A CASE STUDY OF Free Essay Example

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CHAPTER TWO

LITERATURE REVIEW

2.0 Introduction

This chapter reviews literature on real estate financing. It is isolated into areas. The primary segment gives an introduction to the general idea of land, hypotheses, and exact surveys talking about its review and advancement procedure, request and supply, sources and advertising. The following test of the audit builds up the wellsprings of account accessible for land improvement. The fourth area talks about the land budgetary framework and money related cycle.

2.1 Concept of Real Estate

Real estate is defined as land and all the things permanently attached to it, such as trees, buildings and minerals beneath the surface, (World Book Encyclopedia, 2001).

It also refers to land including all the property on it that cannot be moved and any attached rights, (Encarta, 2007). Real estate is also property consisting of land or buildings, (usually residential) that are bought or sold, (Collins Gem dictionary). Real estate is a physical entity including the land and improvement affixed to the land while real property is a legal concept that gives the individual the right to use and control the real estate or physical entity, (Smith, Tschappat and Racster, 2001).

Real estate property is bound to land making it an immovable assert. Land is also a finite and valuable resource, which is affected by numerous legal, physical and environmental constraints and interests. (Smith, 2005)

2.1.1 Overview of Real Estate Development Processes and Risk

The planning and management of large, multiple- use real estate projects is an extremely difficult task. There are complex and uncertain financial, political, and social factors affecting real estate developments.

Major concerns lie in the long time horizon and large capital investment necessary to convert land into a merchantable product, (Miles and Wurtzebach 1977).

Besides technical engineering problems, the real estate developer must deal with the volatile demand for real property and with constantly changing costs over the planning and construction periods. Real estate projects could be developed in many kinds. A few general concepts are common to their developments though each kind has its own unique set of characteristics (Brueggeman and Fisher, 2005). The typical development process is applicable to developing countries including Ghana and common to most categories of project development, but not at their management phase as shown in figure 1. Basically, a developer; acquires a site, develops the site and constructs building improvement, provides the finish-out and makes ready the space for occupancy by tenants, manages the property after completion, and may eventually sell the property. Specific risks are associated to all these phases. Accordingly, risk starts with land acquisition and steadily grows as construction begins until expected cash flow from leasing phase is materialised. The World Bank estimates that registering formal ownership/lease over a piece of unencumbered land in Ghana is the third longest registration process in the world (World Bank, 2004). Risk diminishes at management phase since tenants are committed to lease. The type of business strategy adopted by a developer dictates the exit period or selling time for the project and the economic success. A developer creates value by combining land and building improvements in a manner that is highly valued in excess of its cost, (ibid; pp 433-434).

Furthermore, the business strategies of developers are broadly classified into three groups. Firstly, real estate developers who have leasing and management as integral part of their businesses in conjunction with the development role, have the minds of owning and managing the properties after completion. Secondly, some developers sell properties after completion, and hence, usually rely on outsourcing for other professionals. Thirdly, some developers also normally develop land and commercial properties such as parks and industrial parks for onward lease in a master-planned development. Many developers, in the nutshell, purposely specialise in one or many phases of property development, (ibid, 2008).

2.2 Theoretical Review

2.2.1 The Theory of Financial Leverage and Optimal Capital Structure

Financial leverage is the notion of using debt to fund an investment. Basically, projects are financed by the use of debt and equity including real estate projects. The best way to show financial leverage is by looking at the relationship between the return in general on the project and the return on equity. For instance, a certain real estate asset providing a 12.5 percent return. Meaning, the annual after tax cash flow is 12.5 percent of the cost of the asset where the asset is financed by all equity, the return to the equity investor is equal to the overall return on the asset, 12.5 percent. Where a debt can be taken at a favorable rate, that is less than 12.5 percent, it can be used to enhance the return on the equity. A portion of an asset that gives up 12.5 percent is financed by lower cost debt, the difference going through to the equity holder. This is to mean that, favorable financial leverage will result in an equity yield greater than 12.5 percent. Unfavorable financial leverage will occur if the cost of borrowing exceeds the return on the investment, resulting to a decline in the return on the equity, resulting in a financial risk. According to this theory, the investor’s equity position increases with leverage, hence the irrelevance of capital structure. (Clauretie & Sirmans, 2010).

2.2.2 The Theory of Financial Intermediation.

Allen and Santomero (1999) argue that, Capital market imperfections form the basis for understanding intermediaries; that is, exchange costs and deviated data. The primary explanation behind the presence of budgetary mediators is chance administration, liquidity and credit assessment. These monetary delegates incorporate business banks, shared investment funds bank, reserve funds and advance affiliations and disaster protection organizations. The money related mediators go about as a connection between providers of assets (the investors) and borrowers of home loan credits. They likewise help disseminate assets in a country by moving assets from those parts that have surplus to the territories that need to obtain (Coles and Boleat, 2012).

