on the part of qualified foreign investors, the gap between buyer and seller continue to prevent. A typical strategy of the local owner of commercial property is to hold the property unless an unusually attractive offer to purchase comes across (Colliers International, 2006). Table 3.4: Major Investment Transactions in 2006 Building Sector Purchaser Nationality Yield Volume,$ mln Leonardo Office, Kiev, Quinn Group Ireland 10-11% 93 CBD Piramida Retail, Kiev, 1849 UK/US 16-17% 21 NC Pic/Apollo Ukraina Retail, Kiev, Quinn Group Ireland 11-12% 59 outside CBD Source: DTZ, Kiev 2007

Currently, in all market segments the yields are still higher if one compares with other CEE countries but it is expected that yields will decrease and converge towards those in CEE.

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Chapter 4: Financial Market Overview: Tendencies and Challenges Ukraine as other transition countries face a challenge for developing capital market which would play a significant role in providing funds to the corporate sector and constitute an effective instrument of corporate control. Dasso & Ring (1989) notice that money or credit is the lifeblood of real estate construction. Money constitutes a very strong and very direct link between national economic conditions and real estate market activity. In this section a brief overview on financial market will be presented in the dimensions of debt and equity markets. 4.1 A look at the debt market Debt market is currently presented on the bank level and corporate debt market. Unfortunately there is no strong legislative base for a bond market and it is only at the early stage. 4.1.1 Banking sector development It is argued (Kawalec & Kluza, 2000) that compared to developed economies, transition economies usually have banking sectors smaller in relation to GDP (p.23). However, these banking sectors dominate the financial sector as other financial sector segments are not enough developed. There are three distinct tendencies observed in banking sector: • Upcoming acquisition by foreign banks; • Increase in bank lending to private sector; • Modest growth of deposits. Foreign participation in the banking sector has increased further since the fall of year 2005, when agreements have been signed by European financial groups for the purchase of four top ten Ukrainian banks in term of asset. Sales of stakes in midsized Ukrainian banks have followed, bringing the total percentage of foreign capital in the sector to almost 25 percent by the middle of 2006 (Kyiv Post, 2006). Still underdeveloped, Ukraine’s banking sector promises high growth rates fuelled by increasing consumer lending and corporate credit lines. Ukraine has 200 banks; many of them are so called pocket banks for local business groups. Buying opportunities are abundant, as Ukrainian business group seeks out opportunities to sell their banking operations for top dollar amid high demand (ibid., p.4). The coming acquisition is TAS-Kommertsbank by the Swedbank and UkrSotsbank by Banca Intensa (Italy). Both are ranked among 20 largest Ukrainian in terms of assets (Table 4.1.1). Table 4.1.1: Upcoming and recent acquisitions in Ukrainian banking sector Name of the bank Acquired by Acquired for, USD Acquisition date TAS-Kommertsbank Swedbank 735 mil February, 2007 Ukrsibbank French BNP Paribas 51% for 0,5 billion December, 2005 Index-bank French Credit Agricole 100% for 260 mil June, 2006 S.A Raiffeisen Ukraine Hungary OTP Bank 100% for 833 mil June, 2006 Agrobank Czech-based PFF Group 100% July, 2006 Prestige bank Austrian Erste 50,5% for 35,5 mil July, 2006 Aval Bank Raiffeisen Banking For more than 1 bil October, 2005 Group Agio Bank Swedish SEB The implications of foreign banks entrance are the following: 1) foreign investors brought 24% of foreign capital share into the banking sector; 2) the merged banks tend to have more 27

experience in risk management practices (this suggests that there is a scope for smaller, domestic banks to strengthen their risk management and minimizing the level of bad debt); 3) increase in bank lending. Exhibit 4.1.1: Key indicators for banks 35 30 25 20 15 10 5 0 2000

2001

2002

2003

2004

2005

asset share of state own banks asset share of foreign banks non-performing loans stockmarket capitalization Eurobond issuance

Source: EBRD, 2006, p. 192

The domestic loans to the private sector in percentage to GDP has been rising slowly and reached 35.2% as compared with Greece 86% and Spain 150%. European Bank of Research and Development (2006) notice that expansion in bank lending has occurred due to increased liquidity in the money market and further loosening in the monetary policy. By June 2006, banks’ loans had increase by almost 55% year-on-year in real terms to 40% of GDP (EBRD, 2006: 190). Consumer loans and mortgages in foreign currency have been the fastest growing categories. Last year IMB (International Monetary Bank) has attracted $30 million in long term debt from the US Overseas Private Investment Corporation (OPIC) in order to meet the demand for mortgages. Lending to corporations achieved 20% (see exhibit 4.1.2). However, as Moody Investment Service (2006) indicates, fast growing level of borrowing raise concerns about asset quality and risk management which are often inadequate, especially if the risk function is not independent. In many cases profitability considerations often prevail over the needs to maintain a strong liquidity result in low ratio. Probably, these were the reason of failure of UkrSotsbank - Banca Intensa deal and a sign of foreign investors re-evaluating the high premiums recently paid for business assets. Exhibit 4.1.2: Lending by ukrainian banks Lending by Ukrainian Banks in 2003 - 1H 2006 25,000

160% 140%

139%

US$ mln

20,000

120% 100%

15,000

80% 10,000

64%

63%

60% 47%

5,000

23%

20%

0

40% 20% 0%

31-Dec-03

31-Dec-04

31-Dec-05

30-Jun-06

Loans to individuals

Loans to corporates

Grow th rate (loans to individuals)

Grow th rate (loans to corporates)

Source: Association of Ukrainian Banks

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As a reaction to the credit growth, National Bank of Ukraine (NBU) has decided to raise interest rates and introduce stricter regulation on minimum reserves in order to grapple with credit increase problem combined with rising inflation. At the same time, people get attracted by lower interest rates in foreign currency and by expectation that local currency may appreciate. That is why another challenge for NBU is foreign dominated currency loans which create mismatch between people income and their credit exposure. Table 4.1.2: Interest rates for loans 2004 2005 2006 Interest rate in national currency (UAH) 17.5 16.4 14.6 Interest rate in foreign currency (USD) 11.2 11.7 11.3 Melicher and Unger (1989) state that the basic source of funds supplied to the credit markets comes from savings which represent the accumulation of cash and other financial assets (p.53). Savings may vary in their forms. One of them is bank deposits. In contrast to loans, the level of deposits remains moderate and accounts only 33% percent of a country GDP (EBRD, 2006). According to NBU estimates (2006), the total deposits have grown by 24% compared to 38.6% last year. Also it is worth noting that foreign exchange deposits prevailed in the currency structure of deposits, with their amount having grown by 43.5% compared with 13.8% in national currency (NBU, 2006: 6). NBU explains a lower deposit growth rates as a process of recovery of the banks’ resource base after the events of Orange revolution. On the other hand, low level of deposits can be explained as an expensive instrument in money market. It is much cheaper to borrow in the world market by issuance of Eurobonds and attracting syndicate loans on the European capital market. Moreover, if foreign banks established in Ukraine have access to the cheap resources, it is possible to get a loan for LIBOR rate or LIBOR +1,5 – 2%. Earlier the banks were struggling to make people save and therefore increased interest rate for their savings. Now financial institutions are not afraid to reduce deposit rates as they have access to external funds. 4.1.2 Corporate debt market Corporate debt market is not developed in Ukraine. However, it is common practice among local developers to issue bonds for residential property in exchange for square meters. You buy a bond that corresponds to one square meter of the apartment. Usually companies started to offer bonds on the early stages of the construction. In this case they are obliged within a certain period (usually it is a period of construction) to give away the area people paid in bonds. But in many cases the delays in delivering residential blocks means that the company breaks its promise as a bond has matured. People can not demand their money back because of the price increase. In coming year large development companies with a large number of assets plan to finance their business with issuing Eurobonds. Nevertheless, presently it is not an issue. 4.2 A look at the equity market Although banks continue to dominate the financial sector of the country, there has been growth in other types of financial services. The size of public equity market has started to expand substantially. There has been also an increase in investing in private companies through equity. Most funding for private equity has been provided by foreign institutions as domestic sources of finance are still very limited. Concorde Capital, a Kiev based investment bank, reported the influx of new investors had pushed stock prices on Ukraine First Stock Trading System (PFTS) to the historical heights.

