Fun with Fund Through

Global macroeconomic trends have forced hotel investors to consider a number of unique approaches to acquiring hotel assets, particularly in gateway cities. This article considers how fund-through structures can benefit investors and developers embarking on new hotel projects, as well as the key issues that merit consideration.

A new approach to hotel investment and development

Introduction

Prospective investors face an unfortunate conundrum when trying to break into the hotel market. In gateway cities, the supply of lucrative hotel investment opportunities is low and in many cases (for example, in Australia, particularly in Sydney) the hotel market is tightly held. This has led to many investors acquiring interests in hotels through new developments, particularly where the economics of hotels in markets such as Sydney are strong. 

Traditionally, hotels under development have been acquired in a "take out" where the incoming investor pays a deposit on commencement of construction, with the final payment to the developer of the hotel on completion of the hotel build. However, this requires the developer to fund the development, and sourcing such funding is becoming increasingly difficult. According to recent Reserve Bank of Australia Data, construction finance approval for projects over AU$2 million has consistently remained below the levels reached in the December Quarter 2017. 

An alternative investment structure that overcomes this issue is the "fund-through structure". At a broad level, this involves an investor contracting with a developer to construct a hotel on land owned by the developer. The investor pays a small deposit upfront and continues to pay development fees and costs throughout the duration of the project, which essentially funds the construction. Title to the land may pass to the investor on payment of the deposit or on completion. 

Fund-through structures have already proven particularly popular within the office real estate market, driven by both demand and supply factors. On the supply side, limited availability of quality stock has driven investors up the risk curve. On the demand side, both investor demand for quality office assets as well as the absence of development finance from traditional lenders has driven this trend. For example, the development of MYOB's new corporate headquarters in Cremorne for $100 million, and recently, Mirvac (as investor) and PDG (as developer) have both utilised this structure in the construction of a build-to-rent 490 unit apartment complex next to the Queen Victoria Market in Melbourne (valued at $33.5 million). In the hotels context, the use of these structures is also gaining traction. The soon to be constructed W Hotel in Sydney is one of the first developments to use a fund-through structure.

How it works

There are two principal players in a "standard" fund-through structure – an investor and a land-owning developer (or the developer may have otherwise secured the rights to develop the land). The essential mechanics of the structure are typically captured in a development agreement between the investor and the developer. These are set out below. 

The Developer agrees to: 

(a) pay an initial (recoverable) deposit upfront, being the cost of the vacant land; and

(b) pay the costs of carrying out the development throughout the duration of the Project (inclusive of a development fee to the Developer). 

Where an investor is funding throughout the build, it is necessary for the investor to ensure that these payments are appropriately secured and the investor's rights are protected. As such, a fund-through structure will normally entail a number of ancillary agreements with various third parties. These may include:

(a) a Building Contract between the developer and a builder for the construction of a hotel on the land (usually these would contain guaranteed maximum provisions);

(b) a Side Deed between the investor, developer and builder to provide the investor with step-in rights under the Building Contract in the event of default so that the investor can complete the build directly with the builder, if necessary;

(c) an Independent Certifier Deed between the investor, developer, builder and independent certifier to appoint an independent certifier to certify work carried out and completed, payment claims throughout the duration of the project, extension of time claims and practical completion; 

(d) security documentation, such as a general security deed (or charge) over the developer in favour of the investor;

(e) if title to the land has not passed at the outset, a mortgage taken by the investor over the land; and

(f) a Bank Guarantee (or other security) provided by the developer to the investor. 

Risks and benefits associated with fund-through structures

Investor

Liquidity and Finance

As the investor's consideration for the purchase of the land and hotel is comprised of a prolonged series of payments, this structure is akin to an acquisition via instalment plan. 

Where the developer is not required to seek debt funding, the price offered to investors on a fund-through structure is typically cheaper than the price offered on a take-out structure, consistent with the additional level of risk taken on by the investor as well as the earlier deployment of capital.

The investor will need to have sufficient capital or finance to fund the ongoing progress payments. If the investor does not have access to a large pool of capital, it may face some difficulties in obtaining debt finance. The process of obtaining finance is made harder by the fact that title to the property may not pass until completion of construction, preventing the investor from using the land as security. Even if this were the case, the value of the land itself may not be sufficient to generate the requisite levels of finance during the construction phase of the project. This further reiterates that this structure is more appropriate for investors with existing pools of capital and who are seeking to deploy that capital.  

Secured position of the investor and options on default

Throughout the duration of the project, the investor's position is protected by a number of mechanisms built into the structure. These include:

(a) the security agreements it has entered into with the developer, which (as mentioned above) would likely include a General Security Deed over the assets of the developer, a mortgage (if title has not already passed) and a bank guarantee;

(b) the certification of all payments made to the developer pursuant to the terms of an Independent Certifier Deed;

(c) step-in rights in the Building Contract and Development Agreement, which would allow the investor to replace either the builder or developer (or both) facilitating the completion of the project and the transfer of title; and

(d) insulation from cost overruns (typically the Development Agreement would be on a maximum price structure subject to an agreed project brief). 

In addition to reducing the investor's exposure to liability, these mechanisms provide the investor with greater control over the project. In a typical "take out" scenario an investor is unlikely to be able to seek specific performance of such a contract and its only remedy will be damages. However, in a "fund-through" scenario, the investor can still step in and complete construction, which provides the investor with a remedy which can still ultimately deliver the project to the investor. 

