construction project finance

construction project finance

An In-Depth Analysis of Construction Project Finance

1. Introduction to Construction Project Finance

Traditional financing is difficult to contract as building projects are long-term and the income from the completed project arrives in the distant future. This led to the rise of commercial banks in providing funds for real estate, holding the loans until the developer or ultimate real estate owner could sell corporate or mortgage bonds. However, the long-term bank loans went against the bank regulatory tenet that short-term liabilities fund long-term loans. The result was restrictive bank lending rates, such as one-year mega-loans, which financed the developer for an entire project through pre-commitments of longer-term permanent mortgage funding to arise upon lease-up and project completion and stabilization in a process known as mini-perm financing. These financial arrangements, though useful, had the inherent risk of mortgage market meltdown and loan non-renewal and therefore were not actual solutions to the fund mismatch facing developer cash needs. Furthermore, the mini-perm was very costly. However, when a public offering of stocks and/or bonds was not available to the real estate developer, traditional life insurance companies could supply long-term funding, as they were not subject to the same regulatory and accounting restrictions that were applicable to commercial banks. The life insurance company would lend, taking a first mortgage on the real estate or a first lien on the stock of the owners of the property. The borrower’s equity in the property would be retained, and the developer would pay interest and make payments on the loan for a term of years. Upon repayment of the loan, the equity owner would be left with the property.

Construction project financing is the ultimate requirement for the success of most major construction projects. Construction projects are extremely expensive and the developer does not usually have on hand the substantial capital needed to complete the project. Construction is also extremely financing-intensive and expensive to finance, given the front-loading of construction borrowing requirements and the higher risk of construction lending. The developer needs a specific purpose financial arrangement, separate from the current assets of the developer, to provide the necessary funding. Financing is needed for the purchase and assembly of the land, site development, construction, and ongoing maintenance and repair. It may also be needed for management time, architect and engineering work, site clearances, independent consultants, legal, and other services. These clearly identifiable costs need to be matched directly with a time-phased income flow.

2. Key Players and Stakeholders in Construction Project Finance

2.2. General Management of the Construction Project Management has a very broad meaning. One can also say that management is present in almost every domain of activities, both in the public and private sectors. However, the characteristics of management in a construction project are specific. There are also serious dilemmas and discussions on this subject, especially after a construction project has been completed. Those dilemmas and discussions are usually related to the constraints and bottlenecks that had arisen in the management of the projects themselves, and which have led, eventually, to imperfections in their implementation, as well as the non-fulfillment of the project goals and objectives. Therefore, in order to avoid critical remarks after a construction project, professional management is needed, as well as a high level of mutual participation and cooperation among all the project stakeholders.

2.1. Introduction There are many players and stakeholders in construction finance. Some of them are the initiators of the construction project, and others are directly related to the financing of the construction. The decision to start a construction project has to be made by a certain entity. A proper implementation, monitoring, and control require specific and professional management. There are numerous business entities that may initiate a construction project. However, usually, the project initiator is an entrepreneur or a certain type of private or public sector. In that sense, it is appropriate to make a classification of the project initiators in construction.

3. Financial Instruments and Strategies in Construction Project Finance

Long-term relationships, the sharing of technology, free communication, and trust that creates and sustains the built environment appear to be facilitated by the recently revised American Institute of Architects (AIA) A201 General Conditions 25.14, which provides for an agreement on “liquidated damages” that should adjust the contract sum to the preset amount of damages if a fixed opening date agreement is not achieved. Thus, the agreement could have significant impacts on project management and the project management system because “value” concepts perform a critical role in matching compensation to need and risk in project management. The operational issue relating to the percent growth in design costs and the percent growth in contractor costs which they must memorialize in language also applies and can often only be evaluated with an in-depth understanding of the client’s business environment which comes from working in only its industry.

There are fundamental ideas that greatly challenge the project manager’s ability to effectively manage a construction project. For instance, value and delivery speed are increased when collaboration occurs in the design and construction processes. However, regardless of the basis on which compensation is defined, the most efficient manner of matching risk to interest and the attitudes a party may have concerning risk, need to be made transparent. If design-bid-build is determined to be the safest delivery method, or more importantly, if this method is strongly desired for non-economically related reasons, the differences in profitability or potential loss among the six recognized delivery methods that the literature has identified indicate that responding to traditional ‘low bid’ type solicitations may require increased or decreased amounts of revenue to assure survival and profitability.

4. Challenges and Risk Management in Construction Project Finance

According to the intrinsic different characteristics of the construction project, the financed construction project has its own unique risks. Indeed, there are numerous factors that could contribute to generating the various risk types discussed above and the nature of these risk factors significantly affects the way in which risk can be identified, alleviated, shared, and managed. Based on the classical Aoka’s risk problem framework, it is found that there are three aspects: risk evaluation; risk allocation; risk management. Although a host of different typologies exist in the literature, this framework is probably the simplest and yet the most logical structure for understanding the complexities of risk management of construction finance. In the latter analysis, Pawadyira further specifically considers the implementation aspect of construction projects as being unique and has to be formed carefully in order to address the associated investment risks.

Executing a construction project has to overcome many difficulties and risks. In infrastructure construction projects, execution is a highly risky process. In general, the risks in construction finance are classified into five areas: risks in different stages of the construction process, including pre-construction, foundation, growth, operation, income, and termination stages; the risks of projects themselves, based on location, the age of the building, the grantee, and so forth; the risk affecting the project in the same geographical area in the same period due to competition. This kind of risk is recognized as systematic risk; the risk of law and rule changes. If a construction project is executed in various countries, it will be subjected to differences in rules, so the risk of law and rule changes is considered; and the risk arising from changes in politics, economy, and the environment in the areas involved in executing projects, including politics, economy, and environmental risks.

5. Case Studies and Best Practices in Construction Project Finance

The Tokyo Bay Aqua-Line project clearly demonstrates construction project finance in a major undertaking. The project was organized and managed according to a set of “best practices.” Although the project still encountered the impediments that always befall mega financing efforts, it was completed as planned and has operated without either the management problems or the economic collapse of other toll roads both in Japan and abroad. Finally, the Tokyo Bay Aqua-Line also illustrates some of the activities described in volume two.

In this chapter, we illustrate how the “standard” financing methods of this book are combined and modified to yield practical, large-scale project financing. We do this in a case study of the Tokyo Bay Aqua-Line toll road. Next, we summarize the Tokyo Bay Aqua-Line’s best financial and organizational practices. Using these practices, we construct a set of “Richardson’s Seven Propositions for Developing Asia’s Mega Infrastructure Projects.” Two case studies and a best practices summary may seem brief. However, our detailed presentation of the Aqua-Line, along with the extensive documentation supporting this discussion, should allow the serious student to reverse engineer other similar projects. However, a full discussion of the conceptual underpinning for these propositions, as well as a “how it was done” part of the proposal, will follow in subsequent chapters.