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The index increased by 22% since August and is up 36,9% year to date. The Ukrainian market remains small compared to peers with capitalization hovering just under 40 billion. According to Dragon Capital, Ukraine has lagged far behind Russia, whose market stand at over 1 trillion but on a par with Hungarian market and inching up to Poland, a 155 billion market. In terms of market capitalization as a percentage to GDP Ukraine’s 37,6% mirrors markets in Central Europe, such as Czech Republic. In Russia, whose market is largely driven by big energy giants such as Gazprom, market capitalization of GDP is significantly higher than 104,2%. The Ukrainian stock market has no big names like Gazprom and Lukoil, many Ukrainian monopolies are not listed. Year to date trading volume on PFTS stands at just under 1,2 billion, up from around 650 million last year. While it grows, the small size of the Ukrainian stock market, and the low supply of attractive stocks has kept many interested investors at bay. Much of the growth has been driven by activity in energy-generating companies such as Centrenergo and Zakhidenergo, pipe companies, leading banks, including bank Aval and Ukrsotsbank. The market holds many undiscovered stories: retail and construction sectors continue to post impressive growth, but most of the companies have not yet listed their shares on the market. 4.2.1 Private and public investment funds Private equity is gradually becoming an established element of companies financing. Most funding for private equity in the country has been provided by foreign institutions. Domestic sources of finance are still very limited and it is not possible to get the reliable information on their contribution to real estate. The main public real estate investor XXI century listed on London AIM sold its shares at USD 140 mln. There are a number of smaller Ukrainian funds listed on Ukrainian stock exchange which specialize in investments into real estate, but their capitals are marginal, and it is impossible to precisely estimate amount of capital invested in real estate in Ukraine. 4.2.2 Pension funds USAID provides active assistance for the formation of Non-State Pension Funds (NPF). However, NPF faces challenges. According to a recent survey, only 63% of the respondents did theoretically know about NPF existence in Ukraine (15 min newspaper, 24th March, 2007). Currently, there are around 50 pension funds in Ukraine with accumulated capital of USD 20 mln. In 2006 they invested 1% from their total asset value into real estate, it is 30% higher than in year 2005 (UAIB,2006). It is argued that ‘the creation of mandatory saving in pension fund might constitute a substantial cure for weak domestic investor’s base and for a lack of long term portfolio investors’. Recently a number of banks tried to establish Non-state Pension Funds, however, these attempts were not successful. 4.2.3 Insurance companies A league of insurance companies invests their equity in real estate. In 2006 the percentage invested in real estate accounted 4% of the total value of their assets. The increase of equity invested into real estate is found from year 2004. In 2004 1,69% was invested into real estate from total asset value € 2 000 000, in 2005 the percentage has increased to 2,7% from the same amount of total value, and in 2006 it has reached 4% from total asset value of € 3 000 000 (League of Insurance companies of Ukraine, 2006).

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Chapter 5: Results: Developing Real Estate This chapter presents the developers’ perspective on their business. It examines the criteria and risk perception for development projects. Further the discussion on the preferred strategies is related to the financing schemes of the projects. 5.1 Market perception by the developer companies All respondents agree that the demand for commercial real estate is still far greater than what is available in the market. Following the years of sustainable growth, commercial real estate will continue to heat up. The developers see in a large scale entry of institutional investors onto the market. Though, local developers admit that there is no competition on the market yet. Meanwhile, an underdeveloped legislative base that gives rise to an over-bureaucratized system of building permits continues to challenge the growth of the sector. Especially, it is seen as a huge hurdle for the foreign developer. Foreign developers are still few in the market and can not compete with local ones. Financial Manager of First Ukrainian Development admits ‘it is easier for Russian investors to enter the market since they have similar market conditions, legislative base and mentality’. Some foreign developer companies even avoid making a public statement on their intention to develop projects. They are concerned that the right to lease or own a land plot may be converted to a local player. In some other cases (GLD, Ghelamco, IKEA) the approval process to start a construction takes ages. Managing director of Alacor expects that market will be approaching peak of the expansion phase only in three year time. Retail market is considered the most competitive and attractive among developers. Fast economic growth of the country, increase in purchasing power by population and undersupply of retail space dictate high rental rates in the existing retail centres. Therefore local developers are hurrying up to acquire a land plot, work out a concept for retail in the densely populated regions of Kiev and then to move to other cities. But a local developer lacks the experience of managing and implementing the secure lease schemes to operate retail. They try to speculate on the market ignoring the long term nature in lease contracts. Managing Director of NCH Property Advisors Inc. highlights that often local developers do not care much about infrastructure and site improvement of the property; they do not think about the property from a long term perspective and build for the purpose of selling. Foreign developers are more experienced in delivery higher quality and therefore more competitive product in all sectors of commercial real estate. Office market follows after retail and it is seen as the most sustainable among many developers. The area of office space is still far from that delivered in e.g. Warsaw and Prague. The rent level in this segment is higher than in other CEE countries due to the low supply and increasing demand from expanding local and foreign businesses. The first steps made successfully by foreign developers are logistics projects because this segment is still new and unknown for the local developers. Foreign real estate companies have advantages in industrial development as they have more experience and knowledge in this segment. Local developers give secondary attention to this sector but do not give up opportunities to learn from competitors and start to construct logistics parks. All developer companies independently of their origin include residential development in their portfolio. First of all, due to high demand for the newly constructed houses, this sector very attractive and less risky. Secondly, it gives an opportunity to raise capital very fast and 31

reinvest it into other projects. A new challenge for local companies is seen in development of business and retail parks as well as headquarters. 5.2 Criteria for choosing land plots and schemes to enter the market The starting point for both foreign and local developers to enter the real estate market is Kiev, as it is already tested and examined by investors, and then they move to other regions. When the land resources in Kiev are getting scarce, local developers take risk for the brownfield development and reconstruction or development of former industrial premises and military zones. However, foreign developers go for development of green field land with its proper allocation. The increase in competition in Kiev and shortage of the land plots are pushing the price for land upward. This brings both foreign and local developers to other big industrial cities. The main criteria the developers look at acquiring a land parcel are: 1. location, 2. proper zoning, 3. price, 4. developed infrastructure around a site, 5. the size of the land plot (in some cases). Interview results show that there is no main strategy among developers to enter the market. All companies use different alternatives, each of them have their advantages and disadvantages: • The acquisition of land on the primary market. The advantage is the minimum price for the land use. However, it is very problematic for foreign developer (Russian developers are more flexible) to get the permission for the land use from local authorities and there can be a long approval process. • To enter the project on the pre-construction stage. This alternative might be costly for foreign developer as after every stage of approval, a local developer is increasing the price for the project. Though, the advantage of this is a fast move to the construction stage. • Partnership with the local developer through buying shares in an uncompleted project. Managing Director of Alacor notices ‘there are a number of examples of foreign companies that tried to do something on their own and failed’ that is why they address to local partner to meet their goals. Among advantages of this partnership is a faster process in gaining all approvals (land plot rezoning, bureaucratic obstacles) due to the local developer’s efforts and strong development skills, good management due to the foreign developer’s experience. All foreign respondents agree that it is extremely difficult to deal with a local developer because of an attempt to control the development process, different perception of risk and share in risk and therefore share in the profit, and poor experience in development process management. 5.3 Companies’ structure It was rather difficult to get reliable information on a company’s structure. It seemed that respondents were trying to skip this part in order to cover who and what corporations are actually behind the real estate business. Local developer-companies are usually either the substructures of some other businesses investing in real estate with a purpose to diversify their business activities or sponsored by wealthy individuals. For example, First Ukrainian Development as well as Karavan 32

