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Business And Financial Risk Analysis

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The real estate industry is a sector where the companies generally have a capital structure which is high leveraged. The financing is therefore specifically of high importance for the companies in the sector. Traditionally, the way of obtaining financing is by borrowing from the bank. Lately, due to new bank regulations, the banks have become more restrictive in their lending which have led to a growth of other financing alternatives. For instance, the corporate bond market has grown rapidly. The development has increased the number who acts as lenders. Furthermore, the credit rating agencies plays indirectly an important role in the financing process since their credit ratings are a part in the process of determining the terms.

The terms (such as the interest rate) of the financing are mainly based on the credit risk of the company. Since the topic is of big importance and the financing for real estate companies is changing, the focus is to create further knowledge and understanding regarding the assessments of the credit risk by each factor. This analysis shows the credit risk assessment process by each factor where the banks and the credit rating agencies have the clearest framework. The banks and the agencies do a deep assessment which then is discussed in “committees” internally to reach the final assessment.

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The objective of this analysis is to define

What framework or methodology shall be used in assessing the Credit Risk of the Applicant Company in Austrian market which includes the detailed analysis of

  1. The process of Credit Risk Assessment through analysing the External/Market Data
  2. Standardized models used in the assessments
  3. Important factors that are the determinant of assessing the credit risk.

Today there are several credit rating agencies on the market where the three biggest ones are Standard & Poor’s, Moody’s Investor Service and Fitch Ratings. They assess companies’ capacity to meet their financial commitments. Standard and Poor’s conceptualizes a very structured model to evaluate the credit worthiness of any enterprise, which is into the business of real estate, in diving the determinants into 2 major categories which are weighted together to evaluate the final rating

  1. Business Risk Analysis
  2. Financial Risk Analysis

1. BUSINESS RISK ANALYSIS –

The 4 important factors contributing to the category of Business Risk Analysis have been depicted below. We shall be elaborating each of these factors in the context of the given case study –

Country Risk – apart from considering the credit risk of the country in which the applicant company is located other macroeconomic factors (economic, political and social environments) that affect the real estate company’s credit risk are also analysed. These factors can be summarized as –

a) The extent to which a volatile economy affects real estate prices

b) Leasing activities and rental rates

c) How tax rules affect real estate earnings

d) the legal aspects that influence property ownership and lease contracts

e) how government regulations are related to rental rates

f) the availability of financing

g) the difficulty level to obtain building permits

h) the amount of tax incentives to real estate development activities

i) the process related to development projects of real estates

Industry Risks – include the key industry factors which are compared to other industries like

a) Industry Dynamics & Competitive Environment – like industry cyclicality, ease of entry, competition, product quality, pricing inflexibility, business model instability, demographic trends etc.

b) Growth & Profitability – growth outlook, profit margin outlook, earnings volatility

c) Operating Considerations and Costs – technological risks, cost rigidity, operating leverage, research & developmental costs, energy costs sensitivity, labour costs, environmental impact, supplier concentration, risk management, financial market volatility, etc.

d) Capital & Financing Characteristics – Capital intensity, Borrowing requirement, Interest Rate Sensitivity.

e) Government, regulatory and Legal Environment – regulations, patents, government’s microeconomic & social policies, legal risk.

Company Competitive Position – includes analysis of the diversity & operating stability of the company, asset quality, the market position and strategy/execution management.

a) Diversity & Operating Stability – analysis about the asset type (retail, office, residential etc) and geographic concentrations within the property portfolio. Further the credit profile of key tenants is also considered along with lease terms, current market rents and occupancy rates as compared to market levels.

b) Asset Quality – it has been considered that an above average asset quality can generate better returns and stability in cash flows over the economic cycle. This assessment includes the location, property age and renovations, seasoning of property holdings, size of properties owned and their desirability to potential tenants and any other unique attributes such as excess developable land.

c) Market Position – considers the real estate company’s situation and relative market share in the real estate sector. This is important since a strong company can indicate a better situation in economic downturns under the assumption the larger actors are better to attract and retain tenants.

d) Operating Strategy Execution – regards the management, organizational structure and track records of executions of key strategic projects.

Profitability/Peer Comparison – The profitability is a key measure for credit protection since the returns on capital and margins affect the ability to withstand downturns in the economy. The two-key profitability ratio’s that is used by Standard & Poor’s is the EBITDA Margin and return on capital and is compared with companies within the sector and with companies in other industries. Other ratios that are analysed and set into a broader context are the return on assets and the NOI on property-level.

Inferring the Business Risk Analysis with respect to our Case Study –

Gerald Eve, one of the leading real estate consulting firms in the United Kingdom and an international alliance partner of Modesta Real Estate in Austria and Slovakia, has published the third edition of the European Property Market Brief. This annual report deals extensively with the commercial real estate market in major European cities and provides insights into current developments and prospects for the future. The developments in the commercial real estate market here in Austria and in Slovakia were examined in greater detail.

