Development
Finance:
Doing the Undoable Deals
Lenders are facing increasing pressure to participate in community and
economic development projects. Part of the pressure is in response to Community
Reinvestment Act (CRA) responsibilities. But the interest often goes beyond that. Like
other community members, lenders too are adversely affected by urban decay, economic
disinvestment, and the lack of a diversified economy. The problems are often easy to
identify. The difficulty is in finding widely acceptable solutions. A frequent suggestion
is to undertake more community and economic development projects. This is the question
facing lenders: Is it good business?
NO TERM FOR MARGINAL PROJECTS
The financial literature is replete with terms describing different types of financing
consumer finance, real estate finance, and commercial lending to name just a few. There is
no term, however, that describes the financing of marginal projects and borrowers.
Deals with insufficient or too uncertain cash flows, too little collateral, not enough
management experience, or that pose excessive interest rate risk or overhead costs are
simply not done. For most lenders, their obligations to protect depositors' funds and earn
profits for shareholders preclude excessive risk taking and inadequate profit margins.
Indeed, these tenets of lending are basic, and lenders and their regulators pursue them
vigorously.
Agencies Providing Assistance
Despite these perceived difficulties, many "undoable deals" may be
"doable" because of their eligibility for financial and managerial assistance.
Various government and philanthropic entities provide assistance to projects that aid
economically disadvantaged individuals and communities. The basis for that assistance
ranges from job creation and support for minority businesses to housing low-income
individuals.
Many of the federal agencies providing this assistance are well known: the Small
Business Administration (SBA), Rural Development (RD), and the Department of Housing and
Urban Development (HUD). The state and local government programs, along with the
philanthropic programs, are less familiar but are often as supportive as the federal
programs. The process of using these program enhancements to make undoable deals bankable
is termed development finance.
Article Objectives
This article has two objectives:
1. To examine the structuring of development finance deals.
2. To address the problems associated with institutionalizing development finance lending.
In both cases, the prevalent issues are the same as in conventional lending. Standard
credit analysis principles guide the structuring of individual deals; overhead costs and
interest rate risk considerations guide the decision to institutionalize the activity.
THE DEVELOPMENT FINANCE PROCESS
The starting point to understanding development finance lending is not the
alphabet/numbers soup of government and philanthropic programs CDBG, HUD, NHS, EDA, LISC,
UDAG, GNMA, SBA, 221(d)(2), 235, 504, 312, and so forth. These programs are the caulking
that fill the financial and managerial gaps in individual projects and mitigate the
internal costs and risks associated with development finance lending. They are resources
that can make deals work, but only after a thorough project analysis.
The critical issues and decisions associated with development finance lending are
easily understood when analyzed sequentially (see Figure 1). The
upper portion of the figure addresses credit issues associated with structuring individual
projects. The lower portion addresses internal or organizational issues associated with
development finance lending.
The project analysis section of Figure 1 (the upper portion)
begins with credit analysis. Development finance projects are treated like any other
project the lender considers and are subject to the same underwriting criteria. Projects
that initially pass the credit test without enhancements are eligible for conventional
financing. By definition, development finance projects will fail the test until
enhancements are used.
For projects that fail the credit analysis, weaknesses or gaps are identified and
matched with appropriate enhancements. Since the enhancements usually produce additional
financial support, the project cash flows change. This change requires another credit
analysis.
Projects often cycle through this process several times to obtain the optimal
combination of enhancements. It is a discovery process which the Hungarian chemist, Albert
con Scent-Gyorgyi, once described as "seeing what everybody has seen and thinking
what nobody has thought." If the project can be made creditworthy, however, there is
no guarantee it will be funded by a lender. Much depends on the lender's motivations and
business interests.
Lenders who occasionally participate in such deals for community service reasons will
likely fund the project. Conversely, lenders who make the activity a routine business must
address internal costs (see the lower portion of Figure 1). Here
again, the process involves identifying gaps and addressing them with enhancements.
The following sections explore the credit and institutional analyses individually.
