1. The rise of the forward fund

The BTR/PRS sector in Ireland has historically been transacted on the basis of forward sale agreements. In 2021, however, the recent forward fund transaction at Royal Canal and other recent portfolio launches indicate a move towards the "forward fund" structure in the BTR/PRS sector. While the Irish market is no stranger to forward funding, this structure has been largely utilised in the office and hotel sectors where developers can offer the benefit of an agreement for lease with a strong tenant covenant to the investor.

This move to forward funding is coming at a time when the attractiveness of the BTR/PRS sector is being undermined by legislative and policy uncertainty. On the one hand, investor groups are enticed to the Irish market by consistent yield, robust rent collection evidence during the pandemic, a stable rental market and increased demand for housing (fuelled in part by the opening of large offices by multinational companies such as Salesforce, Facebook, TikTok, and LinkedIn, and also by the general housing shortage). On the other hand, this interest has been counteracted to an extent by recent legislative and policy changes, including the difficulty in securing timely planning permission for sites. These difficulties have given developers holding sites with permissions in place a particular advantage when negotiating with investors and are one of the reasons the forward fund structure has made its way onto term sheets over the last 12 months. However, forward funding offers advantages to both developer and investor alike.

2. The advantages of forward funding

Finance risk

The main advantages of the forward funding structure from a developer's perspective are that it offers significant cash flow from the early site sale, certainty of development finance for the project and a more balanced approach to risk than the forward sale where the majority of construction risk sits with the developer. As the investor purchases the site at the outset and thereafter funds, in real time, the construction works under a development funding agreement, the development risk is shared between developer and investor.

In this era of relatively low cost of capital, investors are likely to be less concerned with the risk associated with ongoing funding requirements during the construction process. In addition, where an income fund investor is involved, the developer will likely be required to pay a percentage coupon on the advancement of construction costs which, unlike a forward sale, will enable the investor to generate a return during the construction phase.

Returns

For the investor, forward funding will likely generate enhanced returns on the investment as it will acquire the development at a higher initial yield than would be possible in a forward sale. It will also be able to negotiate with more flexibility in making alterations to the scheme to suit the investor's specific requirements.

Stamp duty

A further financial benefit to an investor in a forward fund transaction is the potential to confine the stamp duty to that payable on the site value (and the value of any work completed up to the date of taking title ownership). In a forward sale, stamp duty will be payable on the full price for the site and completed works and any increase in stamp duty rates which may arise between contract signing and completion.

While many investors are attracted by the potential stamp duty savings of a forward fund transaction, specific tax advice should be sought in relation to each individual transaction to ensure full compliance with revenue requirements.

Certainty of title

In paying for the land and taking title ownership up front under a forward funding, an investor reduces the risk of a third party asserting ownership contrary to that of the developer during the construction phase. Furthermore, in taking title, a forward fund investor can remove the role of the developer's lender by requiring any charge on the land to be removed as part of taking title. In a forward sale, the developer's lender will look to stay heavily involved in the process, either by appointing a professional team to oversee the process or putting in place various step-in agreements and/or a duty of care agreement. In a forward fund, it will be the investor's lender (if any) who will be heavily involved. This is advantageous to an investor as there is likely to be a strong common purpose between the investor and the investor's lender. This purpose is the securing of a fully developed and functioning site to allow for a long-term relationship. In contrast, the sole focus of the developer's lender will be the return of the funds it has advanced.

3. Getting the drafting right

The goal of both parties is that the development is completed on time, on budget and free from defects. A common refrain for parties who prefer a forward sale is that a forward sale keeps a developer (and its lender) more engaged than a forward fund due to the structuring of payments. However, a well-drafted forward fund agreement will ensure that the developer is fully incentivised to deliver a high-quality product on time and on budget.