Investor control

Increased investor control is a typical feature of these structures. Where payments are not typically made until an independent certifier verifies the development's progress, this effectively gives the investor more supervisory power than it would have under a typical development structure. 

In addition, a developer under such a structure is more likely to be tied to a date for delivery of the project, as distinct from a long stop "sunset date" which is typically used in take-out structures. This provides the investor with greater control and certainty on the time for completion and delivery of the build.

The quid pro quo is that the investor will need to have a team with sufficient  project and contract management skills on the ground early on and throughout the project. 

Tax

Finally, fund-through structures can be particularly tax effective for investors, where transfer duties may be limited to the land price, rather than the combined value of the land and the completed hotel on the land. However, this will ultimately depend upon the nature of each transaction and how it is structured.

Developer

Liquidity and Financing

One of the inherent benefits of this structure from the developer's perspective is that the project is effectively "pre-sold" to the investor. Because of this, the developer does not need to incur any costs that could arise if there was a delay between completion and sourcing a buyer. 

Secondly, the developer's ongoing costs are fully funded as a result of the investor's continuous payments, mitigating the risk of liquidity issues arising. In receiving these payments, the developer effectively obtains project finance at below market rates. This is particularly helpful for developers who would otherwise be unable to obtain finance through traditional sources (ie through major banks). However, as mentioned above, typically these payments would not cover any cost overruns incurred during the course of the project. The developer would be liable to incur such costs, though the risk of these costs arising could be contemplated and built into the Building Contract (ie passing these costs onto the builder). 

Investor default

The investor's ongoing payments also protect the developer's position from being effected by an investor default. If an investor default occurs, the developer's exposure is limited to the cost of completing the project from the point of default. Depending upon the stage of construction, the developer could introduce a new investor who would acquire the defaulting investor's interest and finance the remainder of the project. Alternatively, the developer could obtain debt finance to complete the development and sell the project to a third party at completion. The investor's entitlement to any proceeds of sale would be only after the developer has recouped all costs and losses associated with the project. 

Builder default

Although the developer's position is effectively protected in the event of an investor default, the developer would be exposed to a default by the builder. For example, if delays to practical completion resulted in the developer failing to deliver the property to the investor at the agreed time, the developer would be liable to the investor. Depending on what is agreed between the parties, a default by the builder could also activate the investor's step-in rights, enabling the investor to replace both the builder and developer.

Evidently, this is something that the developer can mitigate by selecting the right builder and engaging in robust due diligence before the choice of builder is made. Alternatively, this could be mitigated under the terms of the Development Agreement, whereby the developer agrees to deliver the property to the investor after a certain period of time after practical completion occurs (ensuring that delays to practical completion would not result in a default under the Development Agreement).

Considerations for both parties

Project Brief

In order for transactions to succeed, one key point that both parties must not forget is the need to establish a clear vision for the project at the outset. This means that the parties must ensure that the project brief is as intricately detailed as possible, as this will provide the parties with step by step guidance as the project progresses. This mitigates the risk of disputes or delays arising throughout the course of the project. 

Hotel or Shell?

At this stage, the parties must also determine whether the final product will be a "shell" (warm shell or a cold shell), or if the developer will effectively deliver a turnkey hotel that is ready to be open to the public on completion. Ultimately, the investor must determine whether it has the capabilities to finish the hotel on its own if the developer delivers a shell. If it does, the investor may prefer the shell approach, as this will enable it to customise the building to align with its vision. If it does not have these capabilities, it would be best to leave the final product in the developer's hands.

The decision as to the level of finish the investor wants is often tied to the extent to which individual specification for the hotel is required in order to comply with brand standards which the investor can best manage.

Role of the Operator

Additionally, the parties should consider the interactions and relationship with any third party hotel operator.

If the operator is to be involved throughout the project, the best approach would be to request for the operator's input during the project brief phase. This will facilitate agreement between the parties on a design that the operator is comfortable with and meets brand standards.

To the extent full design is not available at the outset, the process for incorporating operator requirements as the design progresses within existing agreed budgets and cost plans required detailed thought and consideration.

The parties must also consider which operator will be best suited to running the hotel. Here, the question is which brand is the most appropriately suited for the hotel's market. Whether a budget or a five star ultra-luxury operator is suitable may ultimately turn on the location of the asset. Additionally, if the aim is to attract a greater number of overseas visitors, an internationally recognisable brand may be important.

Final Points

This article has aimed to highlight the benefits to be enjoyed by investors and developers alike in utilising fund-through structures when setting out to acquire and develop new hotel assets. At the same time, this article does not shy away from describing some of the risks faced by investors and developers, as well as the key considerations that both must take into account if they want the venture to succeed.

The final point to stress (if this was not immediately clear) is that fund-through structures involve a great deal of legal complexity. The number of different contractual arrangements involving separate parties, each with their own defined rights, obligations and priorities necessitates that these ventures are not undertaken without considerable thought given to each aspect of the deal. We recommend that any transaction involving these structures be supported by sophisticated legal counsel and advisers. This should ensure that these ventures prove successful and profitable for all parties involved.  

With this in mind, and in the context of continued tight lending practices from traditional lenders, as well as a lack of turnkey hotel investment opportunities and underdeveloped infrastructure in gateway cities, the question remains as to whether the use of fund-through structures will increase as savvy investors seek to take advantage of increased tourism in these cities.