CREDIT ANALYSIS ISSUES
The credit analysis part of the development finance process focuses on protecting the
lender's funds. Lenders, in contrast to equity investors, demand a high probability of
repayment and use the credit analysis process to obtain that assurance. Projects that pass
a variety of credit tests are financed; those that do not are not financed.
A brief illustration of the credit analysis process for a nonprofit organization can be
derived from the fixed asset financing example presented in Figure 2. Gross rent, based on
projected rental rates, represents the maximum possible income from the project. From
that, a vacancy contingency is deducted to determine the effective gross rent. This
deduction gives an expected cash flow that is available for operating expenses and debt
service.
Figure 2. Credit Analysis Example
GROSS RENT
- Vacancy contingency
--------------------
EFFECTIVE GROSS RENT (EGR)
- Expenses
Operating Expenses, Utilities,
Management
Property Taxes
Insurance
Maintenance/Repairs
Replacement Reserve
------------------------
NET OPERATING INCOME (NOI)
- Debt Service (DS) (Principal and Interest)
------------------------------------------
CASH FLOW (CF)
Debt Coverage = NOI
------
DS
Loan to Value = Principal Amount Borrowed
---------------------------
Market Value of Collateral
Cash Flow Rate = CF
---------------------------
Owner's Equity Investment
Operating Expenses and Net Operating Income
Operating expenses must be met first. These expenses include the daily costs of
operations, utilities, and management; property taxes; insurance; maintenance and repairs;
and a reserve for replacing capital items. Deducting operating expenses from effective
gross rent leaves net operating income.
Net operating income is the primary source of loan repayment. A measure often used to
evaluate this source is the debt coverage ratio: net operating income divided by debt
service expense. Projects with a value greater than 1.0 can service debt from operations.
For example, a ratio value of 1.25 means that expected net operating income exceeds
debt service expenses by 25 percent. This 25 percent provides a margin of error in case
income and expenses do not meet projections.
Collateral
If cash flow fails to service debt, lenders seek a secondary source of repayment in the
form of collateral typically the asset being financed. Loan-to-value ratios are a common
collateral measure, comparing the value of the property to the loan against it. These
ratios are usually less than 80 percent and vary according to the nature of the
collateral.
Acceptable ratios are lower with specialized properties such as single-use
manufacturing facilities and with properties in disadvantaged locations. Whatever the
property, the appropriate measure of its value is its market value, not the amount
invested. In the case of many community development projects, collateral value is
considerably less than the construction cost simply because of the property's location.
Ownership Incentive
Another factor lenders consider in evaluating a project is ownership incentive. Even if
a project produces sufficient cash flow to service debt, owners should get a sufficient
return on their investment to ensure their continued interest.
A common measure of ownership incentive is the cash flow rate: cash flow divided by the
owner's investment. With many development finance projects, these rates are far below the
typical 15-20 percent minimums often required by investors. However, this deficiency need
not pose problems. Equity investors in development finance projects are often satisfied
with other incentives such as tax benefits or even the fulfillment of community service
objectives.
These commonly used ratios often form the basis for the credit analysis box depicted in
Figure 1.
While credit decisions are largely financial in nature, other factors are also
important. Perhaps most important is the borrower's character. An honest, committed
borrower with the knowledge and experience to succeed with a project is essential. Also,
knowledge of the community and the local economy are essential to making sound lending
decisions. If a project involves the leasing of commercial space, the creditworthiness of
the lessors is also important. Factors such as these, while not specifically addressed in
the credit analysis depicted here, must be considered and may be cause for denial.
. . . knowledge of the community and the local economy are essential to making
sound lending decisions.
If the project passes the credit tests, it can be funded with conventional resources.
However, if it fails the credit tests, a decision must be made about pursuing credit
enhancements. This decision will depend on the project's eligibility for credit assistance
and the willingness of the project sponsor to expend the effort to undertake further
analysis. Assuming the decision is to proceed with further analysis, the next task is to
identify project gaps and enhancements.
GAP AND ENHANCEMENT ANALYSIS
Lenders and investors have numerous reasons for not funding projects such as sales
projections are weak, overhead is too high, management experience is lacking, collateral
is insufficient, and the business is too new. These deficiencies can be broadly classified
as return, risk, and management gaps. Each represents a sound basis for not supporting a
project.
