Consolidating the two criteria for systematisation yields four basic, possible fund models, which can be established with increasing start-up costs.
Among the four fund types to be presented, the potential risk to the UDF’s operations in- creases, as does the possibility for the public fund participants to exert influence on the ur- ban development projects being funded:
UDF as „Long-
term Property
Investors“
Funding
Lender“
Land
Developers“
Development Loan
Guarantor“
(development and
operating phase)
UDF as „
operating
phases in the
LLC-model
UDF as „
UDF as
„
development
phases in the
LLC-model
Equity funds
(incorporated
business)
Non-equity funds
(unincorporated
business)
Financier
of
UDF as „
(development and
operating phase)
UDF as „
operating
phases in the
LLC-model
UDF as „
UDF as
„
development
phases in the
LLC-model
Equity funds
(incorporated
business)
Non-equity funds
(unincorporated
business)
Long-
term Property
Investors“
Funding
Lender“
Land
Developers“
Development Loan
Guarantor“
Financier
of
Overview business models:
Business
classification
according to
developed
real estate
assets
Business classification accor-
ding to financial instruments
5.2.2.1 UDFs without venture capital employment as a part of a financial or funding institution
The two fund models in the first column are set up to implement a UDF together with a pri- vate or public bank as quickly as possible. Therefore, no separate company is established for either model; rather the “fund” is set up as part of a financial institution with separate book- keeping (similar to segment reporting).
5.2.2.1.1 Model I: UDF as funding lender
For the real estate utilisation stage, the simplest solution appears to be the UDF shown in the following as Model I, whereby it functions solely as a “funding lender”. Its primary purpose is to support sustainable urban development projects by granting loans at preferential, i.e. less expensive interest rates. As part of a partner bank, the UDF acts as lender without its own legal personality; the partner bank handles distribution of the loan (e.g. via its branches). The periodic repayment of loans actually enables the fund to revolve its lending operations. Although the loans do appear in the yearend financial statements (more precisely on the ba- lance sheets) of the partner bank, all credit risks (especially the default risk) and the neces- sary management costs are borne by the UDF. As the loans are granted at rates below the market level (to achieve the funding purposes), however, it is appropriate to primarily use public capital to refinance the UDF’s business operations. Private equity only appears to be applicable here when the public lender waives any return on its capital employed and, at the same time, accepts most of the credit risks. Capital in kind does not play any role for this type of UDF.
With regards to the systematised urban development projects of the previous Chapter 5.2.1, the funding of preferential projects in the utilisation stage by the UDF comes into question, as in this case the regular rental income could service the periodic interest payments. For de- velopment projects, the UDF has to go without regular capital repayment in favour of defer- ring interest and the principal (until the end of the development project). This results in strongly rising default risk and high payloads for the projects due to the high, accrued interest (in the projects’ own high debt financing share).
The advantages of this fund approach are doubtlessly the very low, nonrecurring implemen- tation costs and the limited ongoing management costs. If a private commercial bank is gained as a partner, not only does the approach also become revolving, but a public-private partnership is always ensured as well. Due to the very limited fund income compared to the high loan sums to be disbursed, its use should remain limited to low risk projects in the utili- sation stage with predominantly public fund refinancing. A potential area of application for Model I would be, for example, the promotion of the energy-efficiency upgrading of housing. The rapid, inexpensive implementation (and simultaneous limitation to small loan sums) would especially be feasible via the corresponding housing funds in the new Member States. The granting of inexpensive loans to demolish vacant commercial city properties or to pro- mote Business Improvement Districts (BID) could also represent important funding projects for a Model I UDF. Finally, the UDF could also support the long-term financing e.g. of historic buildings by lending junior loans, which supplement the commercial senior real estate loans. For all areas of application – assuming strong public interest – state aid legal problems should not be relevant.
5.2.2.1.2 Model II: UDFs as development loan guarantor
In order to also help projects in the stage of land and property development with a simple, quick business model, the following, also simple fund type (Model II) is appropriate for a UDF:
This model can and should also abstain from establishing its own fund company. Rather, to lessen the start-up costs, not only is the UDF part of an existing (public or private) bank, but the entire loan management is also handled by the banking partner. The UDF “only” supports sustainable urban development projects by issuing supplementary default guarantees, which should be in a range of approximately 40–60 per cent of the loan sum granted to each pro- ject.
The UDF therefore acts as a guarantor for development or project loans. These should be granted and managed at commercial rates through a private partner, i.e. a commercial bank, which also carries the entire loan in its own balance sheet. To the extent to which supervi- sory regulations do not contradict it, the UDF restricts itself to granting the guarantee (none of its own, direct financing operations) and, at the same time, monitors the project and loan. Here the information of the partner bank could presumably even be used.