Megastore are merely the structures of gas and metal industry. Alacor is a principal development company with local capital. Foreign companies are mainly private Investment Funds investing their equity into real estate development in Ukraine. It is also getting common to form joint venture between landowner and developer, investor and developer, developer and lender. All companies being interviewed are limited liability companies except XXI century, the first real estate developer company entering IPO stage and trading publicly on London AIM stock market. 5.4 Categories of risk and other constrains influencing decision making process Among the biggest problems contributing to low supply of commercial real estate is the process of procuring land plots, as well as recently introduced regulations that make real estate development even more complicated. There are too many vested interests in the various structures and a developer needs hundred permits to build a building. To go through the approval process is costly. Moreover, it affects construction dates. Obviously, every positive statement gained from city authorities adds more value to the project. Back in 2004, a president of Ukraine intended to transform all stations into ‘one-stop shop’ but it never turned into practice. Driven by the shortage of land developers grab a piece of land at first and then think what this land is good for. Another aspect is the legislative base. Managing Director of NCH Property Advisors comments that ‘The current problem in Ukraine is the absence of unified register that include complete information concerning any real objects’. Majority of land parcels are held leasehold. The standard terms of the leases are that rents are reviewed annually (upwards or downwards) in accordance with a city-wide formula that is set by the relevant city authorities. Whilst in Ukraine the lessee of a ground lease typically has a priority right to renew the lease upon expiry on the same terms and conditions, one should be aware that the effectiveness of the Term Extension Right Clause remains largely untested in the market. There is always a risk of delay in delivery that leads to delay in obtaining income form leasing a property. Additionally, a number of the land leases are held for relatively short terms (usually for construction period) and place an obligation upon the lessee to complete development by a prescribed date. In the event that a company developer has not completed development by the completion date stipulated in the lease, the rights to complete the development could be delayed or lost entirely. All mentioned above risks are associated with financial and construction risk since the construction costs tend to increase as a result of inflation. The longer the developer has to wait the higher he should pay for every meter to be constructed. Besides, as many foreign developers look for the partnership with a local developer, there is a certain risk of hidden information from both sides leading to mistrust and lack of transparency. On the top of these there is a political risk of the country. Brueggeman and Fisher (2005) argue, the highest risk is usually associated with completion and occupancy stage (see exhibit 5.1). An example with market scenario with less risk is shown as case (A) where market demand for space is increasing and predevelopment leasing is occurring at an above normal rate, thereby increasing expected cash inflows. Most of local developers, as a rule, are not willing to undertake the longer term market risk after lease up

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period and to provide the intensive amount of property management necessary to retain the tenants. Therefore, they tend to sell property to institutional or other investors who are willing to specialize in real estate managing and bear that risk. The larger, more geographically diversified developers try to manage projects in various regions. Exhibit 5.4: Phases of real estate project development and risk

Phase 1 Land acquisition

R i s k

Phase 2 Construction

Phase 3 Completion &occupancy

B

Phase 4 Management

Phase 5 Sale

C

A

Time A – Greater than normal predevelopment leasing, completion ahead of schedule B – Normal predevelopment leasing, completion on schedule. C – Lower than normal predevelopment leasing, completion behind schedule. Source: Brueggeman & Fisher, 2005:433

So what drives the developers in opaque, immature and highly corrupted market? Clearly, for developers willing to take on the greater risks inherent in emerging economies, the potential rewards are great. 5.5 Developer’s strategy and financing schemes 5.5.1 Build to sell The structure chosen by the developer to finance a project to a large degree depends on what the developer expects to do with the property after construction and leasing are completed. According to Brueggeman and Fisher (2005), three strategies can be identified. Speculative by its nature, development means to build in order to sell. That is why it is not odd that the most developers seek to sell the property after 2-3 years of lease period. In this case the difference between the developer’s costs and the price received for the completed property represents the profit to the developer (the expected profit is 20-30% and sometimes higher than that). With this chosen strategy, the developer considers a short-term financing through borrowing money for construction period or looking for the partner-investor. Presently most of the companies are either using own equity to finance their projects or looking for a coinvestor. One of the arguments for equity use is that both local and foreign developers find themselves in pre-construction stage where there is no need for considerable capital. But in future they are likely to use foreign rather than local banks since the former are more experienced and 34

offer lower interest rate on the loan. The other reasons why real estate development is equity financed are that banks usually demand different types of security on the projects. Such tools are often used: 1) collateral, 2) pre-lease agreements with the tenants, 3) construction permit as a guarantee. Many companies do not have adequate assets to pledge against borrowing money. Lenders prefer to make loans only for the cost of site improvements and require the project should be in the advanced stage (with all permits to start construction). While an external investor is ready to take all possible risks on the early stages and lend necessary money for the project. Additionally, the interest rate for the loan is high (LIBOR +5-7%), and the longer a loan the higher is interest rate. Also, the short-term nature of real estate market is reflected in lease agreements. Most leases in retail are signed for a period of one year (unless it is an anchor tenant). In office sector the length of leases is up to three, five years. Moreover, the risk associated with delivery of the property affects the decision on pre-lease agreements. As it was shown earlier, the risk is greater with lower than normal predevelopment leasing and completion behind the schedule (Exhibit 5.4, C case). It is also worth noting that borrowing is associated with a kind of burden in former soviet mentality. People still have a mistrusting attitude to the banks. In the case of borrowing, all companies being interviewed are concerned with the following criteria: • Volume of necessary capital to be invested into the project; • For how long; • Service charge; • The degree of influence by the lender; • Probability to call a loan by a lender

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Table 5.5: Summary on existing schemes and arguments in their favour Company name Equity financing and origin XXI century, Private equity and Ukraine publicly traded stocks on London AIM

FUD, Ukraine

Equity by businesses

Alacor, Ukraine

Own equity plus external financing by a partnerinvestor

NCH US

Advisors, Own equity

Ghelamco, Belgium AISI Realty Capital, US Karavan Megastore, Ukraine

Giffel*, Canada

Seven Israel

other

Equity for now Raised equity in London AIM Equity from other businesses

Equity of foreign investment funds

Hills*, Equity

MLP*, Russia

Equity

Arguments

Debt financing

Arguments

-long-term and Eurobonds in -no need for cheap instrument coming future collateral -no need for -low cost of long collateral term instrument -transparency -no lender’s required influence BUT: lack of legislative base All projects are in No need in pre-construction borrowing yet stage Few projects Project financing -to use as much which are in pre- by a foreign bank debt as possible construction in coming future -debt gears stage return on equity -cheap capital from abroad No need for loans as it is foreign investment fund Going through No need for approval process borrowing yet -long-term and cheap instrument Project financing -high debt ration loan by Ukrsib gears return on bank, three years equity bonds -banks willingness to finance retail Loans by foreign -opportunity to banks use cheap money No need for high Loans for At the stage of volume of money construction of working on residential financing structure with banks Project financing loan by Hypo Real Estate

5.5.2 Build to manage Another strategy, according to Brueggeman and Fisher (2005), is to retain ownership with expectation to manage, operate, and lease the property as an integral part of the business. In this event, a developer seeks a longer term financing structure and has both permanent loan *

The secondary source of information used, Commercial Property 4(44), pp.37-45.

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and construction loan. Unfortunately, this strategy has not been put as a goal by the interviewed developer companies. First of all, because they should have had more skills and experience to manage commercial real estate. Secondly, because of existing opportunities to get a high return on the capital invested in the event of sale. And at last, in the market with high risk characteristics it is difficult to think from a long-term perspective and permanent loan institutions are not well established in the country. 5.5.3 Sale or refinancing Brueggeman and Fisher (2005) argue a developer may consider the sale or refinancing of a property upon completion. In this case, the developer seeks short-term financing for construction period and/or commitment to extend financing for more years beyond the construction period. Among all respondents there was one company that is following this strategy – Karavan Mega store. Being successful in development of shopping mall and in its operating, a company provides financial data from its operation to a lender for refinancing but now for a lower interest rate (11% in USD). This company is also known for bringing foreign operators with longer term of lease agreements. That in turn guarantees secure cash flows as supermarkets, drugstores, electronic goods maintain relatively stable sales at all times. Additionally, shopping centres offer attractive features for lenders because of the amount of inflation protection they provide due to their shorter net lease character.

