Property development intercompany finances Interest bearing term loan
Senior interest-bearing bank term debt
Parent C operates in the UK real estate sector and purchases land for development into residential units for public sale. Each potential development proposal is supported by a detailed business case which includes a due diligence report in respect of the expected Gross Development Costs (GDC) as well as an independent third party valuation of the Gross Development Value (GDV) of the completed site both of which are undertaken in order to secure bank financing. Management assesses each proposal in accordance with a number of key investment criteria, including for example, the minimum yield required on each development.
Once the proposal has been approved by Management, a new subsidiary is set up for the purpose of undertaking the development and appropriate financing is arranged. Similar to the Investment Property Group, the subsidiaries are generally financed almost entirely through debt. Typically, new subsidiaries are funded as follows:
- Parent C provides an unsecured loan to finance the purchase of vacant land; and
- A third party bank provides a senior secured loan commitment used to finance the development spend based on a maximum loan to GDV ratio1.
The loan commitment provided covers the expected GDC plus a small contingency amount and is drawn down over the course of the development period based on construction certifications obtained for costs of work completed. Typically, different elements of the development are subcontracted at an agreed price prior to the development commencing which reduces the risk of the contingency being required. Property development intercompany finances
Sales of completed units are generally made prior to or during the development phase rather than after the development is completed. Typically, the bank debt must be repaid as and when units are sold/proceeds are received during the development but there is also a backstop or maturity date at which point any remaining unsold units would either need to be sold by the subsidiary in order to repay the bank debt or seized by the bank. Property development intercompany finances
Owing to the nature of the investment, there is no immediate source of income until the property development is completed and units are sold. This means that any interest due on either the loan from Parent C or the external provider will be rolled up and paid as and when the principal is repaid. Property development intercompany finances
In the example below, a new property development project has been approved by Management. Subsidiary D has been set up for this new project and will be funded by a combination of bank debt and a loan from Parent C. The example illustrates how IFRS 9 should be applied to the loan from Parent C. Assume that Parent C holds the loan in a hold to collect business model.
NEW SUBSIDIARY/PROPERTY DEVELOPMENT
At the end of 2017, Parent C sets up a new subsidiary (Subsidiary D) for the purposes of purchasing a vacant plot of land and developing four residential units for sale over a 2 year period. The cost of the land is £200k and the maximum GDC is £840k (i.e. expected GDC of £800k plus a 5% contingency amount of £40k). The four individual units are expected to be sold for £350k (after selling costs) each which results in a total expected GDV of £1.4m.
|Land cost Property development intercompany finances|
|Gross development cost (GDC) – Excluding contingency|
|Total development cost Property development intercompany finances|
|Unit value (350,000 x 4)|
|Gross development value (GDV) Property development intercompany finances|
On 1 January 2018, Subsidiary D enters into the following funding arrangements:
- £200k unsecured loan from Parent C at a market rate of interest of 10%. Both the principal and interest amount is repayable in 2 years following the sale of all completed units and repayment of bank debt. The funds are used to acquire land worth £200k; and
- £840k senior secured loan commitment from Bank X. Once drawn, the loan attracts a market rate of interest of 5%.
Similar to the loan from Parent C both the principal and interest amount is repayable in two years following the sale of all completed units. The funds are used to finance the development of the land into 4 houses which is expected to cost £800k.
Assume the following2:
- No other fees are charged in respect of the bank loan and the EIR is 5%;
- £800k is drawn down on the bank loan on Day 1 and not repaid until the maturity date of December 2019 resulting in an interest charge of 5% on £800k for 2 years.
|Parent C loan|
10% for 2 years
|Bank loan facility Property development intercompany finances|
5% for 2 years
Based on the above and taking into account the total GDV of £1.4m, the following loan to GDV ratio and expected profit amounts (pre and post interest) can be calculated as follows:
Total loan to GDV ratio Senior interest-bearing bank term debt
(£1m / £1.4m)
(£1.12m / £1.4m)
Expected Profit Senior interest-bearing bank term debt
(£1.4m -/- £1m)
(£1.4m -/- £1.12m)
In this example, as the loan from Parent A bears a market rate of interest, the fair value at initial recognition is equal to the transaction price of £200k.