Return Gaps
Low return is perhaps the most common project deficiency. Simply stated, income does
not exceed operating expenses by a wide enough margin to justify either debt or equity
funding. In terms of the credit analysis ratios previously mentioned, the debt coverage
and cash flow ratios are too low or perhaps less than one. A variety of enhancements are
available to augment return by increasing project income or lowering expenses.
Today, income supplements fall into two basic categories: rent subsidies and tax
credits. The Section 8 housing certificate and voucher programs administered by the U. S.
Depart-ment of Housing and Urban Development are the nation's rent subsidy programs. Under
these programs, HUD helps low-income households obtain adequate housing by issuing
certificates or vouchers for the difference between the cost of adequate housing in the
market area and the renter's ability to pay. These payments thus enhance the landlord's
revenues.
Unlike rent subsidies that enhance operating revenues, tax credits do not alter a
project's financial statements. However, they are integral to the financial analysis of a
project because they produce important returns to investors that emulate project income
supplements.
At the federal level, tax credits exist for low-income housing and the preservation of
historic buildings. Both allow investors to obtain federal tax credits for contributions
of goods, services, and cash to approved organizations, including venture capital funds.
Expense Reduction Measures
A more common avenue for augmenting return is by reducing expenses. A wide range of
programs are available.
Local governments often use real estate tax abatements to attract business development.
Tax abatements are usually negotiated and therefore vary from project to project and city
to city. The tax abatements reduce operating expenses and augment cash flow available for
debt service and equity holders. Tax increment financing is another form of tax abatement
that uses taxes for property improvements.
Interest rate subsidies increase the cash flow to market rate lenders and equity
holders by lowering debt service costs. This, in turn, enhances project viability. The
subsidies come in several forms depending on their source of funding. Local bond issues
produce below market rate funds because of their tax-exempt status or the creditworthiness
of the issuers. These funds are used for housing and business development. Another form of
interest rate subsidy is a direct rate buydown whereby a third party helps make interest
payments. Community Development Block Grant (CDBG) funds are often used for this purpose.
Compensating balances can be used to reduce interest expense and enhance project cash
flow. For example, government units may deposit funds with a lending institution at low or
zero interest rates provided the lending institution passes the lower rates on to
borrowers. The deposits usually match in quantity and maturity the funds lent to the
defined borrower(s). However, they do not serve as collateral to offset credit risks.
When commercial lenders participate in a deal at market rates, borrowers can still
benefit through blended rate financing. Housing and community development agencies often
have pools of funds (perhaps from CDBG loan repayments) that can be lent at low rates.
When combined with market rate financing from commercial lenders, the financing package
produces blended, below market rates.
In some cases, the lower cost funds also take a second position to the commercial
lender. This position gives the commercial lender a higher claim on cash flow to service
its loan and on collateral should the project fail.
Like interest rate subsidies, most equity grants reduce debt service costs because they
offset some of the need for borrowing. Cities often own vacant land and buildings,
particularly in lower income areas, that can be the starting point for housing or business
development projects. Urban homesteading programs are a common example of equity grants
for housing. Under these programs qualified, low-income home buyers can buy homes for a
nominal amount provided they meet residency and property rehabilitation requirements.
. . . many nontraditional equity sources . . . seek benefits other than a high
return on investment.
Individuals and corporations are often in a similar position to make property grants as
a result of plant closings or tenants moving. Property grants may also carry with them tax
benefits. Whatever the motivation, property grants enhance project equity and lessen the
need for borrowing.
In addition to property grants, cash grants are sometimes available from public
agencies or foundations to reduce loan principal or to help make down payments. In the
case of home purchase loans, the loan down payment subsidies are often repayable upon sale
of the property.
There are also many nontraditional equity sources that seek benefits other than a high
return on investment. Since the 1986 tax law reform, corporations are the only entities
that can offset earned income with "passive" losses. This tax benefit has made
them prime candidates for syndication efforts.
