Preferential industrial mortgages and the prospects for applying project finance and securitization mechanisms

Preferential industrial mortgages and the prospects for applying project finance and securitization mechanisms

The current challenging macroeconomic conditions that have been aggravated by sanctions, the breakdown of international logistics chains and the termination of the activities of a number of foreign manufacturers in Russia pose a serious challenge to the Russian economy. Even against the backdrop of certain successes in countering the aggressive external environment, additional efforts are required to maintain economic stability. Preferential industrial mortgages is a promising measure aimed at supporting industrial activity and strengthening the country’s technological and industrial sovereignty.

Government preferential industrial mortgage program: loans for manufacturing enterprises of up to RUB 500 mln with a rate of 5% for the purchase of industrial facilities.

On September 6, 2022, the Government of the Russian Federation issued Decree No. 1570 “On approval of the rules for granting subsidies from the federal budget to Russian credit institutions to reimburse lost income from loans issued to Russian companies and (or) sole proprietors for the purchase of real estate property for the purpose of carrying out industrial activities” (hereinafter, the Preferential Industrial Mortgage Program). According to the announced goals, this program aims to stimulate growth of industrial production by increasing production capacities and contribute to ensuring Russia’s technological sovereignty. The potential positive impact of government support is clear:

• Increased production activity and, as a result, economic growth;

• Growth of tax revenues transferred to the budget due to a larger tax base;

• Expansion of the supply of industrial products (including import substitution) thanks to new manufacturers and industries;

• Job creation;

• Diversification of the market by making it more accessible to medium-sized companies while reducing the debt service burden.

Banks that hold assets worth at least RUB 100 bln that have been selected by the Russian Ministry of Industry and Trade to sign relevant agreements following a bidding process will be able to receive these government subsidies. The Russian Ministry of Industry and Trade provides subsidies within the limits established by the federal budget for a period not exceeding the grace period for lending. The subsidy is intended to compensate credit institutions for part of the cost of financing loans issued to borrowers at a preferential rate. It should be noted that the state providing support via banks is an ordinary practice for the Russian market. The main parameters for preferential lending are as follows:

• Preferential loans can be provided to legal entities whose economic activity is listed under Section C of the Russian National Classifier of Types of Economic Activity (with a number of exceptions¹);

• The subject of the mortgage is exclusively a ready production facility, at least 50% of the area of which will be used for industrial production no later than three years after the conclusion of the contract;

• The loan cannot exceed RUB 500 mln, the lending period is up to seven years, and the preferential interest rate is 3% for technology companies and 5% for other production companies.

The bank independently analyzes the borrower’s compliance with the program criteria and credit risks.

The size of subsidies is limited by the value of the key rate as of the date of conclusion of the loan contract for technology companies and the size of the key rate minus two percentage points for other manufacturers.

As the cost of production sites varies widely depending on location, region, area, and overall site configuration, it is difficult to determine a single averaged profile of the program’s participants. According to the Russian Government, the RUB 500 mln ceiling for preferential lending was selected taking into account the average national cost of production sites. The Russian Ministry of Industry and Trade relies on the assumption that a loan provided under the program will allow up to 10,000 sq. m of production area to be acquired, which should be enough to accommodate a medium-sized factory or several workshops of a major company². Even a brief glance at current offers to sell production facilities allows this bar to be raised to 15,000 or even 20,000 sq. m in Russia’s main industrial centers, including Moscow and the Moscow Region. At the same time, there is no minimum loan size, so in theory small enterprises can also receive preferential loans. However, given the higher interest rates for lending to SMEs and the limited size of subsidies tied to the Bank of Russia’s key rate, it is obvious that the program is indeed aimed at medium-sized and large businesses.

