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Property finance: Meczanine credits close capital gap

As a result, there have been groundbreaking real estate finance technologies similar to those used throughout Asia and many parts of the globe for real estate acquisition and development. There are, however, rules and official permits that only apply in the People's Republic of China and that make it difficult to obtain and finance capital, structure project finance and repatriate currencies.

Those determinants present a challenge to PRC's real estate sector banks, especially overseas investment firms and real estate development firms. Although some believe that the PRC does not have the necessary regulatory regime for the securitisation of mortgages or assets, certain types of hybrid instruments may be used within the current regulatory system, provided that they are carefully designed to meet PRC law.

Meszanine financings and their alter egos, the favored assets, are two possible solutions for some of the regulatory obstacles. However, locals and overseas investors have used a mix of their own funds and Chinese or overseas banks' customary mortgages to raise funds for real estate projects in China. Traditionally, a Chinese bank's real estate finance scheme is a loan that encumbers the right to use real estate for the first time.

Real estate developer finance typically provided by a non-resident banking institution consists of directly granting credit to a non-resident investor established by its non-resident borrowers in the PRC and accepting all of the borrower's interest in the loan as collateral for the loan, which includes a first mortgages burdening the right to use real estate, in conjunction with a business bond issued by the borrowers, their parents or their principal.

Due to capital loss caused by the 1997 Asia economic slowdown, many regional bankers and other financiers have reduced their involvement in the real estate market. Quantifying the size of their non-performing loan portfolio is hard, but to ensure the profitability of the Asia bankers' business, most government laws have been enacted to make it easier to sell non-performing credit.

Consequently, governments and their own lending policies have prevented many MFIs from making large investments in real estate. Therefore, many regional development firms were compelled to find innovative finance solutions for real estate firms. Unlike traditional funding through insurers, bankers and Pensionskassen, the equity market is more complex and narrower - and requires significantly lower loan-to-value ratios. However, the risk of a decline in the value of the underlying assets is also higher.

In order to make the real estate transaction capitals market sustainable, banking institutions had to surmount these barriers in order to make their product more competitively positioned vis-à-vis conventional finance. In order to obtain the consent of the loan divisions or favorable assessments of the ECAIs, a priority loan could not be heavily indebted and rarely surpassed a loan-to-value of 70%.

For the underwriters, this was reasonable, but not a viable option to the real estate development company. Accordingly, with the introduction of Meczanine finance, the gap in capital between the collateralised mortgages of older lenders, which could be either securitised or arranged for syndication, was closed. As a result, the overall loan-to-value ratio approached the level anticipated by property development companies.

In one way or another, the use of Meczanine finance and preferential equities has become an integrated part of many transactions that are either securitised or globally-synched. As the PRC's current regulatory system does not allow securitisation, several mutual fund and finance institution companies combine conventional mortgages with a proprietary structured loan to enable the real estate development company to reach the loan-to-value ratio that makes many of these real estate companies commercially profitable.

As there is usually a first mortage on the land, the collateral for the loan is a pledging of shares in all companies that directly or indirectly own and manage the land. Frequently, the Meczanine has stricter standards than a Mortgage Senior because it is in a much more risky location.

Due to the high loan-to-value relationship that the creditor has achieved with respect to the loan to value relationship, the typically experienced Meczanine creditor sees itself as a crossing of borrowed funds and own funds. In return for taking over the more risky item, the creditor will receive a higher interest rate on his loan. As many real estate developer have a very limited endowment base, a heavily geared gearing may be the only way to build a development in many Asia Pacific markets.

The use of a priority mortgages loan and a meszanine loan allows the debtor to obtain a balanced and mixed interest rating that makes the operation profitable for the builder. Given that the syndicated loan is usually greater than the term loan, the result is a weight based mean which further reduces the borrower's overall interest over time.

Branching credit and diversifying the credit exposure provides an option for corporate creditors or mutual fund managers to reinvest in the more risky part of the equity infrastructure. Banking, syndicated or securitisation vehicles retain the priority part. The split of the loan into a low debt, priority collateralised unit and a high debt level Meczanine tranche allows the banks to subscribe the whole transaction.

In this way, the more stringent lending standards of the banks and the needs of the real estate developers are met. In the USA, the US subprime loan business is well established with good results financially and, with the safeguards provided by the subprime banks, many of the risk associated with pledging shares or participations instead of a second directly backed by the real estate has been minimised.

But only a non-resident creditor or the establishment of a non-resident banking establishment in the PRC can offer a real estate development company in China the possibility of providing finance through Meczanine. Chinese enterprises other than banking may not grant credit to subsidiaries, affiliates or independent third parties. Also, there is no difference between a home loan and a loan from a local government institution.