Corporate and foundation grants to project sponsors are also popular, as are
investments by national and local community development organizations. Community
Development Corporations (CDCs) are equity investment vehicles for national banks, state
member banks, and for bank holding companies. The Local Initiatives Support Corporation
(LISC), an affiliate of the Ford Foundation, is a nationally based organization that
relies on corporate investments for funding. It helps pay front-end development costs for
projects in target cities.
In a somewhat different way, "sweat equity" is also a nontraditional source
of equity. It represents an investment from the borrower in the form of personal labor. In
some instances, it may be used toward a down payment. This equity addresses a major
financing problem for many home buyers who can qualify for monthly payments but lack the
savings to make a down payment. Sweat equity is often a component in home improvement or
purchase loans in low-income neighborhoods.
A conventional technique often used to lessen the debt service burden is to extend debt
maturities. This extension reduces periodic principal payments and lowers the overall debt
service burden. The practice can be risky because it prolongs the lender's exposure to
credit risk. Although extending debt maturities does not involve direct subsidies, the
decision may depend on the existence of other subsidies that give the lender better access
to cash flow or recourse to collateral. For example, a charitable foundation equity holder
seeking benefits other than cash returns may provide a measure of comfort to the lender.
A final means of reducing operating expenses is the use of small business incubators.
Incubators allow small businesses to share common facilities and office personnel
including secretarial and bookkeeping services and conference room space. Many incubator
tenants can access technical expertise from nearby colleges and universities; some have
affiliations with technology-based industries. Sharing these services with other small
businesses can reduce many operating expenses.
RISK GAPS
Cash Flow Risk
While low return problems relate to a project's expected level of income or cash flow,
cash flow risk relates to the certainty or uncertainty of the cash flow. If a project's
cash flow were certain, the decisions to invest and lend would be easy. But since it is
not, lenders must carefully weigh their exposure.
One means of addressing cash flow risk is to stabilize income and expenses. The various
income and expense subsidies that address the low return problems often act as
stabilizers. For example, low-income housing projects that have rental rates below market
rates often have long waiting lists of qualified renters. This list ensures low vacancy
rates and stabilizes rental income. Similarly, tax abatements or fixed-rate financing
stabilize expenses and cash flow.
If a project's cash flow were certain, the decisions to invest and lend would be
easy.
Another option for addressing cash flow risk is to risk-price loans. This can be as
simple as charging higher rates on loans that are riskier or as sophisticated as using
loan guarantees (see discussion below) to insure and sell loans on the secondary market.
The sale of guaranteed loans on the secondary market offers a substantial profit potential
because the lender reaps the benefit of converting a loan with traditional market risk
into a less risky instrument backed by the insurer.
SBA loans, for example, can be made at rates of up to 2 3/4 percent over prime. When
these are sold on the secondary market to yield slightly over the Treasury Bill rate, they
bring a substantial premium. Of course, only the guaranteed portion can be sold in this
manner.
Collateral Risk
If cash flow fails to materialize, lenders look to collateral as a secondary source of
repayment; it provides a fallback. Several options are available to strengthen collateral
on development finance projects.
Use of subordinated financing or "soft" second mortgages is a direct way to
enhance collateral. A government or community development organization lends part of the
needed funds and agrees to take a second position to the first mortgage lender on the
collateral. Since the subordinated mortgages often carry a below market rate, the borrower
gets a blended or below market rate on the entire financing package.
Loan guarantees enhance collateral by guaranteeing its value. This is done by insuring
a portion usually 75-100 percent of the loan against default. The Federal Housing
Administration (FHA) and the Veterans Administration (VA) are major federal insurers of
home mortgages while the Small Business Administration insures small business loans.
In addition, many state and local loan guarantee programs encourage various housing and
business development projects. These programs often take the form of collateralized
deposits kept by the insurer at the lending institution. Funding usually comes from
grants, such as CDBG funds.
The benefits of loan guarantees extend beyond the collateral issue. There is an active
market for the guaranteed portion of loans backed by nationally recognized insurers. This
gives lenders the option of selling guaranteed loans to raise funds for additional
lending. It also raises lenders' loan limits, since the guaranteed portion of loans does
not count against regulatory lending limits. Even when guaranteed loans are held in the
lender's portfolio, they enhance liquidity because they are readily marketable.
