Market Know-how: Building with Interest

Raising additional finances in the turnover of the firm helps the development of its own resources and the capacity of the company, widening the scale of its activities. "As a result it enables the possibilities for mergers and takeovers of other companies" says Evegeny Plaksenkov, financial director of MIEL.

According to Dmitry Lutsenko, a member of the board of directors of Mirax Group "realising current developer's projects without obtaining massive investment is not possible, as we are talking about millions of investments over quite a long period of time.”

The principle of selection

Experts single out several criteria, according to which developer companies select possible instruments for raising funds. "There are many factors: the scale of the company's business, its openness, the presence of a public credit history, and the readiness of the owners to share control of the company and others. Actually, how closed the business is and the unwillingness of proprietors to share control and show its financial parameters leads to the distribution of "preferences" on sources of financing. Companies prefer to use more expensive, but not demanding high access and level of corporate management, tools," director of the corporate finance department at Finam Roman Philippov notes.

But, according to Lutsenko, financial transparency in modern conditions is an indispensable condition of the investment appeal of a company. "An investor should understand precisely where the funds will be invested and the structure of the business processes of the company, which will be disposing these funds.”

In other words, the investor should minimize the risks connected with investments," the expert explains. The development business in Russia is now divided into those who have decided "to be open," and those who remain closed, approximately in the ratio of 50 to 50, estimates Lutsenko. "The largest companies in the market would like to become even larger, and to make such a step forward, being a private, closed company, without openness and publicity, is quite difficult,” he says.

To become transparent, a company should take a number of specific steps. "First, financial reports should be converted to international US GAAP standards. This is the first and most responsible step. Following this, changes should be made in corporate management, to credit ratings, independent directors and so forth," explains Lutsenko.

Experts assess the existing tools of attracting financial resources by level of complexity. The easiest, in their opinion, is to receive credit from a bank with an already existing subject as a guarantee. It is slightly more difficult to get project financing from a credit establishment. Next comes direct investments from potential partners, for example, the target purchase of assets of a company or a share in the future project. Market participants name a more difficult tool as the placement of bonds in Russia, but it is even more difficult to place bonds abroad. And finally, crowning the ladder is an initial public offering (IPO).

"If you had to grade the various ways of attracting resources by complexity of their realization the list would go as follows: credit, Russian bonds, eurobonds and, lastly, an IPO, which has different levels - in Russia and abroad, on recognized platforms, for example on the London stock exchange. It is conventional, that the most difficult, owing to the Sarbanes-Oxley Act, is the placement of an IPO on the New York Stock Exchange (NYSE)," Plaksenkov lists, as an example.

The act, mentioned by the expert, was signed by the US President George Bush in 2002 and has considerably toughened the requirements for financial reporting and the process of its preparation due to numerous scandals connected with unprincipled managers of large corporations. Therefore there is no Russian development company on the NYSE. But Russians use other stock exchanges to their utmost.

Russian companies have to choose from the listed tools. "Much depends on what type of real estate the money is needed for - residential or commercial. For the construction of residential buildings the company-builder can involve a partner-co-investor or take credit from a bank. For the construction of cottage real estate it is also difficult to get credit for the purchase of land, therefore in some cases developers creates real estate funds and invest a share in a bank to receive credit," director of marketing at Konti Yuri Sinyaev notes. According to him, a lot depends on the reputation of the company, experience of realized projects and good credit history. The characteristics of the project in which the money will be invested in may also act as a factor of success.

"Sources and ways of financing vary depending on the stage of a project. Unresolved questions with landed property, in my opinion, hamper financing at the initial design stage, which greatly complicates the legal structure of a guarantee. The main ways of structuring are a guarantee of investment rights, a guarantee of the rights of rent, a guarantee of assets of the company-debtor or a combination. But none of these provide a bank with an easy and liquid exit from a project in terms of collecting the guarantee,” general director of BorodinoNedvizhimost Gevork Kazaryan notes.

In the opinion of the general director of Vesco Consulting Alexei Averyanov, choosing the mechanism to attract loans, in many respects, depends on the scale of the company. As a rule, only large market players can afford an IPO, while small companies prefer bank credits or the creation of closed share investment funds.

The purpose of the loan in choosing a financing tool, according to him, is not so important.

