Introduction:
I have been asked to advise Ross Investments on a re-financing option, and to calculate the equity required and the IRR. I am aware that the directors would like capital for future site acquisition.
There are three re-financing options available for Ross Investments, these are:
- Fixed term senior debt
- Corporate bond
- Real Estate Investment Trust (REIT)
To support my evidence and advice, I have used several sources and have referenced these which is shown in the references section.
Part 1
Fixed term senior debt
Senior debt is borrowed money which must be repaid before any other debts when a company goes out of business. The lender – usually a commercial bank or bondholder, are paid out of the sale first (BDC,2020). After this, it is junior debt holders, then preferred stock holders and common stock holders. They can be paid out by selling collateral held for debt repayments.
“Senior debt is a company’s first tier of liabilities, typically secured by a lien against some type of collateral” (Investopedia,2019).
How it works:
Senior debt is set at a low interest rate and time period (on a pre-determined schedule), where the company makes regular payments to the lender, which makes the debt ‘less risk’. Furthermore, the debt is covered by assets which is known as collateral, such as a car, property or machinery. In this case, Ross Investments would use their property assets as collateral.
Banks tend to be the best and cheapest for senior debt loans, and regulators count on banks to maintain the lower risk loan portfolio. They can take the “lower risk senior status” with repayment orders due to the fact that they can afford to agree on lower interest rates (Investopedia,2019).
Benefits:
- If Ross Investments are able to prove that the mixed use development is a low risk investment, this can result in lower interest rates given by the lender. This will save money for the company and ‘free up’ working capital for future site acquisitions.
- The tax can be deductible. This means that the interest on debt is an expense and is recognised on the profit/loss statement. This would help Ross Investments as it would reduce the tax bill (Finmye,2018).
- There is no equity dilution. The owners of Ross Investments will retain ownership while borrowing the money from the lender (Finmye,2018).
- The lender is only to receive the agreed upon principal as well as the interest payments. The lenders do not get any profits made from the company (Finmye,2018).
Disadvantages and Risks:
- Credit risk – the risk of non-payment of the interest that is owed to the lender at a scheduled time. Failure to make payments when required could affect the overall return to the lender and can result in a loss of assets that are used as collateral (Cion,2020).
- Covenant risk – during the period of repayments to the lender, they can put restrictions on Ross Investments from: acquiring further debt; giving out profits to shareholders; or making acquisitions/investments in capital expenditure.
Costs:
‘Positive Commercial Finance’ will fund up to 65% of the Gross Development Value (GDV) or 80% of the project costs. The costs involved in a senior debt loan include:
- Arrangement fees from 1%
- Interest rates from 4% per annum
- Options with no exit fees
- Minimum loan is £50,000, no maximum.
- Valuation and monitoring surveyor costs – required to ensure the development is progressing and there’s no concerns regarding non-payment of interest (PositiveFinance,2020).
Corporate bond
A corporate bond is a debt security which is issued by a company and bought by an investor in order for it to raise capital. “Triple-A” bonds are known to be the highest quality, and safest bonds (Investopedia,2020).
How it works:
The investor will provide capital to the company, in return for interest rate payments (fixed or variable). Once the bond ‘expires’ or ‘reaches maturity’, the payments stop, and the investor will receive the original investment. It is a legal obligation to continue paying your interest when required, even if Ross Investments were to face financial difficulties.
A company is eligible for a corporate bond if they can prove that they can make the payments to the investor which is based on the “future revenues and profitability” (Investopedia,2020). In some instances, physical assets may be used as collateral. Corporate bonds would not require Ross investments to pay dividends to the shareholders, which is something a REIT needs to do (sec.gov,2020). Corporate bonds are higher risk than government bonds, which is why the interest rate is higher, even if a company such as Ross Investments had “top flight credit quality” (Investopedia,2020).
Benefits:
- Corporate bonds allows cash to be retained within Ross Investments – as the redemption date for bonds can be several years after the issue date (ni-business,2020).
- Capital preservation: corporate bonds are suited for investors who want to maintain their income, while preserving their principle.
- Predictable income: corporate bonds provide income certainty, unlike REITs as they distribute dividends based on how well a company does. See figure 1 which illustrates the potential returns and level of risk in comparison to other finance methods (FIIG,2018).
- Corporate bonds have strong marketability. Due to the size and liquidity of the market that Ross Investments are in, a bond can be sold before maturity easily and quickly.
Disadvantages and Risks:
Credit risk (already stated for senior debt) – based on the companies ability to grow, credit ratings can estimate the credit risk of a corporate bond. In order to assess the credit risk of Ross investments, the investors would take into account the ‘five C’s: credit history; capacity to repay; the loan conditions; capital and associated collateral (Investopedia,2020). Ross Investments would need to prove that interest payments can be made to the investors.