The positive trend of commissioning new industrial sites ensures that supply is stable: the volume of commissioned sites will remain at 4.7 mln sq. m in 2022

The Preferential Industrial Mortgage Program does not include requirements for the target real estate property. Industrial buildings require additional investments to set up production, which grow if a building has been purchased in the secondary market. Due to this, it is reasonable to assume that new buildings will be most popular under the program. Unfortunately, only limited statistics are available on the number of transactions in the industrial real estate market, so the most representative indicator for the analysis of supply and demand is the dynamics for putting industrial space on the market. Analysis of Rosstat’s data shows that the industrial real estate segment of the construction industry has been rather stable over the past 10 years — there have not been any sharp fluctuations in terms of the annual floor space or number of buildings commissioned (Fig. 1). The average annual volume of commissioning of new production sites in Russia from 2011 to 2021 was about 4.8 mln sq. m (an average of 3,000 buildings with fluctuations within 10%).

¹ Manufacturing industries, except for the extraction and trade of crude oil and natural gas, the production and trade of liquid fuels, the production and trade of tobacco products and alcoholic products.
² http://government.ru/news/46449/

Figure 1. Statistics for commissioning of industrial buildings in Russia from 2011 to 2021

A retrospective analysis allows us to identify two periods of decline of market activity. The first took place after the events of 2014 (on average -10% compared to the annual average indicator for 2014), which was due to the introduction of sanctions against the Russian economy. The second period, from 2020 to 2021 was due to the consequences of restrictions that were imposed during the pandemic and had a negative impact on market activity and the accessibility of financing. It took around five years for the market to recover after the first period, while after the second it took no more than two. Rosstat’s preliminary data for nine months of 2022 shows that activity in the industrial real estate construction segment continues to be high and the total volumes of commissioned industrial buildings have even exceeded the quarterly indicators for 2020–2021, despite the complex situation in the economy and inevitable changes in the building materials market in 2022.

Per-quarter data for recent years shows that the fourth quarter is the most active in terms of the volumes of completed construction. An extrapolation of data based on statistics for recent years and information on the Russian construction sector for three quarters of 2022 allows us to assume that the indicators for this segment will be comparable to those of 2019 by the end of 2022, i.e. they will be higher than in 2020–2021 (Fig. 2).

Figure 2. Comparison of quarterly volumes of commissioning of industrial buildings in Russia from 2019 to 2022

Clearly, the above does not mean that the current trend will continue in the near future. The length of the construction cycle, which usually amounts to no less than three years, including designing and preparation of construction documents, should be taken into account. Consequently, the positive trend recorded this year is largely due to the completion of projects that were launched in 2018–2020. Despite this, the fact that rather high activity in the industrial segment of the construction market, as well as in related segments (for example, infrastructure construction) has remained stable throughout the year, despite the new economic realities that emerged in the first quarter, gives us reason to be moderately optimistic.

The successful implementation of production projects depends on demand for produced products. On the one hand, the current changes taking place in the economy are accompanied by a certain decrease of effective demand for some consumer and industrial goods. On the other hand, the exit of a number of foreign producers and suppliers from the Russian market creates conditions not only for growth of demand for domestic products, but also for occupying now-vacant market niches. Therefore, it can be expected that Russian companies will drive stable demand for production sites.

Financing of the Preferential Industrial Mortgage Program provided for by the budget amounts to RUB 872 mln from 2023 to 2025; we expect the size of the program to be revised upward.

The 2023 federal budget, which was passed on December 5, set the size of financing for the Preferential Industrial Mortgage Program for next year at RUB 286.7 mln; targets for 2024 and 2025 are comparable at RUB 291.0 mln and 294.6 mln, respectively. Given the program’s parameters, expected size of interest rates and the planned amount needed to subsidize them, we are talking about a loan portfolio of RUB 3.5–5.5 bln. At the same time, it was originally planned to set aside RUB 10.9 bln³ of subsidies for 2023–2025 (which approximately corresponds to the portfolio of preferential loans of RUB 45-70 bln). The Preferential Industrial Mortgage Program currently looks significantly underfunded, however, given previous statements made by the Government of the Russian Federation, we expect it to be expanded in 2023.