Old, kind banks

According to Sinyaev, "now in Russia the main and most popular way of financing construction is a bank credit. About 90 per cent of Moscow real estate is constructed with bank credit," the expert considers. According to managing partner at Blackwood Konstantin Kovalyov, this parameter is actually first for all investment companies that independently are not engaged in construction, but invest in development projects. "The share of loans in the form of bank credit for developers varies from 30 per cent up to 80 per cent of the total financing of a project at an average level of investments in a project from $25 million to $150 million," he specifies.

In Kovalyov’s opinion, "such demand for bank services in development shows that for builders this is the most accessible and cheap way of financing projects. Using loans is profitable for both the bank, and the builder: banks increase their capital, builders get the opportunity to smoothly finance projects, raising the profitability of its own capital."

There are two bank-financing schemes for projects. Under a project financing scheme the company is financed by the bank under the future income of the project, but it should have funds of its own at a rate of at least 20-30 per cent from the total amount of investment. "This money is necessary to carry out of prospecting works, preparation of the design and initial-permittance documentation and the receipt of approval for construction” says Kovalyov.

This mechanism is important for companies who have already developed relations with credit establishments and have realized tens of projects.

On the other hand, according to him, under the scheme of guaranteed financing, banks give credit with the guarantee of available assets: land plots, real estate premises, securities, precious metals, antiques and so forth. Credit is given in the sum of no more than 60-70 per cent of the real cost of the asset.

In both cases banks enforce strict conditions on the borrower. It should show a credit history, inform it of the volume of its own capital, provide full information on the project, prove the presence of design and permittance documentation, etc. However the receipt of bank credit does not demand a high level of openness and the standards of business management that are necessary for more complex forms of attracting funds.

"Banks are ready to finance by conclusion of a preliminary contract with a delay condition. Usually, a project is prepared at the concept stage and gets weighed by both parties and if everything suits everybody then it is possible to receive credit at the stage of site preparation," says Kazaryan. According to director of the investment consulting department at Colliers International, Oleg Smirnov, in that case the guarantee can be the documentation of the project or the uncompleted construction. Under such circumstances the risks for the creditors are the highest, therefore the contract is for a short period of time, and the rates on average are 1-4 per cent above the market. Therefore, when all papers have been received and construction works have begun developers prefer to refinance loans, i.е. Re-borrow money under more favorable conditions. Usually large western banks which possess a lot money act as the new creditors. For example, in 2005, Capital Partners, having received $130 million in credit from Eurohypo bank, refinanced its loan for the construction of Pushkino logistics terminal. In July 2006, Merrill Lynch Capital Markets Bank and Aareal Bank gave Capital Partners $205.6 million of credit, to refinance the expenses for the construction of the Ritz-Carlton Moscow hotel.

Bond obligations

Bank credit is usually used to invest money in specific projects, and thus it is impossible to receive funds for the expansion of a portfolio of projects, the purchases of new areas or re-structuring of the business. A bonded loan allows for the collection of serious resources.

"Bonds are a tool used by settled corporate structures with an already formed specialization or precise plan for development," says Smirnov.

Bonded loans in the Russian market have been placed by many development companies, including those that don’t have lead positions, for example, SUIholding and RIGrupp. However this tool is not as popular as bank credit yet.

"Bonds are still rather rarely used although real estate market participants are traditionally perceived as reliable issuers. This year representatives of the sector placed 18 bond issues for a total sum of a little more than $1 billion, i.е. less than 15 per cent of the total investments in the sector," says Philippov.

"An enterprise, having issued bonds, becomes a public player and shows transparency. And the more open and public the company is, the cheaper it manages to attract loans," considers Plaksenkov.

Placing Eurobonds, the issue of a foreign currency and distributed among foreign investors, remains an inaccessible tool for Russian developers. Although this way of attracting of funds is favorable enough. "If a company is large then the receipt of non public credit, even from western banks, for certain projects may not be optimum. Interest rates on refinancing can be almost 8 per cent, while a bond issue may provide a lower rate," Smirnov says.

However such tools are most popular among large primary goods and financial companies, for example Gazprom and Vneshtorgbank. "For the real estate sector Eurobonds remain an exotic tool – they have been used by only four issuers," says Philippov. In particular, Don-Stroi issued Eurobonds worth $150 million and St. Petersburg’s LenSpecSMU issued $100 million. Mirax Group has placed two loans for $100 million and $180 million. This has only been repeated by Theorema, which belongs to Igor Vodopyanov, which has placed two loans for $75 million and $148 million. Curiously, after that these companies announced plans to issue IPOs. In addition, Barkli had planned to place eurobonds, however, according to Cbonds news agency, at the moment there are only exchange bills of the company worth 300 million rubles in circulation.