As the loan is in a ‘hold to collect’ business model, the key classification question is whether the loan meets the Solely Payments of Principal and Interest (SPPI) test.
In considering whether the loan is likely to meet the SPPI test, Parent C must take into consideration the fact that the loan is implicitly non-recourse in nature because Subsidiary D only holds only one single property development project. This means that Parent C must look-through to the cash flows expected to be generated from this project and determine whether the non-recourse nature of the loan restricts the contractual cash flows on the loan in a manner that is inconsistent with the SPPI test. Parent C notes the following:
- The contractual terms of the loan specify a fixed repayment of £200k which is equal to the principal (being the fair value at initial recognition) and interest of £42k (being 10% interest compounded for 2 years). The contractual cash flows of the loan are not linked to changes in the property value;
- While the loan advanced by Parent C provided financing for 100% of the cost of the land, the total loan (i.e. Parent C loan plus bank loan) to GDV (post interest) is 80% which suggests that there are more than sufficient cash flows expected to be generated to repay the amounts of principal and interest outstanding on both loans, with a residual equity margin;
- The investment is made in accordance with Management’s investment policies which specify a number of key criteria including for example, minimum yield and loan to GDV accepted. When Parent C provides funding to Subsidiary D, its aim is not to take construction risk but to provide financing for the development which will in turn generate profits on sales of developed units for the group. Senior interest-bearing bank term debt
Based on the above, Parent C concludes that the loan to Subsidiary D is a basic lending arrangement that meets the SPPI test and would be classified at amortised cost because it is in a hold to collect business model.
As the loan is classified at amortised cost, it is within the scope of the ECL model and subject to the general approach. Parent A, therefore, needs to determine whether the loan is in Stage 1, Stage 2 or Stage 3 and measure 12 month ECL or Lifetime ECL accordingly. Parent C should follow a similar approach to that set out in ‘Interest-free term loan – No bank debt’ which illustrated a term loan being advanced to an investment property company (taking into account that the loan advanced by Parent C is interest-bearing). It should also take into account the additional considerations that are required as a result of the interest-bearing senior bank debt set out in ‘Interest-free demand or term loan’.
In addition, the nature of Subsidiary D’s business as a property developer (rather than an investment property company) means that different factors are likely to be relevant to the analysis. Some possible examples are noted below. Senior interest-bearing bank term debt
(i) Staging Assessment
When determining which stage the loan is in, Management will need to develop appropriate accounting policies including how default is defined and what constitutes a SICR. In this regard, Management may consider:
- Different indicators of default e.g. the loan to GDV ratio falling below a minimum threshold, costs in excess of a maximum threshold, the loss of a potential purchaser, events of default under the bank loan; Senior interest-bearing bank term debt
- Different indicators of SICR e.g. increases in actual and expected development costs (i.e. GDC) or decreases in sales values (i.e. GDV) since initial recognition, actual or expected covenant breaches under the bank loan. Senior interest-bearing bank term debt
(ii) Estimating the risk of a default occurring
When estimating the risk of a default occurring, Management should consider forward-looking information about various factors that could affect the risk of a default occurring. For example, cost inflation (in cases where costs are not agreed with subcontractors upfront), expected sales values and market sentiment.
As noted previously, even if the most likely scenario is that no default will arise, the possibility of default must be considered. In this example, this could include a scenario where the expected GDV reduces and/or cost inflation increases to a level which would not only eliminate profits but also result in the subsidiary being unable to repay the loan.
(iii) ECL Measurement
Once the risk of a default occurring has been estimated, Management must estimate possible credit losses that could arise. Similar to the previous examples, it should consider different possible recovery strategies, for example: Senior interest-bearing bank term debt
- Allowing more time for Subsidiary D to execute sales resulting in late payment; Senior interest-bearing bank term debt
- Being forced to sell the underlying units at a discount in cases where the bank is unwilling to wait;
- Selling the development prior to completion.
See also: The IFRS Foundation