According to this theory, mortgage finance can only be obtained through financial intermediaries due to the risk involved in direct borrowing. This is because; the financial intermediaries can assess the viability of projects to be invested in as well as their location and advice investors accordingly. They also look at the credit position of the borrower before advancing the credit to minimize cases of default in payment. Therefore, financial intermediaries have established some strict measures for borrowers to ensure that depositors’ money is put into most useful projects that yield a reasonable return.

2.2.3 Portfolio Theory

This theory states that, “when assets are combined to form a portfolio, the expected return on the portfolio will be equal to an average of the expected returns on the individual assets, weighted by the relative amount of each asset included in the portfolio.” A portfolio of several assets has expected return and expected risk (as measured by the variance in returns). A portfolio helps in reduction of risk that is present in an individual asset, without a sacrifice in expected returns. There is a greater benefit in diversifying through portfolio construction of real estate assets. Properties of different types (hotels, warehouses, office building, and farmland) and/or different geographical regions are combined for maximum benefit. The greatest reduction in risk is through geographical diversification, where regions are defined in terms of their economy (Clauretie & Sirmans, 2010). However, this theory to a large extend favors large investors and not individuals, like life insurance companies and pension funds as a lot of capital outlay is required. Messah (2011) employed an illustrative overview planned for giving an image of the connection between the pay of the land proprietors, request of genuine homes, and the area of land properties, and the reach out of the real estate professionals commitment on the land costs. The consequences of the examination uncovered a relationship between’s land costs and pay of financial specialists. Despite what might be expected, there was no affiliation found between the area of the land and its cost. Be that as it may, cost was observed to be identified with interest of the genuine property.

2.2.4. Efficient Market Theory

This is the conception that an assets trades in a market where its value reflects all available information about that asset. As such, the asset is priced “efficiently” in the sense that no one individual is able to trade on the basis of information available to all other market participants and in the process make excess returns. The concept of an efficient market prevents an investor from taking advantage of information that is generally available to all investors to make abnormal returns. However, market imperfections, asymmetric information and the high fixed cost of small scale lending do exist leading to market failures which are a primary reason for poverty and financial market failures (Stiglitz, 2006).

Ebrahim (2009) in his research, sought to establish a framework to increase the affordability of formal housing. His motivation was based on ad-hoc practice of clans in Oman to fund the purchase of houses for their poor brethren by use of interest free loans. He commented that, a casual monetary framework concentrated on subsidizing homes through moderating antagonistic determination, moral risk, authoritative expenses and exchange expenses is probably going to advance improvement by giving access to budgetary administrations to numerous who are disregarded by the formal framework. This is in concurrence with Emmons and Mueller (1997), Buijs (1998), Hart and Moore (1998) and Smets (2000). Callier (2003) likewise certified that casual account frameworks wins for the reason that it settle central issues that are not taken care of in like manner by most monetary frameworks in creating nations.

2.2.5. Agency Theory

Otherwise called head specialist hypothesis includes the utilization of game hypothesis to the investigation of a specific class of social collaborations. For this situation, one individual (the operator) follows up for the benefit of another (the head) and is required to propel objectives of the head. In this sense, the specialist is qualified for consult for the benefit of a head or bring the head into an authoritative connection with an outsider. However, these relations results in to agency conflicts due to conflicting objectives of the individual parties. The theory of the firm explains how the conflicting objectives are brought to equilibrium in order to yield profit maximization. Nevertheless, agency theory has its shortcoming in that, the relationship maybe used as an excuse for unethical conduct, as agents seek to avoid responsibility claiming to be following orders or serving the client (Boatright, 2010). This therefore brings out a challenge in acquiring mortgage finance as it is likely to result in to higher transaction costs. It also poses the question of the effectiveness of mortgage brokers.

Mortgage is the most prevalent method of borrowing for the purchase of real estate. A research by Fang and Jie (2008) showed that the Chinese real estate market has made a significant progress since 2008, as a result of economic reforms that lead to home market liberalization. This has seen development of home loans advance which has turned into the essential financing instrument for Chinese residents. As per the People’s Bank of China, the equalization of home loan amplified by in excess of multiple times, from 126.0 billion yuan in 1999 to 29.83 trillion yuan in 2008. Be that as it may, the test featured was expanding house costs because of improvement of home loan administration, while the salary of the natives stayed consistent.

A Research Publication by Thomas (2009) suggests that the advancement of industrialization, trade and international trade supported by cheaper transportation in the 19th century led to the emergence of large urban populations in Europe and North America. It highlights the case of the USA which presents the best example of a country whose enlarging economy was rapidly fueling demand for housing through the escalation of immigrants, growth of industrial employment as well as rapid urbanization.