In the opinion of experts, an alternative to placing eurobonds is often the attraction of investors. "In the real estate sector the attraction of direct investors and the sale of a share in the business or project to receive funds for its development are rather actively used. This segment provides no less than 25 per cent of the inflow of investments," says Philippov.

According to him, Eurobonds and attracting investors are approximately the same in terms of their level of complexity. "A portfolio of assets which can be considered as a guarantee, or the presence of assets, as a rule, is enough for banks, but to attract a direct investor or place bonds, growth rates and a strategy of development are necessary, and for a placement of assets, financial transparency is also desirable," explains Philippov.

For example, in the last two years Morgan Stanley Special Situations Fund has become a shareholder of such companies as RosEvroDevelopment, RGI International and RBI Holdings, and Austria’s Strabag has created a joint venture with Oleg Deripaska's Bazel-Cement.

Shock workers of a capitalist work

The "top of a career" of a company, from the point of view of attracting additional financial resources, is an IPO. "To get to the level of an IPO, it is necessary to meet the corresponding requirements. Those who have prepared a company use this tool successfully to increase its own capital. Those companies that are not ready for an IPO yet but have experience connected with an international audit and preparation of consolidated reporting place Eurobonds," says Plaksenkov.

According to leading adviser at Cushman Wakefield/Stiles Riabokobylko, Ilya Kutnov, "if the company dares to become public and issues an IPO, other ways of attracting finance become easier and cheaper: bank credit for a public company is given at lower interest rates, and the issue of bonds is also considerably facilitated.".

For Russian developers the last step of the ladder in attracting financial resources is the London Stock Exchange (LSE). Because of the complexities with American legislation and the closed character of Russian players the NYSE is inaccessible to them. In the last year in London, assets have been placed by such companies as RGI International, Sistema-Gals, AFI Development, PIK and LSR. It can’t be said that all the placements were successful.

In particular, in May 2006 the top managers of Sistema, when placing Sistema-Gals on the LSE, calculated capitalization of $2-4 billion, then after half a year the price range was lowered to $1.55-$1.85 billion. Then, in June 2007, the capitalization of AFI Development, which belongs to Lev Levayev, right after placement on the LSE fell from $7.3 billion to $5.86 billion, practically 25 per cent.

In the opinion of experts, it is important for a company placing assets on a stock exchange to choose the right moment. "The issue of an IPO is risky if the market is overheated. For example, during 2007-2008 in the Russian market several tens of Russian companies, including development companies are expected to make IPOs, at the same time there is the risk of western investors in the Russian market of IPOs being at their limit," says Averyanov.

Market participants recognized autumn 2007 as an improper moment for an IPO in connection with the mortgage crisis in the US and following that the liquidity crisis in the world markets. Waiting for a better situation, Mirax Group refused to carry out its public placement and has delayed the IPO for a year. In connection to this Maxim Frolov left his post as chairman of the corporation. However developers’ fears appeared to be in vain. At the beginning of November, LSR group sold 12.5 per cent of authorized capital for $772 million on the LSE, having placed the offering exactly in the middle of the price range. The capitalization of the company as a result stands at $6.8 billion. The company became the second developer after PIK in Russia.

After the success of LSR the desire to issue an IPO was declared by another St. Petersburg company - Theorema, who plans to sell about 30 per cent of its assets for $500 million in London. It turns out that consequences of the world crisis who came to the LSE have not been reflected on Russian developers. "The assets of Russian companies and those that work in Russia are in demand, despite the crisis. This basically proves to be true by a decision of LSR not to postpone its IPO and by a successful placement by Strabag in Austria: the assets have been sold at a good price, and, according to the issuer’s announcement, a significant part of the funds will be used in Russian projects,” Kutnov says.

According to Smirnov, in general it is difficult to assess the consequences of the world financial crisis for Russia, but firstly companies focused on direct investments might suffer. "Banks will continue to give credit under successful projects as it was earlier as risks of reception of income under these projects do not carry global character," he says.

A visible consequence of the crisis, in Smirnov’s opinion, is the desire of some banks to leave some projects in which they are shareholders. "It is necessary to expect an increase in the number of projects for sale," he predicts.