A result of this construction is not only to hold its own fund management costs to a minimum, but also to limit the risk to its own funding operations. On the one hand, the UDF “only” bears the default risk (no other risks, such as to interest rates or liquidity); on the other, the default risk is limited to a portion of the loan amount (40–60 per cent). Based on an equity ratio of approximately 20 per cent of the investment costs in the urban development project, the UDF “only” bears the default risk of approximately 40 per cent of the total investment costs. The risk is thus limited, even though the UDF concentrates its operations on risky development projects.
The “reflux of capital” for the UDF comes, on the one hand, from the guarantee fee, which the project developer has to pay regularly (normally approximately 1 per cent). On the other hand it comes from the lack of loan defaults. The effect is that the capital can be used multi- ple times and remains at a nominal amount almost automatically. Depending on the default risks which the fund in fact takes on (and the probability of default in each case), the existing fund capital can already be used multiple times as long as the private commercial banking partner is willing to grant the corresponding loans.61
For each of the urban development projects, granting the guarantee firstly means the general authorisation for large development loans. Furthermore, it results indirectly in preferential in- terest rates, as the private lender bears fewer risks. This leads to lower risk and capital costs, which can be passed on to each project developer.
An assessment of the business model shows similar arguments to those for the first model: In addition to lower start-up and management costs, the risks to fund operations are also li- mited despite the involvement in the development stage of real estate projects. Similar to the first business model, it is also the case here that the granting of guarantees only brings in very limited ongoing inflows to the UDF. In the best case, these should cover the UDF’s own
61 For example, with an average default probability of 10 per cent, the fund capital would still be used ten times for development projects. Depending on the extent of the guarantee (measured by the investment sum) and the amount of the default probability, this “leverage effect” can increase further.
low management costs, so that, as long as no projects default, the fund capital should re- main at a nominal amount, which can then constantly be reused for new projects. Charging market rates on the fund capital, as must be expected for private equity, cannot happen here due to the existing management and risk costs. Insofar, the refinancing here should also be limited to public cash. Capital in kind is not suitable for the proposed business activities of the UDF.
For this business activity, each urban development project must be completely privately fi- nanced in the end. Thus, there does not only need to be sufficient equity but also large out- side capital. The guarantee fund can only offer support here, but it is not a replacement for other private lenders.
In both proposed UDF models, it has to be borne in mind that the “trade off” for the simplicity of the fund type is the general disadvantage that the public authorities’ influence (in regard to the public interests) is necessarily limited as a lender in the utilisation stage and as a guaran- tor in the development stage. The private partners in each of the funded urban development projects will have more capability to implement their own project goals.
5.2.2.2 UDFs as investment companies offering risk capital
In order to have more influence on the urban development project for the benefit of the public interests, it is necessary for public funders to take over more entrepreneurial risk, i.e. they have to provide projects with liable equity in the way of equity financing. This option is ex- pressly stipulated in the framework of the JESSICA initiative. Through their funding activity here, the public funders could take on the role of either a financier of land developers or long- term financial investors. The two approaches differ in terms of the perception of the role of the (public) funders and in the question of how income can be earned on the fund capital to implement the revolving approach.
For the two fund approaches to be presented, it is necessary to establish a separate legal and commercially independent organisation or legal entity. Thus, an independent company should be established with the private partners, though the form will vary depending on the concrete business activities.
5.2.2.2.1 Model III: UDFs as a financier of land developers
In the case of Model III now to be presented, the UDF acts as a financial institution, which in- vests in land developments. It can be established as a separate company with diverse part- ners. It is possible for the UDF to finance the development, preparation for building and, if necessary, decontamination of land exclusively with public capital. In order to implement a PPP in this model as well, however, private partners (financial investors and/or lenders) as well as private property owners could be involved according to their capital invested on fund of project level. Fundamentally, this model is therefore suitable for the use of private and public cash and capital in kind investment for fund refinancing in any form.
The primary aim of the business activity in Model III should be to finance the development of the land and less so of the building or project. On the one hand, this will considerably limit the business risk and the necessary fund capital employment. On the other, in the subse- quent project development and property holding, private partners can be involved in the im- plementation of the entire urban development project in any case. On the level of the land
development companies, in which the fund could invest, the still undeveloped and unsold land makes up the assets. Besides the fund investment the land developers will normally also need comprehensive, supplementary (private) project loans to implement the develop- ment project.
The revolving approach is implemented via a trading method, i.e. the proceeds from the sale of developed land to private project developers, investment companies or owner-users should cover all development, management and loan costs. In this case, the fund capital would at least be maintained at a nominal amount. The project companies should not hold the land due to the resulting lack of income.