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Chapter 6: Results: Financing Alternatives This chapter presents common practice of financing development. The interview results obtained from banks review current types of loans to real estate. Further, lending criteria are examined for both construction and permanent loans. Also the creation of venture capital and equity investment into the projects is briefly discussed as an alternative to borrowing. 6.1 Types of loans regarding real estate One major problem identified by most of the respondents is the poorly developed commercial real estate finance market. This makes it difficult for real estate companies to mobilise the capital tied up in real estate. If a picture on residential property is somewhat different due to the arrival of foreign banks that brought mortgage loans to Ukraine, commercial market still lacks the opportunity to use real estate as collateral for raising investment finance. With other existing schemes in the market as equity financing (by using own equity or using partner’s equity) and with bank restrictions on the amount of money for one bank per one customer3 a developer goes for one that meets his project requirements. If he needs large funds he will likely chose equity financing, with smaller amount of money needed for construction he would choose borrowing from a bank. If we recall real estate market some years ago it was extremely difficult to obtain funds for project financing. Nowadays banks are not only willing to offer loans but they are looking for the alternatives to be partners in undertaking development activity. As it was mentioned in chapter 4, banks occupy a dominant position in lending market. The following types of loans are in common practice within the banking system. 1. Traditional loan 2. Project financing 3. Syndicated loans 4. Participating loans 5. Commercial mortgage Some loans are provided for either land development or construction purposes, so they are short-term interim loans. Project financing loans can be regarded as mini-perm loans (a single loan for both finance construction and operations for a year or two beyond a lease-up stage). Financing land acquisition is not a practice among the banks as raw land is not able to generate any income. Traditional loan This type of loan is widely spread in residential development but is also used in commercial segment. Among advantages of this loan type is a rather fast (compared to other types of loan) procedure for its submission. Lenders requirements in this case are: estimated value of the project and its feasibility analysis, with market data on the project. Project financing Currently this type of financing is getting more recognition among developers. The reason is that a loan is completely non-recourse to the developer, i.e. a developer has no obligation to make payments on the project loan if revenues generated by the project are insufficient to cover the principal and interest payments on the loan. In order to minimize the risks associated with a non-recourse loan, a lender typically requires indirect credit supports in the form of guarantees, warranties and other covenants from the developer, its affiliates and other 3

It is not allowed to provide a loan amount exceeding 25% of the registered charter fund of the bank.

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third parties involved in the project. In a project financing, a developer seeks to finance the costs of development and construction of the project on a highly leveraged basis. Frequently, such costs are financed using 70% debt. Project financings is structured to maximize tax benefits and to assure that all available tax benefits are used by a borrower or transferred to another party through a partnership, lease or other vehicle. Among disadvantages of this type of loan is its complexity. It may take a much longer period of time to structure, negotiate and document a project financing than a traditional financing, and the legal fees and related costs associated with a project financing can be very high. Because the risks assumed by lenders may be greater in a non-recourse project financing than in a more traditional financing, the cost of capital is greater than with a traditional financing. CFO in UkrSotsbank notices that the distinguished feature of this loan is ‘it is repaid when a property is able individually generate the income. Therefore, thorough income analysis is required’. With project finance the collateral on the property becomes a project itself and the shared rights for developed property. The common practice is a creation of separate SPV (Special Purpose Vehicle) for every single project. So inflows and outflows of the project will be reflected on the balance of project SPV. Depending upon the structure of a project financing, a borrower may not be required to report any of the project debt on its balance sheet because such debt is non-recourse or of limited recourse to the sponsor. Usually one bank offers different schemes for financing development projects that suit to a customer’s purposes. As of January 1, 2007, the market share of the leading lenders for commercial real estate was Alpha bank with 7%, OTP bank with 17%, Ukrsotsbank 13.8%. Syndicated loans This loan is not as widespread as two types mentioned above. By their nature syndicated loans are short-term loans aimed at import-export operations. However, if the syndicated loan is attracted for a bank’s general corporate objectives, the amount can be used for mortgages. The reasons for creating a syndicate loan is that a single bank is unable to satisfy the borrower’s demand in term of the volume of funding due to insufficient own funds or a bank is not wishing to assume the full risk of the funding operation. In many instances syndicated loan is used by a developer as a single bank unable to satisfy the borrower’s demand for fund because the scale of funding exceeds the risk threshold that the bank is allowed to offer to a single borrower due to the conservative lending norms. Despite of few examples of syndicated loan in real estate, Financial Director of FIM Group, sees great opportunities in using it: ‘Attracting a syndicated loan for a large-scale project is not only the way of using this instrument. We expanded its application when we took out a loan against recently completed project. This allowed us to refinance FIM Group’s own capital, invested into construction and reconstruction of two operational properties. This helped us to obtain funds and develop new projects’. In some other cases syndicated loans are used for supporting small and medium sized enterprises. Among other benefits of this type of loan is securitization of the capital invested into the project through risk elimination among banks participants in a syndicated scheme. Also, a relatively small number of Ukrainian banks can approach external market to attract the funds. Syndicated loan helps local banks to cooperate with foreign banks giving an opportunity to attract funds at lower interest rates than in the domestic market. Moreover, it creates a public credit history on the international lending market.

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Participating loan The lender provides higher loan-to-value rates in exchange for a percentage in the profit. Many banks invest their equity into real estate. This scheme is used by both foreign and local banks. EBRD, Reiffesen Bank, Alpha-Bank, HVB are participants of the projects and have all rights, obligations, and return on equity as the investor or co-investor. The benefit of this type of financing is high rate of return through higher risks involved. Beside this, from a developer perspective, this is perhaps the easiest form of joint venture because it involves only one other party. The lender structures involvement in a variety of ways. The preferred return is paid when cash is available, whereas the interest must be paid immediately. This type of financing is used as a borrower does not have enough capital, or collateral, or other alternatives to finance a project. Alpha bank in this case offers financing for land development purposes. The collateral for the loan is regarded either real estate or a developer company with all its assets. After a developer has gone through all approval process, a bank offers a project financing loan. Commercial mortgage As it was mentioned earlier that mortgages are common for residential segment and the volume of mortgages in banks portfolio has been increasing very fast. The rise of the mortgages in residential market is a consequence of two factors: 1) steadily rising housing market are motivating people to finance property purchases with bank loans at the interest rate lower than appreciation in real estate prices, which justifies such borrowing; 2) bank loans have become more affordable because the large banks have started working with retail clients and are more pushing expectation of their retail businesses via new retail-tailored loan product. Analysts notice, that despite of rising demand for commercial mortgage, this market is still immature. The head of Starokievsky Bank mentions several reasons for this: lack of transparency on business mortgage from legal point of view4, higher risks by banks connected with default, and longer payback period of commercial real estate. In future the situation is expected to be changed in favour of bigger banks with large credit portfolio and reliable clients. For now commercial mortgages are known as “business mortgages” and primarily used by small and medium size enterprisers for developing their businesses. Commercial mortgage is different from a project financing type of loan since it is used for acquiring existing property. There are two criteria that the banks are looking at deciding on commercial mortgages. First of all, it is the yielding (the income generated by the property should be enough to off set the interest payments), liquidity of the acquired property, and, secondly, its quality and location. Commercial mortgages are offered by a number of banks. However, the banks terms and conditions are different to a certain degree (Table 6.1).