Another important area for optimizing and promoting this program is to diversify lending purposes. Limiting the loan purpose to acquisition of ready-made facilities largely impairs the program’s potential. Not every finished industrial facility meets the specific requirements of a particular production process, therefore, significant additional costs may be required to arrange the production process, but these costs cannot be included in the loan amount (the same applies to the condition and the degree of wear and tear of the purchased industrial facility).

In November this year, it was reported that the Government of the Russian Federation is considering options for expanding the program to cover the construction and repair and/or reconstruction of buildings. The Russian Ministry of Industry and Trade’s forecast for 2022–2025 indicates that demand in this area will exceed the supply of ready buildings by more than double: 6.2 mln sq. m and 3.6 mln sq. m for construction and repair, respectively, vs. 2.8 mln for purchasing of ready facilities. The limits of preferential lending for these purposes may be increased to RUB 2.0 bln for construction and up to RUB 1.5 bln for major repairs, while the maximum term of preferential lending may be extended to 10 years⁴.

³ https://www.vedomosti.ru/economics/articles/2022/09/01/938601-minpromtorg-predlozhil-vidavat
⁴ https://www.kommersant.ru/doc/5667048

Securitization of industrial mortgages makes it possible to increase the efficiency of interest rate risk management; this is possible if the program is extended to structured finance special-purpose entities (SF SPEs).

Securitization of debt portfolios within the framework of industrial mortgages is possible and may potentially be of interest to banks seeking both to free up bank capital and share risks with financial market participants. Interest rate risk management seems to be one of the main incentives for making securitization transactions. An important reason is that funds allocated for the implementation of government programs for subsidizing interest rates are spent within the relevant sections of the federal budget, so the process of making changes (for example, to adjust or expand the scope of programs) is formalized and it can take quite a long time, while the result of consideration of such amendments is by no means guaranteed. In addition, since the funding costs of credit operations of commercial banks largely depend on fluctuations of the key rate, the risk of mismatch between the declared amount of subsidies and the current needs of a bank to maintain the profitability of lending significantly increases (that is, an additional interest rate risk arises). Although the terms of the Preferential Industrial Mortgage Program include a possible increase of the rate, this increase is capped at three percentage points relative to the key rate (the program does not specify whether it is possible to establish a floating rate or to periodically revise the rate). Securitization makes it possible to solve these problems to a certain extent, since structured finance transactions are carried out through the assignment of the loan portfolio of the SF SPE, which acts as an issuer of collateralized bonds at a fixed coupon rate. At the same time, issue terms may provide for a reinvestment period during which the repaid debt is replaced by new loans. The reinvestment period may be terminated prematurely in the event of an increase of the default rate or a decline of the average interest rate.

Depending on the concentration of securitized portfolios by the amount of individual loans and the share of debt per borrower, such transactions can be qualified either as SME loan securitization or as securitization of large debt obligations. The threshold values of the portfolio parameters in this case can be estimated at 80–100 loans with a maximum concentration of loans of up to 5% per borrower. In both cases, the law requires the originator bank to retain a portion of the credit risk of the collateral portfolio. In practice, this means the acquisition by the originator bank of a junior tranche (with lower priority from the point of view of fulfillment of obligations). To place a higher priority senior tranche on the exchange, a credit rating should be assigned to this tranche.

Of course, the interest rate under the Preferential Industrial Mortgage Program (3% or 5%) by itself cannot provide sufficient cash flow to make coupon payments on issued notes and, accordingly, ensure the highest credit rating. The list of recipients of subsidies must be expanded for securitization of subsidized loans: in addition to banks, it is necessary to include SF SPEs⁵ in the program. The tranching mechanism reduces the pressure on the incoming cash flow required to service the senior notes. An additional way to ensure the stability of interest income may be the inclusion of loans with higher rates that are not subsidized in the securitized portfolio (Fig. 3). This will not only overcome the restrictions imposed by the maximum allowable amount of interest margin in the event of cessation of subsidies, but increase portfolio diversification, and therefore it will help to streamline applicable rating approaches.