The higher start-up and management costs for the business activities of this type of UDF are not only legitimated by the far-reaching possibilities to integrate private and public capital. In fact, this construction makes sure that the public funders can exert a great deal of influence, as they get involved at the earliest possible point in the lifecycle of the properties (see Figure 45). Finally, the present business model also allows diverse possibilities for setting up the distribution of profit and loss risks from the funding activities. For example, asymmetrical dis- tribution, especially of fund profits, is also possible in this model, whereby private property owners, financial investors and/or lenders can also earn market rates on their fund capital employed. In contrast, the public funders could waive their return on capital in favour of their public interests in the urban development project (= nominal capital maintenance). In this way, the capital base of the UDF can be dramatically increased through a high share of e- quity and debt from the private sector, which should be especially meaningful for capital- intensive development projects. Typical areas of application here are all area development projects, which do not ensure commercial return on equity in line with the market. Neverthe- less, the use of the developed land must result in limited income from rents and/or sale pro- ceeds. In the area of Brownfield refurbishment, which is a typical area of application of Model III funds, one speaks of so called “B-areas” following the classification by the CABERNET network. Other typical projects would be, for example, the development of cultural, educa- tional, recreational, or public health properties in their own urban context.
5.2.2.2.2 Model IV: UDFs as long-term property investors
One last and efficient alternative for this funding activity could be Model IV, whereby the UDF takes on the role of a long-term financial investor. Here the UDF leaves the entire land and building development to potential private partners (e.g. private development company and/or property owner). These could either develop their own property or public property as well, which the UDF could provide as an investment in kind.
The UDF itself would be established as an investment company in the form of a limited part- nership with a limited liability company as general partner. The fund has its own legal per- sonality comparable to a closed-end investment company. Its business purpose is solely to invest the fund capital in real estate to be developed in the framework of sustainable urban development projects. Both majority and minority interests are possible through the UDF, which will be booked proportionately as assets on its balance sheet. Therefore, the UDF also participates in equity financing in this case, though not until the utilisation stage of each property. This type of fund approach is thus revolving, whereby the return on equity is re- ceived in the form of regular rent and leasing income (minus the non-allocable operating costs). This should remain the focus, even though there might also be occasional proceeds
from the sale of individual properties. The UDF itself should not grant any additional loans to individual project companies pursuant to state aid laws. These can and should be granted by private commercial banks at market rates. A potential area of application for this type of UDF are real estate projects similar to those for Model III, though here the influence on the project development to the benefit of public interests does not come from the upstream land devel- opment, but rather from the prospective, long-term property holding. Furthermore, the UDF could invest in the broadening of the uses of existing public real estate (e.g. schools) or in in- terim acquisitions of existing real estates.
Similar to Model III, it is also possible to set up an asymmetrical distribution of profit and loss which grants the private fund investors a higher and thus for them sufficient return on equity. Similar to the “sustainability funds”, which have been known in the private sector for a long while, here the public fund partners could in turn waive a part of their return in favour of rea- lising public interests. In this model it would also be possible to integrate additional, private equity from private sustainability funds under similar conditions. This would significantly in- crease the equity base. The public funders could also, according to Figure 45, considerably increase their influence on the projects in this model if they limit themselves to investing in urban projects newly developed by the private sector. The reason is that, in this case, private developers can also better consider potential public interests in the project development, as they can anticipate higher sales proceeds (with no change in rental income) from the begin- ning due to the lower return on investment for the UDF.
In both cases, a partnership agreement for the development or investment company appears to be necessary. This has to ensure a different return on equity (profit distribution) and, if ap- plicable, different liability conditions (so called “first loss”) in the event of loss. Considerable private cash and real capital can be gained in this way. In both cases, therefore, the imple- mentation costs, especially for the public authorities, are much higher than for the two mo- dels without legal personality according to Chapter 5.2.2.1.
Model III is especially appropriate when a city already intends to develop a specific neighbourhood and/or individual Brownfield (or even owns it) and already has its own deve- lopment concept; in this case, this model is faster to implement, as it is “only” necessary to gain private capital (financial investors or property owners) through the attractive set-up of the UDF and project company contract. In contrast, Model IV appears easier to implement in larger cities, which have a sufficient market for commercial project development with the cor- responding developers and investors; the development risk in the funding activities can be shifted entirely to the private sector in this case.
5.2.2.3 Experience with the business models in the analysed case studies
The presentation of the case studies in Chapter 3 shows that the predominant use of projects with financing elements of the JESSICA initiative are found in business models of type III, whereby the UDF acts as land developer (together with the corresponding trading approach). In one case (France), the business model of a long-term property investor (Model IV) and a funding lender (housing funds in the new Member States, NMS) could be identified. So far, the business approach of a guarantor has not been implemented (neither in the development nor the utilisation stage) (see Figure 56).