4

According to the ’Law on mortgages’, it is not possible to sign a mortgage on the property under the construction on the land that is leasehold

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Table 6.1: Commercial Mortgages: terms and conditions Bank

Amount for borrowing

Time

Interest rate

Euro€ 0,005 – 1,5 mln

Debt to equity ration 20/80

Raiffeisen Bank Aval OTP Bank Alpha bank Nadra Bank

15 years

12,5% in Euro€

Euro€ 0,005 – 1,5 mln US$ 0,005 – 3 mln US$ 500 000

30/70 30/70 or 100% 10/90

10 years 15 years 15 years

11% in Euro€ 12-14% in US$ 12,8% in US$

6.2 Development loan: terms and conditions In order to carry out their businesses banks need the ability to secure their loans with various types of collateral and be able to quickly seize the collateral in case of loan default. In some cases it is a pledge of company’s shares or real estate itself. For Ukrainian developers it is a problem to provide security as in most of the cases the value of all company’s assets is lower than loan amount required with debt coverage coefficient. Therefore, they favour project financing where the project is used as a security on the loan. When a developer has problems to disburse a loan, he sells the project as it is and repays the rest of the loan with money from sale. Most of the banks offer this kind of loan as they are concerned that market value of the project under the construction in the period of sale will be still higher than the amount of money a bank has lent. Another problem with borrowing is when a developer is looking for cheaper financing from abroad a lender requires a freehold interest on the land, which is not the case in Ukraine, since 99% of land is leasehold from city council. The reason why is evident – uncertainty in the land rights on the land. Before going into details on lending terms and conditions, it is worth noting that all respondents highlighted that every project is individual and therefore, the lending terms and conditions differ to a large degree. Sources of risk Lenders balance their opportunities for profit against risk, or the chances of loss of profit and principal. Their principle is: as risk increases, profit should also increase. Three sources of risk are identified by Dasso and Ring (1989): 1) borrower, 2) property, 3) portfolio. The risk categories are the same for lending institutions. However, different financial institutions highlighted different key concerns that they looked at deciding on debt financing. It is possible though to identify a set of factors that are most important for them: 1) client’s track of record in order to identify the capacity of the client to repay debt; 2) detailed feasibility analysis of the project; 3) information on other participants involved into the project; 4) work experience on real estate market, experienced and responsible management; 5) delivery of good quality product and ability to sign pre-lease contracts. The last point is important for EBRD as they consider that the income produced from the property must repay the loan, the property value must always be sufficiently high to repay the loan balance. LTV ratio Different banks require different proportion of company’s own capital involved into the project. Alpha bank, for example, demand 25% of borrower’s equity, OTP bank, Diamant, Ukrsotsbank – 30%. The standard LTV ratio is 70/30 (in some cases 60/40) as compared to some years ago 50/50. 80% leverage is not offered yet but expected to be granted in coming

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years, as IFC (International Finance Corporation) noticed. For hotel segment the leverage is not higher than 65% due to the risk of the hotel business. Loan maturity and methods of disbursement On average a loan maturity is 5-8 years. Hence, the payback period for commercial property is much longer than this. Ukrsotsbank provides a loan for period of 10 years. Besides, this bank is giving a grace period for 12 months. Capitalization of interest occurs during the period of construction. Outstanding debt is paid off once construction is finished and a property generates an income. 75% of the loan is usually repaid before the last year, according to loan term agreement, and 25% - in the last year. In some other cases a lender offers a grace period up to two, three years. Interest rate Interest rate on the loan is determined by the risk of the project and has a short-term character. CFO of International Finance Corporation notices that flexibility of interest rate depends on quality of security provided. EBRD admits that after a developer has gone through construction stage, the interest rate may drop. The prime rate that the local banks charge corresponds to LIBOR +5-7%, EBRD offers LIBOR +4% and LIBOR+3% after construction. There is seen a tendency of decrease in interest rate due to increase in competition among banks and opportunity to borrow money in international market. However, interest rate has not dropped in recent years as the market hopped. Investment and banking manager of ING bank explains it as the LIBOR rate itself has not been stable and increased to a certain degree. Foreign banks pay a substantial premium for their Ukrainian assets, expecting healthy margins and high revenues, which they utilize to earn the fastest possible return on their investments. Recent tendencies The size of the banks also influences its customer profile. Large banks tend to lend to larger clients. In doing this they exploit economies in scale. On the other hand, because of size limitations, smaller banks are not able to compete with larger companies and have instead comparative advantage in lending to the smaller scale developers. Moreover, foreign currency lending is increasing because borrowers are attracted by lower interest rates on loans and by expectation that local currency may appreciate. Small neighborhood or community centers are seen as particularly stable investment by lenders. Many banks are involved in providing loans for retail projects, especially if it is wellestablished operator in the market. Office financing is also seen attractive in terms of loans, but in this case a lender is more concerned about leasing and requires pre-leasing 20-50 per cent of the office space. 6.3 Equity financing Another way to finance real estate is equity financing. This alternative is used and preferred by most of the developers. Equity funds supplied to the development activity have different origins. They come from the personal resources of individuals or money accumulated by other business who seek the alternatives to reinvest their capital or diversify their businesses. Real Estate Investment Trusts are not established in Ukraine yet. Many external investment funds from Europe and other parts of the world find arbitrage opportunities in financial market in transition countries. Investors are going into developments, even without pre-lease, for a bit of extra yield: ‘Many funds are changing their strategy to include direct development as a way of

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getting money invested faster’ (Emerging Trends in Real Estate, 2007, p.11). They are not afraid to take a high risk and think that they can mange it. There is enough finance on the market as a Director of NCH Property Advisors noticed, but there are limited possibilities for it to be reinvested into because of lack of investment product. Presently local developers are in the pre-construction phase, where there is not big need for large funds. A new way to raise equity has been discovered by local developers through entering IPO (Initial Public Offering). The major public real estate investor is XXI Century (PLC) listed on London AIM that sold its shares at US$ 140 mln in the end of 2005. There is increasing interest among local developers to test project financing by issuing shares to the public. This may stimulate intense interest from investors. However, many analysts agree that Ukrainian legislation hampers rather than facilitates the trend. A Ukrainian company can not issue 25% of its shares overseas, nor can it allocate the shares at a price lower than that of the Ukrainian stock market. These are only some of many restrictions and gaps in Ukrainian legislation. The established practice in Ukraine is to set up SPVs (special purpose vehicle) with Ukrainian assets in other jurisdictions in order to conduct an IPO. The key factor when choosing the jurisdiction is a low tax regime and the existence of a double taxation treaty with Ukraine (Kyiv Post, 23.04.2007). According to EBRD research (2005), among the other impediments in Eastern Europe countries are bureaucracy, lack of market opportunities, a weak bankruptcy framework and obstacles to starting a business. Joint ventures between the developer and third-party investors are very common. The third party puts up necessary equity. The profit split with private investor typically is 70/30 and 60/40 depending on the risk of the project. In many cases a foreign investor willing to enter the project already gives up for 50/50 split. The party with the right on the land (in many cases it is a local player) makes land input plus additional 10% of construction costs. The rest of construction costs are paid by another party. The parties agree on the cash split correspondingly to their shares in the project. But in many cases it does not go so far and an investor buys out the share of the party with the right on the land once property has been delivered. Unfortunately, there are few good examples of joint venture between land owner and foreign developer due to obvious cultural differences and business practices. It is likely to be changed over time.

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Chapter 7: Analysis of Results in Respect to Capital Structure This chapter draws conclusions on preferred financing strategies among borrowers and provides arguments for this. Moreover, the results are seen through the lenses of theories on capital structure presented above. 7.1 Analysis of dominating financing schemes Analysts generally agree that developing real estate is far riskier than simply purchasing real estate as a stabilized fully leased asset. A speculative industry by nature, real estate development offers higher returns to compensate for the inherently higher risk. The interview and questionnaire results show that developers, either foreign or local ones are willing to take on the greater risk for great potential rewards. There is a range of risk factors involved in property development. Among them is financial risk. As results show, outside equity is preferred by most developer companies. Why is this financing source preferred over other alternative such as debt financing? There are several reasons of this: 1. Debt financing in real estate is primarily undertaken through mortgage market. This market is immature due to various reasons. The debt source of financing is presented by bank sector. Non-state pension funds, being a source for permanent lending, face considerable challenges in diversifying their portfolios since they operate in fledging capital markets and are hampered by numerous investment restrictions. Other debt instruments (as bonds) are not developed due to lack of proper legal regulation. 2. The ownership structure and size of the bank determine its ability and willingness to lend to a particular type of customers. The history of problems (bad debt and liquidity problems) in the banking system has resulted in very conservative lending norms. 3. To be able to secure a loan banks require collateral in form of land and buildings, other financial assets and guarantees. In many cases a borrower can not provide adequate collateral for a lender. As a consequence of this, project financing loan and participating loan got more recognition among developers due to the absence of this particular requirement. 4. A lender usually requires the whole package of planning permissions for the project to enter the construction stage. Often to get all permissions is time consuming procedure with bribe payments. Therefore, it is easier to attract another investor who is interested in the project and is ready to offer necessary amount on the early stage of the project. 5. Lent resources are expensive; interest rate for interim and mini-perm loan is higher than in other European countries. There is a shortage of long-term money in lending market. Domestic banks have limitations in access to the resources in the international market. 6. Real estate market is still too small. Developers do not need large funds as projects themselves are not large. Therefore, they do not think whether it is worth to borrow saving a small fraction of percent from the bank and spend more time on providing all necessary documents for the loan or to attract outside equity. 7. Unfortunately, Ukraine is seen as a country with a shadow economy. The players in the market try to get benefits from this. The numbers of players establish the offshore companies and attract money from abroad for much lower opportunity cost of the capital.

