Real-estate Project Financing and Its Impact on the Financial Sector

Financial woes caused by global recession and worries about housing bubble were the reasons for slump in sales of new homes and buildings built by a number of construction companies in Korea. In these kinds of circumstances, many of them had difficulties in acquiring money needed to construct apartment complexes and infrastructure. On top of that, Korea’s construction industry had to face more challenges after financial markets around the world were rocked by  Dubai’s debt moratorium declaration in November, 2009.

One of the ways to supply money to construction companies is construction loans, called “real-estate Project Financing” (PF). Banks and other financial institutions have been more reluctant to provide loans for construction project than ever before, regardless of the size of the companies since Dubai crisis in particular, on fear that several struggling companies will not be able to pay off the debt. Recently, construction industry is heavily relying on the PF loans to finance the building of the project. As of February, 2010, there were 40 sites across the country where the construction projects had been suspended due to financial distress.

What is Project Financing?

Project Financing (PF) refers to a way of securing funds for real-estate projects such as apartment complexes, shopping mall and infrastructure, in which the debt is paid back later from the profits produced by the project itself. PF was first introduced in Korea by the government back in 2001 in order to boost domestic demand by stimulating investments specifically in large-scale construction projects.Financial institutions provide loans for construction firms after they estimate the future profitability and the cash flow from the project.

Correlation between Construction and Financial Industries

When a construction project goes smoothly without any problem, this financing scheme brings huge profits for financial institutions and builders. And in most cases, when the developer seeks project financing, financial institutions usually demand the builder of the project guarantee payment. But in the midst of recent financial distress, many construction projects led by highly leveraged and small- and medium-sized builders with low credit ratings are turned down in search of PF from financial institutions. As a result, some of those developers encounter financial trouble and hand over the rights to better funded or larger ones to give up on the execution of the project.

Financial institutions, these days, are not willing to give out loans easily for real-estate project because a number of builders are struggling financially with a slump in sales. If they don’t pay back loans on time, the soundness of the financial institutions could severely be threatened by the insolvency of PF loans as well.

Potential Risks in relations with PF

According to FSC data released in February, all of the country’s financial institutions have a total of KRW 82 trillion  in outstanding PF loans as of December, 2009. From 2008 June to 2009 June, the country’s financial sector steadily saw the amount of PF loans rise with outstanding debt breaching 80 trillion won level. It still remains as a great risk to the financial institutions, although the total amount went down slightly at the end of last year.

And what the government is looking at closely is the default ratio of the PF loans of  some financial institutions. Average default ratio of PF in financial circles reached 6.37 percent with non-bank lenders such as securities and savings banks recording the highest default rates among those financial institutions. PF loans accounted for over 40 percent of the entire loans from savings banks currently, and if its default ratio continues to rise, those savings banks could be in trouble.

In addition, since Korea’s financial regulator started controlling the amount of PF loans, PF Asset-Backed Commercial Paper (ABCP) has been on the surge due largely to some builders. The issuance of PF ABCP has been being increased to pay back PF loans. Another important sign of possible problems is the fact that PF loans reaching maturity this year accounted for over a half of the total amount of the debt.

This means that if financial institutions don’t extend the maturity to pressure builders to pay back loans on time, both developers and builders could have hardships paying off the debt. All this does pose a great risk not only to the construction industry but also to the financial sector unless those construction firms secure financial resources in advance. So the government is watching carefully of the rising numbers regarding PF and has decided to rein in those problems.

Government’s Efforts to Reduce Risks in PF

From 2008 to 2009, the FSC came up with policies to address the concerns about rising PF loans and to prevent the effects of defaults from further spreading to the financial sector.

1) High-risk PF loans were purchased by KAMCO (Korea Asset Management Corporation). Through this process, Non-Performing Loans (NPL) worth about KRW 2.9 trillion were purchased from the entire financial institutions in the country for a year.

2) Government supported additional funds for construction industry in exchange for “PF Loan Workout Agreement”, which was led by creditors (financial institutions). With this program put into effect, some operations of the suspended construction project led by PF were normalized so that the builders were also able to recover some amount of revenue out of the projects. As a result, this played a key role in reducing the default rates of PF and the amount of distressed assets at the financial institutions.

3) Government also ordered savings banks, which were considered risky due to its high default rates, to enhance the loan-loss reserves to guard against possible financial troubles caused by PF loans. The FSS also conducted surveys on the PF construction projects across the country in order to look into the details of the current state of PF loans extended by financial institutions. It promised to continue monitoring the situation closely to control the amount of PF loans and secure the soundness of the financial sector.

To keep a lid on the situation, following measures are being placed.

1) Government will put stricter limits on the PF loans extended by savings banks than before and put restrains on the excessive loans through subsidiaries so as to strengthen the soundness in the coming days. According to the current rules, outstanding PF loans cannot exceed a 30 percent cap of the entire loans provided by the savings banks. The FSC will also examine the future profitability of the construction project led by PF loans and the ability of the savings banks to cover the loss through provisioning.

2) The financial regulator will raise loan loss provisioning for all financial companies.

3) Builders will have to submit regular reports on PF ABCP to the regulator more frequently than now under stringent regulations. They will also go through much more thorough examinations when getting PF loans to conduct projects overseas.

Necessary Steps by Participants

Aside from the government’s regulatory measures for PF loans, more efforts should be made by the construction industry to improve the financial conditions in the market. While taking market situation  into consideration, the construction industry has to find solutions that will help pick up home sales and it has to be willing to go through restructuring process to clear up the troubled companies and assets. As for PF loans, concerned parties will ultimately make the current system better in the near future so that the risks  with PF loans could be dispersed and reduced.

Especially, those different financial institutions have to try to secure liquidity for unfortunate urgency such as bankruptcy of the companies or insolvency of the PF loans. In the coming weeks and months, under the regulations they will also provide PF loans in a more careful and manageable manner than in the past. When those participants find consensus and try their best to cooperate to solve the problems in uncertainty, the impact of PF loans would also be minimized within the financial sector.

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2 Responses to Real-estate Project Financing and Its Impact on the Financial Sector

  1. Nice blog. Maybe you should try to monetize it with

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  2. At the moment PF loan rates are really low, hopefully will remain so for a long time, although when global economies pick up there will be inflationary pressures in the markets which will push up rates.

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