A draft law to protect residential property investors and to offer new financing options to developers
Authors: Alexander Borodkin, Vasil Kisil Partner, Tetiana Revutska, Vasil Kisil Senior Associate
Starting from early 2020, Ukrainian construction industry undergoes a string of core reforms. Aimed to reboot the industry, the reformative laws will establish new authorities to oversee all regulatory matters, will streamline the procedures for issuing construction permits and set new rules for inspections.
The changes will also concern how individuals and companies invest in construction projects. The proposed approach is presented in draft law “On guaranteeing the property rights to real estate to be constructed in future” No. 5091 (the “Draft Law“), which is now being considered by the Ukrainian Parliament.
Per the Draft Law initiators, its main aim is to offer more protection to those who invest in properties under construction. Yet aside the declared goal, the Draft Law may reshape how the developers structure their projects in general.
Title to real estate under construction
The major change is that the Draft Law allows to attract funds from individuals or companies for constructing real estate only if the properties under construction are registered with the State Register of Property Rights to Immovable Property (the “Rights Register“).
Currently, any real estate is subject to state registration only after it has been constructed and commissioned into operation.
After the Draft Law is adopted, special title to building under construction may be registered with the Rights Register. If the property contains separate items, for example, apartments, offices, or parking spots, etc., each of these items shall be registered separately as well and will be considered future real estate.
Only after the future real estate is registered with the Rights Register, the property sellers may start attracting investment from individuals or companies in exchange for delivering title to real estate. The investment is formalized as a sale agreement for a future real estate, which shall be notarised. The special title to the future real estate is then transferred to the buyer and is registered with the Rights Register.
If the investor has not paid for the future real estate in full, it remains registered to the seller yet is encumbered with the Rights Register in favour of the buyer, disallowing the seller to dispose of it.
A portion of all future real estate in the building must be allotted as a guarantee portion. The guarantee portion is encumbered with the Rights Register, may not be sold to any investor and its construction shall be funded by the developer on its own dime. The guarantee portion is reserved so that it can be sold to potential buyers to attract funds to finish construction if the project stalls and gets taken over by the responsible authority.
The percentage of the guarantee portion is not set by the Draft Law and shall be defined by the Cabinet of Ministers of Ukraine. For a reference, the initial lawmakers’ idea was to set it as not less than 10% of the total area of future real estate in the building – that is apartments, offices, parking spots, etc.
The developer is a new project participant, who may organize and fund the construction. The developer acts based on an agreement with the project owner who holds title to the land plot and is a formal client per the construction permit.
Both the developer and the project owner receive the future real estate in ownership per the agreement between them and are both entitled to sell the property to the investors.
Introduction of the notion of the developer is long-overdue on the construction market. It will allow the developers to have a clear and formal role in the project, as well as to have the right to sell the future real estate. The developers will be allowed to engage the contractors and manage any works on the site as well.
Impact on investors
Although applicable to both residential and non-residential properties, the change is expected to be most beneficial to those who invest in residential buildings.
The major change is the registration of title to the future real estate. This means that the investors may check independently whether the future real estate truly exists and is under construction and whether the seller has a right to sell it per the Rights Register. This will also save the investors much effort while doing due diligence for the project, given that many developers are reluctant to disclose their project structure to prove that the company has legal title to the property in question.
Registration of title to future real estate also removes a common risk of double-selling the future apartments, either unintended or deliberate.
Second risk, that is of the project not being finished, is expected to be mitigated by reserving the guarantee portion, which sale will generate funds to finish the project in case of the developer’s failure.
And third most common risk, that is of the project owner changing the design during the project, is mitigated by requiring to seek consent of all investors to change the area or the building by 10% or more and seek consent of investors from the top floor before adding additional floors to the building.
Changes to projects structuring
For the project owners and the developers, an important change is that the Draft Law cancels the rule that requires them to attract private funds for constructing residential real estate only through special entities and structures. Those instruments are construction financing funds or real estate operation funds, mutual investment institutions or special purpose corporate bonds.