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On the other hand, there are other issues when considering outside equity financing. Equity providers are concerned about profit sharing rules and control issues that are not as important to debt providers. This creates monitoring and legal costs for both the inside and outside equity holders. Risk concerns are intensified because the property owner generally has better information about the true risks and return on the investment. Nevertheless, as EBRD (2006) notices the volume of private equity investments is lower than in developed market economies. To some extent, this reflects a number of constrains such as lack of local investors, high risk perceived by foreign investors and insufficient loan finance for private equity transactions (p.73). The shortage of experienced local management team is also seen as obstacle. Legal, regulatory and tax issues pose further difficulties. The large-scale entry of foreign banks has been transforming the banking system in Ukraine. Foreign strategic investors have introduced new products to the country and have increased efficiency and quantity of lending (see chapter 4). They have also proven to be relatively stable providers of finance. The main benefit of this is increased household lending and development of mortgage market for residential sector. Retail segment is viewed as a second potential for commercial mortgage development due to increase in purchasing power of population that enables both borrowers and lenders to rely on the relatively stable cash flows. Retail offers another attractive feature to lenders because of protection against inflation due to the lease terms. Another important consequence of banks’ extending activity is introducing project financing loan for commercial real estate. This loan is on the rise among developers and seems to be well suit for the transition conditions on the market. No collateral needed, the chance to borrow large amount of money (LTV ratio is high) and non recourse clause limit the liability of the borrower by restricting the claim of the lenders to proceed from the sale of the real estate in the event of default. Additionally, principal payments occur only when a property starts to generate income. The payback period in this case is long and this makes a developer to think more in long-term and manage property longer. In turn, speculative nature of the project is likely to be eliminated. As real estate companies are growing, large companies start requiring large funds. Since Ukrainian banks individually are unable to operate with large volume of capital for a single borrower. Therefore, it is possible to expect growth of the syndicated loans that in turn can be seen as a means of securitization on the assets. Besides, banks actively started participating in development and create structures and funds for undertaking development activity. This enables them to diversify their portfolio and eliminate risk. The larger the bank, the more likely it requires collateral in form of immovable assets. Banks operating in lower scales tend to use other financial assets as collateral. This can be explained by the differences in cash available in these cases. 7.2 Capital structure: common ground between theory and practice The form of capital structure is the result of financing scheme chosen by company. As it was discussed above, typically the company uses the combination of debt and equity. Moreover, capital structure depends on the strategy of the company. Most of the developers seek to sell the product to the investor after the construction and lease-hold period is complete. When the market is significantly undersupplied, this leads to speculation and creates arbitrage opportunities. Shortage of good quality product used as collateral, absence of legal regulation

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on the commercial mortgage market, and shadow economy cause financing gaps to emerge. These gaps are filled by outside equity with higher exposure to risk. From M&M argument if a capital structure decision has no effect on the cash flow generated by the company, the decision also will have no effect (in the absence of transaction costs) on the total value. In perfect market for financial capital, the supply (S) and demand (D) exactly coincide (see graph 2.5.1). This means that outside financiers are willing to supply as much capital as is needed at a constant risk-adjusted return (Riddough, 2004:6). In real world this is not the case. And opportunities for arbitrage exist between debt and equity markets. Due to taxes and other factors such as financial distress and costs of bankruptcy (trade-off theory), the capital structure choice for real estate is relevant. At higher level of outside finance the demand curve starts to flatten out (become more elastic, since property owner is willing to substitute inside equity if outside capital is too high) (ibid., p.6) Transaction costs and conflicts between the property owner and outside capital providers increases as the amount of outside finance is increases. Another constraint on supply is regulation. Since the bank is concerned with credit quality of the loan portfolio, supply curve will increase in slope at higher quantity levels (see graph 2.5.2). In this traditional setting there is no financial gap, as the property owner is able to fund investment through traditional suppliers (mortgage institutions) of outside finance at relatively low costs. In Ukraine lending conditions are tight and constrained by strict regulatory oversight of bank, legal imperfections, and lack of long-term money. Banks place a higher value on liquidity and transparency factors as indicators of asset quality. The situation is gradually changing due to upcoming of foreign banks, and increase in syndicated loans. On the demand side, there is a flow of private market investors being attracted by lower capitalization rates from higher relative transaction prices. When constrained supply and increasing demand are considered, a new equilibrium for outside finance emerges. Representative market outcomes are displayed in Exhibit 7.2. Exhibit 7.2: Equilibrium for outside finance in constrained market Risk-Adjusted Return (r)

S S’ r*

D’

r’* rf

0

D

Q*

Q’*

Quantity of Outside Finance (Q)

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Increase in demand for real estate finance in the short-run will cause the uplift of real interest rate with a little increase in quantity of outside finance. Gradually, financial institutions starts to react on the change in demand and this will make a supply curve to shift upward a slope. These shifts cause a new equilibrium to emerge for outside finance with a small effect on the real cost. In response to the change, the quantity of outside finance will be increased from Q* to Q’*. When the new capital suppliers have opportunity to enter the market to offer funding, then plenty of money is available. This will consequently cause a drop in interest rate again to the initial level. Earlier it was highlighted in trade-off theory that corporations are supposed to pick up a target capital structure that maximizes firm value. If a public or private firm does not have an optimal capital structure, its cost of the capital will be too high and the value of the firm will not be maximized (Anderson & Liang, 2001). The companies that do not employ optimal capital structure are considered undervalued and can be used as a target by investor. Among all companies being interviewed, currently there are few that have debt in their capital structure. The company profile is development of retail centres with a purpose of managing them. According to trade-off theory, the interest on debt is tax deductible; thereby the after tax cash flows will increase with the increase of debt. This consequently leads to favor debt over equity financing. However, as many of the companies pinpoint, tax shield does not play a significant role on capital structure decision. The form of their capital structures is the result of the small scale of a company’s own fund, rather simple financing channels and unwillingness to be dependent on bank loan. However, a distinct factor is that lending institutions favor retail centre development (EBRD, ING bank, etc). Within current market conditions this segment is expected to provide more stable and secure cash flows due to the sale of the non-durable goods. According to the Pecking Order Theory, the ranking of financing channels of the firm should be: internal finance (own fund) =>Debt (bank loan) =>Stock. With the shortage of own money, a company looks for external funds. The traditional way of financing is mortgage debt, which economizes on transaction costs and provides proper incentives for the property owner. Hence mortgage market is poorly developed, the only way is to attract outside equity. But in this case the risk is even more intensified due to asymmetric information between the developer and investor. If a developer chooses bank financing, again it is not certain that the risk is minimized due to external impediments such as planning permissions, delay in delivery, high costs of borrowing, etc. So, a financing scheme in this event will be: internal finance (own fund) => Outside debt/equity. For listed company this scheme will be somewhat different due to the different source of funds: stock => internal finance (own fund) => convertible bond. This scheme is an assumed one by only one listed real estate company developer and can not be regarded to be a reliable one. The low debt to value ratio in capital structure can also be explained by high risk involved in development activity. Therefore, high leverage is seen as a greater exposure to bankruptcy and financial distress risks.