Assigning ratings to securitization transactions of diversified loan portfolios involves, among other things, the application of a less labor-intensive polyparametric comparative approach based on statistical modeling methods, while an individual assessment of each asset in the portfolio is required to assess the credit quality of concentrated portfolios.

⁵ There are similar precedents: for example, according to the title “Rules for granting subsidies from the federal budget to Russian credit institutions  and special-purpose financial entities in order to compensate for the lost income on loans issued in 2019–2024 to small and medium-sized enterprises, as well as individuals applying the special tax regime ‘Tax on professional income’, at a subsidized rate”, an SPFE can receive subsidies.

Figure 3. Simplified structure of a securitization transaction of a combined portfolio of industrial mortgages and government-backed corporate loans

Source: ACRA

Expanding the program for the construction and repair or reconstruction of industrial facilities with an increase in the ceiling of a subsidized loan to RUB 2 bln will make the program more attractive, and using project finance special-purpose entities (PF SPEs) to finance construction will open up new opportunities.

The potential expansion of subsidized mortgages to the construction and repair or reconstruction of industrial buildings allows us to talk about the possibilities of using project finance tools. There are plenty of options for structuring such projects, while both the originator and the manufacturing company itself may act as the initiator.

Taking into account the program’s focus on banks as the recipients of subsidies, it seems that a structure that includes the assignment of loans is a better option in terms of labor costs and the number of necessary changes to the program. This financing option does not conceptually differ from the securitization transactions discussed above, but the form of implementation may be different. Given the potential increase of the maximum loan amount to RUB 1.5–2.0 bln, as well as the nature of risks of construction projects, it is worth considering securitization of individual loans collateralized by project assets as the most effective and easiest way to apply structured finance mechanisms.

In the basic securitization scenario, the credit quality of financial instruments secured by the claim rights to a single loan completely depend on the creditworthiness of the borrower (industrial enterprise), while in the case of construction of a new facility, the transaction can be structured with the separation of project assets. Consequently, the main credit risk factor is the production facility itself. Investment projects may be financed or relevant subsidized loans may be refinanced with the involvement of either an SF SPE or a PF SPE. The law stipulates that the second type of issuer can acquire the claim rights for financial obligations related to the implementation of investment projects, or directly own project assets. In this regard, the use of this mechanism opens up additional opportunities for financing construction. A PF SPE, for example, can acquire the claim rights on subsidized loans and, acting as a project company, be a borrower of a subsidized industrial mortgage. At the same time, it becomes possible to attract additional funds by issuing project finance notes, which will allow larger construction projects to be implemented.

However, the immediate purpose of this class of special-purpose entities is to issue project finance notes for the implementation of investment projects. If we assume the hypothetical possibility of extending the program to coupon rates on notes secured by project assets, then a PF SPE can also act as a recipient of subsidies. At the same time, an industrial enterprise, which is the ultimate beneficiary of the construction of a production facility, can act as a customer and determine the basic requirements for the technical and operational characteristics of the facility under construction. This will allow the specific requirements associated with the production process to be taken into account to the greatest extent. Since this approach does not provide for the participation of banks in the project, the credit risk assessment of subsidized financial instruments should be carried out by assigning a credit rating involving a comprehensive analysis of the project, business plan, and key counterparties.

Despite the great potential and flexibility of arrangements for raising funds for the implementation of projects, the application of securitization and project finance tools in Russia is still very limited.

There is still no answer to the questions of whether the Preferential Industrial Mortgage Program will be able to meet all the needs of the market and whether budget funds will be allocated for its expansion. However, in ACRA’s opinion, such a mechanism to support Russian manufacturers is needed and can have a noticeable positive impact on the industrial sector. Expanding the tools available to both domestic industrial enterprises and credit institutions to finance the development of existing industries and the opening of new production facilities (including with the involvement of new forms of government support) is an important factor in supporting the Russian economy, which is especially relevant in the current difficult situation.