Finally, collateral positions can be strengthened through increased use of equity
financing. This lowers the need for financing and strengthens loan to value ratios.
Management Gaps
Management is a final project-related concern in all small business ventures. It is
often of special concern in real estate development projects where the developer is a
not-for-profit developer. Business ventures require a breadth of expertise and a wide
variety of management services ranging from the development of business plans to
accounting and secretarial services.
To address management gaps, two significant resources are available: incubators and
management consultants. The benefits of incubators were discussed previously. In addition
to those benefits, there is often an additional benefit to the tenants who can learn from
their fellow entrepreneurs' solutions to similar problems.
Management consultants are helpful for technical problems as well as general management
problems. The SBA, through its Service Core of Retired Executives (SCORE), provides
experienced management consultants to small businesses. Also, many colleges have small
business development centers that provide business and technical assistance.
Return, risk, and management enhancements bring constraints along with subsidies. These
constraints include job creation requirements and housing disadvantaged people. All the
constraints must be satisfied. When several programs are used, the constraints of each
must be compatible with the original project as well as with the constraints of the other
programs.
In the end, the enhancements will produce new project cash flows that must be
reanalyzed in the credit analysis process. If the project remains uncreditworthy, it can
be analyzed again, and other program enhancements added. However, the project must
eventually pass the credit analysis test to have a chance for approval.
INSTITUTIONAL ANALYSIS ISSUES
Successful completion of the credit analysis process does not assure project financing.
The lower portion of Figure 1 depicts the institutional issues that
must be addressed before the funding decision is made.
Two Basic Problems Precluding Funding
Two basic problems may preclude a lender from funding a creditworthy development
finance project:
1. High transaction costs associated with assembling, analyzing, or monitoring the
credit.
2. Long-term funding risks.
The former is an overhead issue concerned with recovering the often extensive costs
associated with development finance projects. As is evident from the section describing
the credit analysis process, lenders must have a high level of expertise and spend a
significant amount of time to assemble and manage deals while juggling a maze of
government and private program restrictions.
. . . lenders must have a high level of expertise and spend a significant amount
of time to assemble and manage deals while juggling a maze of government and private
program restrictions.
When combined with a modest volume of activity, this often translates into excessive
overhead. However, a variety of cost reduction and cost shifting efforts can mitigate the
transaction cost burden for the lender and make the activity profitable. The latter issue,
interest rate risk management, is familiar to most lenders and is also eligible for a
variety of enhancements.
Transaction Cost Gaps
Cost reduction efforts for organizations funding development finance projects generally
focus on two areas: staff training and organizational structuring. In the area of staff
training, knowledge of the development finance process is essential. The Federal Reserve
System through its Community Affairs programs has been an active participant in training
efforts, largely through the sponsorship of seminars explaining available program
enhancements.
Also, the agencies offering program enhancements are generally willing to assist
program users. In recent years, many of those agencies have undertaken efforts to reduce
the paperwork and make their programs more user friendly.
Organizational structuring is also critical to controlling transaction costs. By
focusing community development lending activities in a single department or with a
specialized group of people, lenders can take advantage of knowledge and experience
developed from the activity.
In addition to undertaking efforts to minimize transaction costs, lenders can shift
some of those costs to others. One popular means is to establish working relationships
with community organizations such as not-for-profit development companies and neighborhood
organizations. These groups are often helpful in defining credit needs and products.
Depending on their purpose and expertise, they may assist with marketing, project
development, or even credit screening of potential borrowers.
Another approach to shifting transaction costs is to form a community development
corporation or CDC. Banking regulations permit their formation as national bank, state
member bank, and bank holding company subsidiaries. While they have latitude to engage in
a wide variety of activities from real estate development to property management, a major
benefit can be reaped by absorbing transaction costs.
. . . the agencies offering program enhancements are generally willing to assist
program users.