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Chapter 8: Conclusions and Recommendations for Further Research The final chapter of the thesis presents a summary and implications for further research. The intention here is to outline the significance of the research topic – development finance in emerging real estate market – based on the particular case study on Ukraine. In line with discussion the chapter draws conclusions and recommends insights for approaching the issues from various angles. The thesis attempted to uncover the research topic in terms of national practice and international experience. By this the author sought to pinpoint the historical, theoretical, and factual underpinnings relevant to the study. Indeed, real estate market in Ukraine is getting a higher speed due to economic growth and active involvement into development activity. Remaining severely undersupplied, it draws both national and international actors into play. Higher investment yields in comparison to the regions of Central and Western Europe is one of the main factors which attract foreign investors to the Ukrainian market. Although their willingness to enter the market is great, there are significant hurdles that slow down this process. Poorly transparent market, process of procuring land plots, recently introduced regulation on land acquisition, current availability of capital sources cause further exposure to risk. The financial market is represented by lending institutions and private equity funds. Banking sector dominate the financial market. The large-scale entry of foreign banks has profoundly transformed the banking system in Ukraine. The main implications of this are: foreign strategic investors have introduced new products (residential mortgages, project financing, participating loans, etc.) to lending market, have increased the efficiency and quantity of bank lending, and have proven to be relatively stable providers of finance. Although banks continue to dominate the financial sector, there has been growth in other types of financial services. The size of private equity has been expanding during the last years. Private equity funds are primarily of foreign origin. However, there is a growing willingness among wealthy individuals and companies to channel their funds into private equity. As the Ukrainian marker becomes more sophisticated, domestic companies are also likely to request advices on debt and equity finance, doing IPO or taking part in merges and acquisition. As the average size of IPO increases and the banking sector develops, the target market for private equity may become increasingly clear. Among other objectives of the study are to discuss possible financing schemes used by the developer company and relate this to capital structure of the company. The results of the interviews show that most developers seek for outside equity rather than use mortgage debt. It raises immediate question, why? Mortgage market is a capital or long term market. The long term resources are expensive due to high volatility, uncertainty, low liquidity and other risk factors. Moreover, non-state pension funds and insurance companies, being the main providers of the permanent loans, are very small in size. Commercial banks are constrained by National Bank’s restriction on their reserves and legal imperfections. Therefore, short-term instruments are used in the lending market such as construction (interim) and mini-perm loans. Additionally, most lending institutions require collateral to secure a loan, and guarantee for construction to start. In many cases a developer does not have enough equity to pledge their assets against borrowing. Pre-construction period takes longer time due to bureaucratic

48

reasons. That is why it is easier for developer to attract a co-investor, who is ready to provide money on the early stage, than to wait until all permissions are received. Alongside, the volume of current project financing is not as large that makes a developer to think whether he should borrow from a bank in order to save a small fraction of the percent. According to Peiser & Frej (2003), the holding period is a key to decide appropriate type of financing. As results show, most of developers seek to sell property after leasing up period. Money raised from the sale may be reinvested in other projects. Consequently, there is a little need for additional debt. Pecking order and trade-off theories are found relevant among others in the explanation why developers use low loan to value ratio. A speculative industry by its nature real estate development entails higher risks. With increase in leverage a company may be a subject to additional financial distress and bankruptcy risks. Therefore, developer companies either seek an external investor ready to take risk or finance the projects by their equity. This paper gives a broad picture on real estate financial market. As many respondents pinpoint, every single project is individual. Financing terms and conditions depend on various factors of the project, such as belonging to the market segment, location, parties involved, etc. In joint ventures between developer and investor, between developer and lender the arrangements on cash flow distribution vary to large degree. Therefore, several suggestions for further research can be outlined: • To analyze and compare different projects within the same segment of the market, the ways of financing by different investors/lenders. • To find how the existing real estate companies employ the capital structure. • To compare development of real estate and financial markets in Ukraine with other Eastern European countries and to discuss similarities and differences.

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References Adlington, G., Grover, R., Heywood, M., Keith, S., Munro-Faure, P., Perrotta, L. (2000). Developing Real Estate Market in Transition Economies. Geneva: UN ECE Anderson, R. I. and Youguo Liang (2001). Mature and Yet Imperfect: Real Estate Market Arbitrage. Journal of Real Estate Portfolio Management, Vol.7, No.3, 281- 288 Arco Real Estate (2005). Kiev Real Estate Market Overview 2005. Kiev: Arco Real Estate Ballard, T. and Muldavin, S (2000). Does Mezzanine Real Estate Investment Make Sense Today? Real Estate Finance, 17(2), 37-46 Bondaryev, T. (2007). Registration of Real Estate Property in Ukraine. DOM.COM, 4, 16-18 Brealey, R. A and Myers, S.C. (2005). Principles of Corporate Finance, 7th edition. NewYork: McGraw-Hill Brueggeman, W. B. and Fisher, J.D. (2005). Real Estate Finance and Investment, 12th ed. McGraw-Hill Clauretie and Sirmans (2003). Real Estate Finance: Theory and Practice. 4th ed. SouthWestern Colliers International (2006). Ukraine: Real Estate Review. Kiev: Colliers International Dasso, J. and Ring, A. A. (1989). Real Estate. Principles and practices. 11th ed., New Jersey: Princet Hall Denscombe, M. (2000). Good Research Guide for Small-scale Social Research Projects. Buckingham: Open University Press. DTZ, Zadelhoff Tie Leung (2006). Capital Market Overview. Kiev: DTZ Duenwald, C, Gueoguiev, N. and Schechter, A. (2005). Too mauch of Good Thing? Credit Booms in Transition Economies. The cases of Bulgaria, Romania, and Ukraine. IMF European Bank Research and Development (2006). Transition Report 2006. Kiev: EBRD European Development Finance Institution (2006). Development Finance Explained. Retrieved on 30.06.2006 from http://wwwedfi.be/devfinance Eros, I. (2007). Expert: Market still not Meeting Demand. Retrieved on 16.02.2007 from http://www.kyivpost.com/business/industglance Grinkov, D. (2007). News in Banking Sector. Business, 10(737), 50-55 Hoesli, M. and MacGregor, B. (2000). Property Investment. Principles and Practice. Portfolio Management. Edinburgh: Pearson Education Ltd Jones Lang LaSalle (2006). Emerging City Winners Profile: Ukraine, Kiev. Moscow: Jones Lang LaSalle Kawalec, S. and Kluza, K. (2000). Challenges of Financial System Development in Transition Economies. Prague: IMF Kyiv Post (2007). Real Estate Growth Continues. Retrieved on 16.02.2007 from http://www.kyivpost.com/business/industglance MacPhail, B. and Johnson, P. (2007). Mortgages on the Rise. Business Ukraine, Vol. 1, No. 7, 22-23 Melicher, R. W. and Unger, M.A. (1989). Real Estate Finance, 3rd ed. Ohio: South-Western Publishing Co. Modigliani, F. and Miller, M. H. (1958). The Cost of Capital, Corporate Finance and the Theory of Investment. American Economic Review, 48, 261-297 Myles, M. E., Berens, G, Weiss, M. (2000). Real Estate Development: Principles and Process. Washington: Urban and Land Institute National Bank of Ukraine (2007). Monetary Review (Q III 2006). Kiev: Monetary Policy Department

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Pejser, R. B. and Frej, A. B. (2003). Professional Real Estate Development: the ULI guide to the Business, 3rd ed. Urban Land Institute Riddiough, T. (2004). Optimal Capital Structure and the Market for Outside Finance in Commercial Real Estate. Real Estate Finance, October, 3-13 Sugak, M. (2007). Real Estate Financing by Commercial Banks: Main Terms and Conditions of Credits. Commercial Property, 4(44), 26-31 Lysnyak, N. (2007). Foreign Developers in Ukrainian Market. Commercial Property, 4(44), 32-45 Urban and Land Institution and PricewaterhouseCoppers (2007). Cycle? Emerging Trends in Real Estate Europe, January USAID (2007). Ukraine Develops Non-State Pension Funds. Retrieved on 20.02.2007 from http://www.usaid.gov/locations/europe_eurasia XXI Century Investment Public Limited (2006). Interim Consolidated Financial Statement for the Six Months Ended 30th June, 2006. Kiev: XXI Century Yakovlenko,B. and Sorokin, V. (2007). Syndicated Loans for Developers. Commercial Real Estate, 10, 42-45

Internet links used for data search: http://www.uainsur.com http://www.unia.com.ua www.pfts.com.ua

The list of respondents: Alimardanov R., Principal Investor Officer, Central and Eastern Europe Department, International Finance Corporation of World Bank Group Bariyatsky V., Head of Project Finance, Karavan Megastore Berthram M., Managing Director, NCH Advisors Church I., Managing Director of London and Regional Properties Demchishin V., Associate Investment Banking, ING bank, Ukraine Dixon A., Managing Director Real Estate Opportunity Funds, a member of Deutsche Bank Group Georgiev M., Principal Banker Property and Tourism, Banking Department, EBRD Kalashnik E., CFO, UkrSotsbank Kazantseva M., Investor Relations, Business Development, First Ukrainian Development Klimets O., Managing Director, Reiffaisen Bank Aval, Nikolaev department Pivtorak A., Deputy Head of Financial Analysis Department, XXI century Sikharulidze B., President of AISI Realty Public Limited Shkarupa A., Managing Director, Alacor Shmarov P, CFO, FIM group Stelmakh N., Senior Valuer, Investment Consulting, DTZ, Kiev Zelemtsova G., Head of Finance, BMG (ICD Investments)

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Appendix 1 Interview questions for a company developer Section 1: Company’s background 1. 2. 3. 4.