Event risk – this explores the drawbacks that would result in Ross Investments not being able to pay the debt on time. This includes:
- Increased cost of building materials
- Changes in management (redundancies, new structure)
- Political factors (Brexit, Indy Ref 2)
- Pandemics (COVID-19)
Economic risk – this is how vulnerable the bond would be in an economic decline. In recessions, “high-yield bond prices typically fall more than investment-grade bonds, a reflection of their credit quality” (HJ-sims,2020). See figure 2 for the different types of economic risks.
Inflation risk – inflation can cause the bond price for Ross Investments to rise, which will see smaller returns for the investor. In turn, this would discourage investors, unless inflation linked bonds are used in order to protect investors from the risk of inflation.
From the investors perspective – potential risks include call risk and liquidity risk.
Costs:
The costs for Ross Investments to have a corporate bond would be the interest payments, which will be paid on a pre-agreed schedule, and the original investment that was made by the lender.
Real Estate Investment Trust (REIT)
Established by Congress in 1960, a REIT is a company that owns, operates or finances income producing real estate or real estate related assets. Assets in a REIT may include offices, warehouses, hotels, retail units, mortgages or loans (Investment Property Forum,2009).
How it works:
REITs allow individuals to have shares in the income produced through the ownership of commercial real estate, without actually having to buy the real estate. REITs collect rent from leased space, then shares the income as dividends to the shareholders. This means the employees of Ross Investments would be shareholders, and receive extra income based on how well the company does. REITs are obliged to give out 90% of their rental profits generated by the assets. This can be seen as a disadvantage for Ross Investments as they are looking to save money for future site acquisitions (pwc,2017).
Benefits:
- A benefit to REITs is that investors can own and sell a portion of the commercial real estate within the portfolio, which creates income in the form of dividends.
- A REIT is able to deduct from its corporate taxable income, all of the dividends.
- From an investors perspective, it is said that REITs can produce higher returns than corporate bonds (REIT,2020)
- The assets within REITs are real and tangible, providing shareholders income from the rent collected.
Disadvantages and Risks:
Lack of diversification – Ross Investments must show diversification within the property portfolio, with assets ranging from offices, industrial warehouses to hotels. This will prove to the prospective shareholders that investing in this REIT is less risk. Showing that there is demand for mixed use commercial buildings can help investment.
Fluctuation of share price – based on the financial performance from Ross Investments, the share price can fluctuate. During times of uncertainty, share prices can drop, which means the value of the company drops. This is happening at present, due to the COVID-19 outbreak, as you can buy “high-quality shares while they are trading at low prices” (Stephens,2020).
Costs:
In order to qualify as a REIT, it must pay out at least 90% of its taxable income annually in the form of dividends to the shareholders, which shows a lack of control over the profits on the assets. For publicly traded REITs, the minimum share investment is one share, and the transaction fees include brokerage costs which are the same for any other publicly traded REIT. For non-traded REITs, many will charge up to 15% of the investment for “broker-dealer commissions” and other costs. Fees for ongoing acquisition and management on the assets are required. The minimum share investment amount is between $1,000-$2,500 (£800-£2000). A publicly-traded REIT is better than a non-traded REIT. This is because it’s a safer option and provided investors with the opportunity to add real estate to the portfolio and earn strong dividends (sec.gov,2020).
Chosen finance method:
I would recommend that Ross Investments chooses a fixed term senior debt to finance the mixed use commercial development. This is because senior debt shows the lowest risk and is the cheapest finance method in comparison to the others that were discussed (Finmye,2018). Figure 3 shows the goals that each party involved within a senior debt loan have. Senior debt lenders will be able to provide support and guidance on how to maximise capital growth, for future site acquisitions (Prudential,2020). From a lenders perspective, they would be paid off first in the case of bankruptcy, so would therefore support Ross Investments. Helping optimise and protect the shareholders return, the fixed term senior debt is the chosen method of finance which should be used.
Part 2
Equity calculation:
Below is a calculation that was done in order to find out the equity required.
Using an LTV of 55%:
- 55% of £80,000,0000 (completion value): £44,000,000
- 2% for arrangement fees: £880,000
- 5% interest per annum: £2,200,000
Total interest over 5 years: £11,000,000
Total cost of loan: £55,880,000
Using an LTV of 65%:
- 65% of £80,000,0000 (completion value): £52,000,000
- 2% for arrangement fees: £1,040,000
- 5% interest per annum: £2,600,000
Total interest over 5 years: £13,000,000
Total cost of loan: £66,040,000
The calculations above show the total cost of loans that Ross Investments would have to pay back. In this case, the higher Loan to Value means the company would have to repay more.
The completed portfolio shows a rental income of 7.5% on the estimated completion value. This works out at £6,000,000 per year on rental income (7.5% rental income over 5 years). However, this will not be guaranteed income, unless Ross Investments have pre-lets in place for when the development is complete.
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