Most CDCs are formed as not-for-profits so they can use funds from government and
philanthropic sources to structure deals. This lets the lender's organization control the
deal while others help underwrite it. If the deal is bankable, then the CDC's affiliate
bank can participate as a lender without incurring excessive transaction costs.
Maturity Gaps
The funding risk issue is a function of credit maturity. Many development finance
credits, whether business or housing related, are longer maturity credits--including
financing for plant, equipment, and home purchase. Banks generally lack longer term
funding sources and are not willing to fund long-term loans with short-term deposits. The
risk of paying more for their funds than they get is too great. Several options are
available for dealing with this issue.
A direct means of addressing interest rate risk is to match sources of funds with uses
so that both are of the same maturity. Many state and local government entities,
foundations, corporations and pension funds are willing to commit long-term deposits to
lending institutions contingent on their making similar term loans to specified borrowers.
Usually the depositor is not at risk if the loan defaults. These arrangements do not
absolve lenders of credit risk. Furthermore, if the borrower repays the loan early or
defaults and the deposit is not withdrawn until its original maturity, the lender also
bears some interest rate risk. State linked-deposit programs are a typical example of
matched funding. In some instances, the deposits are made at below market rates provided
the favorable rates are passed on to the borrower.
The secondary market is another alternative for minimizing interest rate risk. Because
of various government loan insurance programs, insured loans can be frequently sold on the
secondary market. This limits interest rate risk to the short time period needed to
package the loans for sale. Even this risk can be minimized using futures market hedges.
When the secondary market is not available usually because the loans have nonstandard
terms or they do not meet insurer standards private placements may be an option. State and
local governments, foundations, and others often have loan purchase programs funded by
local bond issues, churches, and other sources.
For example, the Colorado Housing and Finance Authority will purchase the guaranteed
portion of an SBA loan with fixed rates on the guaranteed portion. The lender funds the
unguaranteed portion at a variable rate. This solves the lender's interest rate risk
exposure, and since up to 90% of the loan carries a fixed rate, the borrower also has
little interest rate risk exposure.
Other programs also offer an outlet for loans that do not comply with national loan
packaging standards. For example, Neighborhood Housing Services of America will purchase
noncomplying home improvement and rehabilitation loans in Neighborhood Housing Services
(NHS) neighborhoods.
Like the credit enhancements, the institutional enhancements produce a variety of
financial benefits and constraints. Again, the constraints must be carefully addressed.
Ideally, the benefits will be significant enough to overcome the obstacles to funding and
managing creditworthy development finance projects. For an occasional deal, the
institutional issues may not be that important. For the lender interested in pursuing
development finance as a line of business, they are critical.
Two observations about the process depicted in Figure 1 deserve
special attention. First, the existence of government and philanthropic enhancements in
development finance deals is not a sign of weakness. The enhancements are an integral part
of the deals.
Second, profits and risks should be balanced. Credit weaknesses are not tolerable and
lenders should get competitive returns. If a project cannot pass conventional credit
tests, it should not be funded. Similarly, lenders should not routinely fund development
finance projects if they cannot cover their transaction costs and manage the interest rate
risks associated with the business.
OBSERVATIONS AND CONCLUSIONS
Any discussion of the development finance process would be incomplete without
mentioning the people involved. Structuring and funding development finance deals is a
partnership effort involving bankers, assistance program administrators, community
leaders, and project sponsors among others. While the parties often have different agendas
and may even be competitors, they are all integral to the deal, and all must agree on a
project's viability. They are, in many respects, like a loan review committee; each member
has veto power over the deal.
While the success of individual deals is never guaranteed, the partnership nature
of the effort and the veto power of each partner improve the chances of success.
Development finance is doing "undoable deals." It is making some projects
work that would not work without enhancements. While the success of individual deals is
never guaranteed, the partnership nature of the effort and the veto power of each partner
improve the chances of success. No one wins if a deal fails, and the deal is made stronger
when each party adheres to its investment standards. For lenders, this means lending for a
profit and prudently managing their risks as they would for any other type of loan.
Larry G. Meeker
Copyright 1990 by Robert Morris Associates. Reprinted with permission from the
Journal of Commercial Lending July 1990.
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