Iain Morpeth, head of Ropes & Gray's international real estate investments & transactions practice, discusses forward funding as a source of construction financing.


Hi, my name is Iain Morpeth. I'm a partner in the real estate practice based in Ropes & Gray's London office. In this video, I'm going to talk about forward funding of development projects.

When construction finance is difficult to get from lenders, forward funding always seems to be re-discovered as a source of construction financing.

Conventional forward funding arrangements
You will be familiar with a conventional forward funding arrangement. Here a developer, who owns a development site, enters into a bilateral agreement with an investor under which it transfers title to the property and agrees to procure the construction and letting of the project. The investor will reimburse all of the development cost and pay a profit share when the project has been practically completed and let. Today these deals are done indirectly via a capital partner/operating partner joint venture. The essential elements of a conventional forward funding are replicated however in a shareholders' agreement, a subscription agreement and a management agreement, rather than in a single bilateral forward funding contract.

Development procurement arrangements
The development procurement arrangements will be found in a development management agreement between the joint venture vehicle and the sponsor. A management fee is typically payable during the development phase, unlike a conventional forward funding agreement. The level of the developer's construction procurement obligations will depend on the relevant bargaining strengths, but will range from a true management only obligation to a full development procurement obligation more typical of a forward funding agreement.

Investor's commitment to fund
Another key element is the investor's commitment to fund. Instead of this being a contractual obligation in a bilateral forward funding agreement, this will be found in a subscription agreement with the joint venture entity. The commitments, however, will look very similar with draw-downs monthly in arrears against architects certificates, monitoring surveyor's sign off, cost to complete certificates and commitment caps.

Profit payment to the developer
The third essential element in a forward funding agreement is the profit payment to the developer. In a conventional forward funding arrangement, the developer's profit will be calculated by taking the capital value of the completed project using the actual rents achieved multiplied by the agreed cap rate and then deducting the development costs plus a funding cost. The variables are the rents achieved, so these are often capped to avoid over-renting, the cap rate, which can be one rate or multiple rates applied to different slices of rent, the development cost, where savings will benefit the developer so limitations are imposed on changes to the specification, and the interest rate, which is usually somewhere between an interest return and the agreed cap rate. In a joint venture, however, this profit payment is dealt with differently. Instead, it will take the form of a promote or a carry, payable on exit after the capital has achieved an agreed hurdle IRR. If the investor intends to hold long term, the sponsor will want a right to monetise its promote at some point in the future off a valuation.

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