Major state-owned institutions such as the Bank of China, China Construction Bank and Industrial and Commercial Bank categorise all credit to real estate development companies as Real Estate Development Loans granted (Fang Di Chan Kai Fa Dai Kuan), whether the credit is backed by a mortgages on real estate, a pledging of capital or stock, or a third partiesecurity.

According to PRC legislation, no local PRC institution may grant a real estate development loan to a builder if the loan-to-value ratios exceed 70%. Therefore, local bankers cannot offer Chinese development agents financial assistance in the form of either local financed enterprises or overseas invested corporations. Non-resident off-shore financial institutions may only grant mid-cap finance to non-resident Chinese mutual funds.

The State Development and Reform Commission must grant a domestic financed enterprise a leverage rate before it can raise external funds. Due to this currency controls, the entrance of domestic financed enterprises to external finance is almost not possible. Offshore branch offices of overseas financial institutions in China are not required to have a loan-to-value of 70%.

This enables them to supply both domestic and non-domestic investors with financings of local currency. Irrespective of whether the real estate loan is to be securitised or syndicated, the general architecture is designed to create a layer of borrower that is at least one layer higher than the one that actually owns the right to use the real estate and one or two layers lower than the principles that eventually own and govern the overall owner mix.

One of the most commonly used forms of loan business outside the PRC is a Kommanditgesellschaft or Private Joint-Stock Corporation, which holds the real estate and enhancements, 99% of which is owned by a Kommanditgesellschaft or Private Joint-Stock Corporation, which is actually the debtor of the debt instrument. Originally, the CRAs did not want the controlling side to be affected by the exercise of their legal recourse by the Meczanine creditor, but in recent years the CRAs have generally agreed that a pledging in one stage of the process can be agreed by the companies owning the general or executive member.

Redirect pledging of the general partner's or executive partner's interest in connection with pledging of the Kommanditistin's interest allows the Meczanine Creditor to directly and directly obtain a 100% pledging of the shares in the company holding the real estate. Prior to any appeal by the Meczanine Creditor, the Creditor must contact the agency that initially evaluated the deal and go through an authorisation procedure to realise the promises and take direct influence over the Meczanine Creditor and ultimately over the Owner Company.

Credit ratings institutions usually ask the creditor to maintain the current owner status and have a substantial non-consolidation report provided by his lawyer showing that the structural integrity remains sound and that there is no enhanced insolvency exposure from the creditor taking direct control of the owner status.

A number of financiers offering leveraged financings are trying to get pre-approved by the credit ratings institutions so that they can immediately pursue their appeal. It is easy to modify the described structures to fund a PRC investment if the right to use the site is transferred to a 100% non-Chinese company (Wofe). Its most common type consists of two specialised off-shore vessels.

Stage one is the 100% ownership of the wolves, which is 100% held by another off-shore unit. Borrowers of mezzanines are first stage off-shore units. Stage Two is a guarantee for the commitments of the first stage off-shore unit. The second stage participation in the first stage company is pledged to the brewer.

The majority of creditors like the Meczanine loan, which is directly given to the first stage off-shore unit, so that it is nearer to the unit that holds the right to use the plot. There is a fee paid by the first stage company on its participation in the wolves, and this fee is recorded in the PRC to give the creditor some convenience that its pledge is in the official record.

Due to the complex rules on the share capital and the shareholders' loan with regard to the capitalisation of a wolf, the creditor also receives a pledging of the first stage shareholders' loan to the wolf as extra security. This is because, under Chinese legislation, the share-capital and the shareholder loan of a non-resident investor, such as a wolf, are fixed by statute in a certain proportion.

Given that repayments of equity, interest and net profit are the only dividends permitted under PRC legislation without specific state authorisation until the wolves are liquidated, most shareholders have invested as little share-capital as legally possible and the bulk of their investments are made as shareholders' credits. Pledge of interest and credit to the creditor is permitted under Chinese legislation.

However, the loan may also be restructured outside the PRC and the law of that country governs the perfect participation in the shares or interests. However, the other kind of structuring is more complex and necessitates specific adjustments to the JV contract to allow the loan to be repaid.

If there is a Chinese unit JV with a Chinese unit JV, the only way to make the credit business of Meczanine credit work from the lender's point of view is a CJV. Due to the exchange rate constraints placed on a Chinese unit and the restricted assignment of exchange rate quota for non-government related investments, the whole loan has to be granted to the Chinese unit, which becomes the main debtor of the loan.

Accordingly, the PRC company will not benefit from any dividends until the loan is fully reimbursed to the subsidiary abroad. This is likely to have a negative effect on the value of the investments acquired by the creditor. Every creditor should, when arranging a transaction in the PRC, request that the pre-emption right of the PRC non-controlling interest be cancelled if the creditor appeals.