Construction costs and profit

The investor will fund construction costs during the construction phase (typically on a monthly basis and subject to an overall maximum commitment cap) and standard drafting will provide for appropriate budgeting, vouching and oversight by the investor's advisers. The developer will not usually take a profit during this phase – its reward being factored into a "balancing payment" payable shortly after practical completion. Where the developer delays completion or overruns maximum caps, the balancing payment will be at risk of reduction. As collection of the balancing payment is the developer's main incentive, the calculation around any coupon offset, the maximum commitment caps, the balancing payment, an investor's ability to request work variations and delay event impacts are always carefully negotiated but will ultimately depend on the transaction. Moreover, the developer also needs to retain confidence in the investor's continued ability to fund construction. There are various options available to provide additional payment security to the developer, including guarantees and segregation of funds for construction.

Delay

While timing is critical on every project, the risk of delay may need to be managed differently – depending on the nature of the works. For student accommodation projects, completion in time to allow students to move in for the start of a university year will be crucial. For BTR/PRS, completion must tie in with the letting strategy which will be more complex, the more units are involved. Dealing with timing in a forward fund scenario may mean that liquidated damages become significant very quickly or increase exponentially after particular milestone dates. It is often difficult to pass on the full weight of these damages to the building contractor, which means the developer will often have to bear the risk of delay attacking its bottom line. The investor will need to be comfortable that the developer can bear this risk, particularly where the developer is an SPV and the necessity for a parent company guarantee will be part of this picture.

Aligning practical completion and acceptance

Practical completion (PC) under the building contract and acceptance/handover under the development funding agreement need to be very carefully aligned. It is in the interests of both parties that there are no gaps and each process can flow very easily and quickly from one to the other. For the developer, any gaps between the criteria for PC under the building contract and acceptance from the investor should only be accepted where the difference can be comfortably managed (i.e. an additional document required, which the contractor cannot provide but can be easily procured elsewhere). The developer certainly wants to avoid a situation where PC is achieved under the building contract but the investor has not accepted the completed development and the developer is left in the middle. Ultimately, for the investor, it wants use of the development that it owns and has paid for, so there is little comfort in being on the right side of the drafting where handover is delayed because the developer cannot procure an essential sign-off or there is confusion over what was precisely required. When drafting completion deliverables and criteria for acceptance, both parties need to be completely ad idem as to what is required and what will be accepted. This includes everything from the wording of the collateral warranties, opinions on compliance and BCAR registration to the manufacturer's guarantees, statutory consents, safety file contents etc.

What happens next?

Once construction has completed and the premises has been handed over, the developer will be looking to move on from its relationship with the investor, with as much profit and as little risk as possible. While it is market standard for the developer to stay in the picture to oversee the close-out of the defects liability period under the building contract (usually 12-18 months), thereafter the developer will argue that the investor must then rely on its suite of deliverables going forward and release the developer from ongoing liability. The investor will naturally be apprehensive. What if the building is suddenly plagued with defects and the building contractor becomes insolvent or ceases to trade or key members of the design team no longer have good PI insurance? Would it be more prudent to retain recourse to the developer? This will be a hotly negotiated area and will depend on the transaction, but it is certainly true that a robust PC/acceptance procedure together with delivery of an appropriate suite of warranties and other documentation will render the investor more comfortable in allowing the developer to sever ties at an appropriate juncture.

4. Conclusion

As the Irish BTR/PRS sector continues to develop, investors and developers alike will adjust the structures of transactions in a way which balances their respective desire for maximum return against the desire to have a collaborative approach through development. Where developers have little track record in delivering product, investors will likely continue with forward sale structures. However, as many developers in Ireland now have a good track record of delivering on time and to a high standard, they will now likely see the opportunity to move towards forward fund structures. This is helped by the pool of investors engaging in forward funding arrangements increasing as the market matures. European and US investors in particular have significant experience of the Irish market at this juncture and this, combined with their experience of forward funding in other jurisdictions, allows them to fully weigh up the benefits of a forward fund arrangement as set out above.