The approaches listed above will still remain as options for structuring a residential construction project. However, they all have been revised to accommodate the novelties introduced by the Draft Law.
Functioning of the construction financing funds will be altered, so that the fund manager may attract money from an investor only based on the sale agreement for a future real estate with that investor. The key rule here is that if a fund is involved in the structure, all sales shall go through the fund manager and not the project owner or the developer. Still, involving the developer will be possible – for example in a structure, where the fund manager funds the developer, who in turn finances the construction.
For mutual investment institutions, future real estate will be added to the list of their allowed assets. This is by itself a very progressive amendment beneficial to developers, which would allow to avoid many tax disputes. If the fund acts as the developer, the future real estate shall be initially registered with the Rights Register to the fund. Alternatively, the fund may purchase the future real estate from the project owner or the developer, and then sell that future real estate to the private investors under a sale agreement or by assigning its rights under the original future real estate sale agreement.
Special purpose corporate bonds may be issued by the project owner or the developer after registering titles to future real estate to themselves. The sellers than shall simultaneously enter into two agreements with the investor – one for sale of the bonds, and the other for sale of future real estate. The investor’s payment for the bonds shall be deemed due payment for the future real estate and serves as a basis for title registration with the Rights Register. This approach operated in practice in a similar manner even before, but now it will be a direct provision of law. The bonds will be considered repaid by transferring the real estate by the seller and the buyer signing a transfer protocol for that real estate after the building is constructed and accepted into operation.
And finally, the approach of funding the construction using preliminary agreements was also significantly altered. The Draft Law allows the parties to enter into a preliminary agreement for entering into future real estate sale agreement, yet that preliminary agreement may only envisage payments that comprise not more than 10% of value of that future real estate. Receiving 90% of funds will require entering into the future real estate sale agreement with the investor. This will protect investors willing to book their target even before the construction permits are all in place.
Impact on project owners and developers
Using special instruments mentioned above, that is construction financing funds or real estate operation funds, mutual investment institutions or special purpose corporate bonds will remain possible. Some project owners may find using them more beneficial, mostly for the tax or marketing reasons. For example, using mutual investment institutions may be lucrative due to them being exempt from corporate profit tax, or using the special purpose bonds – since transfer of securities is not subject to VAT.
However, they do require constant upkeep and are heavily regulated by the Ukrainian laws. In most cases they require involving a separate legal entity with a specific licence and status of a financial institution, etc.
Instead, the developers may arrange the project’s structure as a set of contractual duties towards each other and the private investors. The Draft Law does not define any mandatory rules for drafting the agreements, except for a list of material conditions that must be included there. This gives a lot of freedom in drafting and negotiating such agreements, provided always that developers diligently do their homework and propose the draft contracts that cover all issues that may arise in such lengthy project in the future.
The Draft Law is far from perfect. Its most uncertain concept is the guarantee portion, since the Draft Lawoffers no details on how to define that the developer fails to finish construction, or what is the price and the procedure for selling the guarantee portion, etc. The only proposed solution is that selling the guarantee portion will require a court decision. Everything else remains not regulated.
Yet we find that the concept of registering title to future real estate will be adopted one way or another. It fits the main framework of construction reform in Ukraine, which aims to improve transparency in the field and make sure that the private investors’ rights are better protected. It also conforms to the general approach set by two major reformative draft laws in the field. They were already adopted in the first reading and will create a unified electronic system for all construction data, from the town-planning conditions and limitations to commissioning a building into operation.
The Draft Law may change how the developers regard the special instruments, like construction financing funds, mutual investment institutions and special purpose bonds. It will also add options to structure construction projects without resorting to the special entitles. This approach will require the project owners and developers to draft comprehensive and balanced contracts between themselves, as well as the future real estate sale agreements with private investors.
Foreign developers may also be interested in funding and organising construction in Ukraine, since the Draft Law does not require the developers to be a Ukrainian company, hold a license, etc.
And finally, we may as well expect many active developers to seek guidance to review how they restructure their real estate pre-sales and probably the construction business in whole.