What is your company’s profile? How long is it active in Ukrainian market? Are there any significant structural changes in the company within this period? What are the most recent projects that your company develops? (Retail, office, industrial?) 5. What form of business organization do you have in your company (corporate, limited partnerships, S corporations, and the joint venture)?

Section 2: Information on real estate development market in general 6. What cycle real estate market in Ukraine is going through, to your opinion? 7. Did you have any difficulties to find the source of financing? If yes, what were the obstacles? 8. Do you consider a competition in lending market tough? 9. What criteria do you choose to find a right lender? 10. What is the most attractive instrument the lenders use to bring the customersdevelopers? 11. How active do you find foreign developers? How can you explain their interest? 12. What recent trends and tendencies in real estate development market can be observed?

Section 3: A company financing strategy 13. How do you finance your recent projects? How much debt do you have in project financing? Is this amount of debt enough for the project or you had to look for other alternatives? What is preferred amount of debt? 14. What are the purposes for loan obtaining? Land acquisition, construction loan, etc. 15. Do you see other alternatives to finance the project? What is the most used scheme, to your opinion, developers use to finance a development project? 16. What lending terms do you find most important when you are making decision on debt financing? Leverage, amortization, etc. 17. How does your company decide on the amount of debt? Do you consider tax policy and high debt-to-value ratio issues in project decision making? 18. What type of loan did you manage to obtain? In what terms and conditions? 19. What is a typical loan, to your opinion, when banks finance development? Do you see any other alternatives that might better suit to your strategy but they are not in practice? 20. What is the interest rate do you pay on your loan? What are the risk factors in the project your company recently develops? How does a level of risk affect a structure of the loan, to your opinion? What is the interest you pay on amortization?

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Questionnaire Design: Developers’ Perspective The main research motivation behind this questionnaire is to find out what financing schemes are used and preferred by the developers. Moreover, the questionnaire tends to explore the mechanism of finance alternatives. It also aims to define the common capital structure among real estate development companies. Please, select an answer you feel best corresponds to the strategy your company implement in financing development projects. Section 1: Basic information of the responder Date: Name of the company: Name of the responder: Responder’s position: Section 2: Information on the company 1. Define your company using categories a. Foreign developer b. Local developer c. Foreign + local developer 2. Type of company, listed or unlisted? a. Listed b. Unlisted 3. Recently financed project within commercial real estate a. Office building b. Retail c. Industrial or logistics d. Other. Please, state Section 3: Financing schemes and capital structure 1. In the project financing that your company develops, do you use equity financing with a. 100% equity b. 80-100% equity c. 60-80% equity d. 40- 60% equity e. 20-40% equity f. Less than 20% g. Single choice. 2. What is/are the sources of equity funds in the project? a. By individual b. By tenancy arrangement c. By business organizational arrangement(corporation) d. The joint venture 3. In the project financing that your company recently develops, how much is the proportion of bank loan in the total project investment fund? a. Bank loan 0 b. Loan 30-50% c. Loan 50-75%

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4.

5.

6.

7.

d. Loan 75- and more% e. Single choice. What is/are sources of debt financing in the project that your company recently develops? a. Pension fund b. Commercial banks c. Insurance company d. Non governmental organizations e. Other. Please, specify One reason for borrowing is creating financial leverage that is controlling a large investment with a relatively small equity. Would you consider borrowing only for this reason? a. Yes b. No What type of loan do you use to finance a project? a. Annuity loan b. Non-recourse loan c. Spec financing d. Collateral loan e. Single choice. Please, specify. What type of loan would your prefer? Please, specify.

8. In the project financing that your company recently develops, with respect to capital structure, to what degree does the tax policy influence your company’s decision making on the amount of debt? a. To a large degree, increases incentives for high LTV b. To a small degree, may influence the decision making c. Does not matter 9. Would you prefer high debt-to-equity ration in project financing? a. Yes b. No 10. In the project financing that your company recently develops, if the bellow financing ways are options that you can choose, ranking the following strategy you prefer to, by placing 1 beside the best, and so on. a. Convertible bond b. Stock c. Equity fund d. Bank loan Section 4: Additional information 11. What are the obstacles do you see in obtaining the adequate loan financing? a. Market immaturity b. Legal procedures c. Other reasons. 12. What are the obstacles do you see as a foreign developer in entering Ukrainian market? (for foreign developer)

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Appendix 2 Interview questions for lenders Section 1: Basic information on a lender 1. Name of the lender. How long have you been established in Ukraine? 2. Who are your main clients among real estate developers? Foreign or local?

Section 2: General information on money and capital markets 3. Your comments on money market development in Ukraine? How can you characterize it? Scarcity of money or abundance? 4. Do you find the competition for clients within real estate market intensive?

Section 3: Financing strategy 5. What type of financing do you usually involved into: equity or debt? 6. If it is debt, what is the maximum LVR can you offer? What are the reasons? 7. What are the most important criteria you are looking at deciding on lending terms? Leverage, amortization, margin, fees? Preferences of the borrower? Type of lease? Property characteristics? 8. What factors determine interest rate offered to a client? What type of rate is used? Fixed or floating? Why? 9. What kinds of loans are commonly used by your company in finance development projects? 10. What kind of loans do you frequently offer to the development companies? 11. How do you decide on risk of a certain project? 12. What are the factors that determine different risk categories and affects lending terms? 13. Recent trends on the market?

Questionnaire Design: Lenders Perspective The main research motivation behind this questionnaire is to find out what financing schemes are offered and dominated in the lending market. Moreover, what may affect the lending terms lenders offer to their customer-developers, and if they are willing to be more flexible in financing certain projects. Section 1: Basic information of the responder Date: Name of the company: Name of the responder: Responder’s position: Section 2: Decision making 14. Who are your potential borrowers? a. Local developers b. Foreign developers c. Both 15. To what degree do you consider personal contacts may influence the decision on finance project development? a. To a large degree b. To some degree c. Does not matter

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16. To what degree do you consider a position or company prominence is important at deciding on finance development? a. Very important b. Somewhat important c. Not important at all 17. To what degree do you believe income generating ability of the property developed may affect the decision of the firm/bank on its financing? a. To a large degree b. To somewhat degree c. Do not play any difference 18. Are there any other criteria that affect your firm/bank decision on financing property development? Please, specify. Section 3: Financing schemes 19. What amount of debt do you offer to your typical customer-developer? a. 30% and more from value of the property b. 50% and more from value of the property c. 70% and more from value of the property 20. What factors determine debt ratios? a. Capital structure and income of the developer company b. Type of tenants c. Property location and its physical attributes d. All mentioned above e. Other criteria. Define, please 21. What kinds of loans are commonly used by your company in finance development projects? 22. Do you use collateral loans in your practice? a. Yes b. No 23. In the case if a loan is collateralized and your client needs additional loan what do put up for collateral in this case? a. The deposits of borrower b. Another institutions guarantees 24. Do you use mezzanine debt in your practice? a. Very often b. Not so often c. Not at all 25. What are the factors that determine different risk categories and affects lending terms? 26. Recent trends on the market and future expectation

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