The demand for office space in Vienna has grown and the trend in prime yields fell only slightly to 4% in 2017. In Bratislava, in addition to a solid economic outlook, demand for new office space also remains high. “The report shows that neither Austria nor Slovakia can speak of a slump in the office real estate market. And the consistently positive forecasts for 2018 promote confidence, “says Andreas Polak-Evans, SIOR and managing partner at Modesta Real Estate. Investments in Austrian commercial real estate also remain strong and transaction volumes in the first half of 2017 were 80% higher than in the previous six months.

The findings of these studies reveal that the Applicant Company for this loan will be receiving the expected demand within the market and hence show us the stability in the growth prospects of this nature of business. Other factors that will influence the market analysis in Austria for evaluating the credit worthiness of the Applicant Company shall be:

  1. Basel III implementation – implemented in Austria by a directly applicable European regulation (the Capital Requirements Regulation) and the transposition of the Capital Requirements Directive IV into the Austrian Banking Act, both applicable since 1 January 2014. The aim of this extensive reform is to strengthen the EU banking sector by introducing higher capital requirements in terms of quality and quantity, new liquidity requirements, improving risk management and governance, and by strengthening banks transparency and disclosures.
  2. Austrian With-Holding Tax – Domestic income from the granting of capital (capital investment) is subject to a withholding tax of 25 per cent or 27.5 per cent under specific circumstances unless an exemption applies. In a typical loan or credit transaction involving a (domestic or foreign) corporate entity as a lender and an Austrian borrower or an Austrian branch of a foreign borrower, no such withholding tax applies. In a typical loan or credit transaction involving a (domestic or foreign) corporate entity as a lender and an Austrian borrower or an Austrian branch of a foreign borrower, there are also currently no limitations on the deduction of interest. Austria has no interest barrier rules. Interest paid to unrelated parties is, therefore, currently fully deductible by the borrower. Note that when the ‘BEPS’ Directive (Directive EU 2016/1164) will be implemented in Austria (in 2019), interest will likely be deductible only up to an amount of 30 per cent of the EBITDA.
  3. Loan Trading – In Austria, loan participations are regularly traded. Transfers of loan participations are most commonly achieved either by an assignment of rights or by a transfer of rights and obligations by way of assumption of contract, in which case the whole contractual position of the transferring lender would pass to the new lender. Any debt trading requires careful structuring because of regulatory requirements. In the context of debt trading provisions encompassing banking secrecy rules need to be considered. Since Austrian banking secrecy rules are rather strict, these need to have already been considered at the stage of granting the loan, so that trading is not hindered by banking secrecy obligations.
  4. Legal Opinion Practice – Legal opinions in (secured) lending transactions in Austria are usually provided by lenders’ as well as by obligors’ legal counsel. Pursuant to good market practice, legal advisers to the lenders are asked to render an enforceability opinion on the relevant financing documentation and legal advisers to the obligors are asked to render the capacity opinion with respect to the (Austrian) obligors involved.
  5. Austrian Capital maintenance Rules – A strict system of protection of capital of companies against undue distribution to its shareholders applies to Austrian corporations and partnerships whose general partners consists merely of corporations. The concept is based on the principle that the entire set of assets of a company should be protected on behalf of the company’s creditors. Generally, Austrian capital maintenance rules are applicable in relations between the company and its shareholders. However, a loan agreement or security agreement may be null and void and a recipient of security or a third-party lender may not be able to claim the full amount of its loan and be liable for repayment of monies received if it either knew or by gross negligence did not know that the transaction violates Austrian capital maintenance rules. While there is no general obligation on a lender to verify or investigate this matter, such an obligation exits in cases where there is a strong suspicion that a transaction violates capital maintenance rules.

While we do not see any new legal, regulatory or market developments in the near future that would have a strong impact on the Austrian law loan market, we believe that compliance with European and Austrian legislation providing for strict regulatory frameworks is an ongoing challenge for loan market participants and comes with material (and ongoing) costs assigned to the implementation of the various components imposed thereby. Furthermore, the still continuing restructuring needs of several debtors (in particular in emerging markets where Austrian credit institutions play a very active role) have sharpened lenders’ sensibility in general; this sensibility, however, not necessarily leading to the effect that Austrian lenders are more conservative in terms of providing new financings, but decisions whether or not a new financing is provided are carefully considered and well founded in response to the financial crisis. In general, Austrian lenders are very active and, by conducting significant lending business in Austria and the CEE region, are contributing to further stabilisation and growth in Eastern Europe.

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