Financing - Funding a Real Estate Project

We got a feedback from some of our readers that our last post Ownership - Holding a RealT was a bit too much complicated to understand for a beginner. Totally respecting their valuable comments, we have tried to mellow down this post on RealT Financing (although the topic is way more complicated than the last one :-/).


What is Financing?

So coming back to the main business, the second level of Value Chain in Real Estate circumference – Financing. Just as you require money to pay for your household items, you need money to pay for your house (realty property) too. But financing a RealT deal is not as simple as buying vegetables down the street! More often than not, realty buyers need a proper plan, strategy and an agency to finance their dream projects. This is where this post originates J


How is Financing classified?

There are several ways in which a RealT deal can be financed. Typically all the ways can be classified under 2 heads – Equity & Debt.



To start with, we will cover the Debt portion in this post and try to explain the various options to raise finance through debt.


Debt

Debt, in literal sense means – “raising money from the market for a particular time horizon, at some interest rate”. Due to the advancement in the financial markets, many instruments have been developed to carry out this function. These instruments, if used rationally can benefit both lenders & borrowers, but improper use of such instruments can even lead to catastrophes like ‘Sub-prime crisis of 2008’.


Bank Loans



Raising money from a commercial bank is the easiest way for an individual investor. Banks offer attractive interest rates to the borrowers and are easily accessible. But this may not be the most effective way to finance a real estate deal due to the following reasons:
  • Banks disburse loans for short-term
  • The amount of disbursement depends on various factors like – individual’s net worth,  MPBF (maximum permissible bank fund), income statements, securitization etc.
  • Indian Banks generally do not grant loans to a new real estate developer
  • Banks generally do not grant loans on ‘land’ alone


Mortgages



Mortgage typically means taking loan from a party by pledging your property as a collateral against the loan. The mortgagee reserves full right to take a control over the pledged property in case of foreclosure (default, in simple terms).

Whatever you will read after this point is a bit complicated, but we have tried to simplify the concept as much as possible. Let’s see how much sense it makes. So, mortgages can be carried out in 2 ways:



Mortgage Broker:




The whole idea of Mortgage Broking is depicted in the above figure. Few points about this process:
  • Brokers are independent agencies, having tie-ups with fund providers
  • Fund providers generally prefer these brokers so that the borrower is already researched for credit worthiness
  • Mortgage brokers are generally not involved in ‘loan servicing
  • They don’t use their own capital to fund the borrowers


Mortgage Banker:


These are specialized agencies which provides mortgages directly to the borrowers, using their own capital. These agencies do not accept deposits from the public, rather makes money from the loan origination fees & servicing fees.

They typically packages the loans & sell them to the institutional buyers or government sponsored enterprises in secondary markets. In US, there are Freddie Mac & Fannie Mae to carry out these functions while in India there is no such institution yet for this function. The nearest equivalent that can be thought of is Mortgage Risk Guarantee Fund.

We know that this has become a bit too much complicated to understand, but the following diagram may relieve our brain nerves a bit ;-)




So the whole process of Secondary Markets is depicted in the above figure. It shows step by step process followed by the loans to finally reach the borrower.


Note: We understand that this post has been a bit too much complicated. Please feel free to write to us in case you need any explanations on any of the above topics. The remaining portion of financing by equity will be covered in our next post. Stay tuned!!


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