Solid construction monitoring is crucial

Real estate debt funds are increasingly becoming direct competitors to traditional real estate banks. Do comparable regulatory requirements apply to both?

Martin Kleemann: In 2017, BaFin published the minimum requirements for the risk and liquidity management of capital management companies for German credit funds (KAMaRisk), according to which, the minimum requirements for credit institutions’ risk management apply equally to all capital management companies. It is true that KAMaRisk is not applicable to European credit funds, even if they grant loans in Germany. But, of course, funds domiciled in Luxembourg, for example, are also regulated regarding sufficient risk management structures - for example CSSF Regulation N° 15-07.

Dr Achim Johannis: In addition, it is apparent that professional fund investors typically require company-wide and effective risk management systems and compliance functions that correspond to the formal supervisory regulations. In short, investors demand a high level of commitment to transparency, clear, regular and often tailor-made reporting, and watertight compliance.

Debt funds are increasingly offering whole loans and mezzanine loans for development projects. Are there any special regulatory requirements for this form of project financing?

Martin Kleemann: Absolutely. KaMaRisk takes the specific risk situation of development projects into account. In general, the risk management system must ensure that significant risks can be identified at an early stage, fully recorded and presented in an appropriate manner. Especially in the case of project financing, it is explicitly required that, in addition to the economic consideration, the technical feasibility and development in particular be included in the assessment. The same applies to the legal risks associated with the project. Inspections and construction status checks must be carried out at regular intervals during the construction phase of the project.

What does this mean for debt funds that allocate capital to project financing?

Martin Kleemann: Processes and documentation must be compliant with the regulatory requirements. This must be carefully checked and, if necessary, adjusted accordingly.  BaFin and auditors focus on the specific requirements and their implementation during the audit. 

Dr Achim Johannis: Special attention is paid to the technical and economic project monitoring. The processes implemented must guarantee the technical and constructional assessment competence and at the same time be methodically integrated into the overarching risk strategy - in accordance with the regulatory requirements. Those responsible for the process are explicitly checked for their suitability.

That sounds complex and time-consuming. Debt funds score with their speed and efficiency. How can they still maintain this competitive advantage over traditional financing? 

Martin Kleemann: We strictly align the processes of technical and construction project monitoring according to risk-oriented assessment methodology, with which we have had very good experiences. This form of assessment forms the working basis for auditing and revision. It has proven itself over many years and is extensively documented in the International Standards of Accounting (ISA), for example. Based on this methodology, the monitoring processes are audit-proof, structured, efficient and leanly focused on the relevant risk indicators and contractually defined covenants.

Dr Achim Johannis: In addition, some debt funds have been able to significantly develop the degree of digitalisation in project loan monitoring in recent months. Some system providers provide IT solutions tailored to the specific requirements of real estate loan monitoring. This allows the borrower to flexibly access relevant data from project accounting and efficiently condense it into early risk indicators. The systems also support multi-project controlling and thus transparent liquidity management at loan portfolio level.

Thank you very much for the informative interview. Martin Kleemann is managing partner of KKM Wirtschaftsprüfungsgesellschaft in Munich and supports funds and other participants in the capital markets in establishing processes and organisational structures that comply with supervisory law. Dr Achim Johannis is managing director of assetecture GmbH & Co. KG, which contributes comprehensive professional expertise in the field of real estate loan monitoring as a cooperation partner, and is a trustee of the RICS continuing education programme on construction monitoring.