The Chinese have undertaken to progressively give overseas banks' branch offices the opportunity to do reinminbi operations. This means that Chinese real estate development companies are in a technical position to obtain Meczanine credits from overseas financial institutions. Due to concern about the possible real estate market meltdown in China, however, bankers have warned against lending.

A number of benefits exist for banks that fund part of a real estate business in the PRC through a meszanine loan facility. Restructuring the loan abroad allows the bank to take full benefit of the jurisdictional legislation with entrenched debtor-creditor legislation and proven execution practices, although WTO entry and the wish of the PRC authorities to raise FDI has enhanced the law's overall quality over the past 10 years.

The choice of a venue such as Hong Kong and the structure of the off-shore deal brings a degree of security that does not exists within the PRC. A further advantage for the creditor is that if the Meczanine creditor is exercising its legal rights and taking a controlling interest in the shares or interests in an off-shore operation, there are no fees for the disposal of those shares.

Lock-box agreements are also made so that, once the servicing of debts of senior creditors and the reserve for default ownership fees have been established on a quarterly base, all funds are transferred through a tripartite arrangement to an offshore bank managed by the provider of credit and paid out via a cascade to the contractual beneficiaries of the distribute.

A lot of creditors, also in the PRC, would rather have a second security right over a mortage directly guaranteed by the real estate in concerned. Due to the limitations on high loan-to-value and insolvency risk associated with an additional pledge burdening the same security pool, however, in many parts of the globe origination of Meczanine credit has become more popular.

Although it is still customary in the PRC to place second mortgaged properties on real estate titles, the above explains why many overseas banks want to restructure their lending as off-shore investment. A problem that none of the three above minded entities will be able to prevent is the need to obtain the approval of the prior ranking mortgagor in order to introduce a direct or indirect pledge on the real estate.

Although approval is not required for technical reasons to grant a loan of one of the participating units, most creditors wish to have an inter-borrower arrangement that allows them to take on the borrowers' roles without having to make any payments, or without having to trigger a maturity or charge condition in the priority loan documentation.

A number of Chinese banks have never contemplated a Meczanine credit facility, so their credit documentation does not need approval to prevent a failure of the prior loan. The majority of Meczanine creditors wish to obtain the advantages of the priority mortgages and, in the framework of a building loan, would like the lead creditor to maintain the financing of the building cost, regardless of the appeal exercised by the Meczanine creditor and the transmission of direct property from the initial borrower to the Meczanine creditor or affiliated company.

Part of most miszanine credits is the inter-creditor agreement between the Senior Mortgagor and the Miszanine Mortgagor or the Miszanine Mortgagors (if more than one stage of miszanine financing) prior to the closure of the Miszanine Credit. In order to mitigate the risks of insolvency at all stages, the credit ratings companies and creditors also demand that, in the case of a securitised and a syndicated business, all the normal procedures of a distance insolvency operation be complied with in the case of a credit arrangement with a brewer.

Conventional convenants are necessary in the charters of the prior ranking mortgagor and meszanine obligor, and a substantial non-consolidation report is usually also necessary under the terms of the financial statements. It can be tricky to prepare the report if there is a disappearing guarantee from a holding entity that not only exempts the creditor from the non-recourse clauses of the credit documentation for conventional hive-offs.

Furthermore, the loan is usually granted with reference to the debtor. As an additional safeguard against insolvency filings, the parental entity converts the nonrecourse loan facility from a nonrecourse loan to a fullcourse loan to the parental entity if the affiliated entity or a member of the owner hierarchy demands forced insolvency of the seniors or the borrowers.

In the People's Republic of China, however, financial leverage and preferential capital resources seem to be gaining in importance. Although there are additional transaction charges associated with a number of exposures and two or three different counterparties to negotiating the conclusion of a priority mortgages loan and a meszanine loan, the domestic markets will begin to apply the same cost-saving technologies that are becoming more and more common in other parts of the area.

Whilst the meszanine subprime markets have evolved, many of the leading mortgages have begun to offer their borrower both the older mortgages and the meszanine loan component. Often the older mortgages banks had a subsidiary in the Meczanine lending industry, or they had a relation with one of the major Meczanine credit institutions to buy the Meczanine package, either on completion or later.

In the course of the development of the Asian residential mortgage markets, local providers will pursue similar initiatives to make their product more competitively. Within the PRC, the only two sustainable financial structuring instruments that may be available as a further option for financing real estate projects may be leveraged by existing credit facilities and preferential participations, until such time as changes in regulations allow for a genuine mortgage or asset-backed securitisation.

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