A BEGINNER'S GUIDE TO DEVELOPMENT FINANCE
There are multiple considerations to make when planning a new build development or a commercial conversion. By choosing to raise external finance from a lender you may be able to make your own cash spread further and therefore either undertake schemes of a larger size or alternatively, it may also allow you to grow your business quicker by undertaking more than one project at a time. However, it is important to remember that the development lenders will still want to ensure that you and/or your team have the relevant experience and that you are able to complete your obligations without putting schemes and finance at risk Development Finance can also help to spread the risk in both the construction and sales phases by providing sufficient funding throughout the construction and sales phases. As there is a financial risk to the Lender, it is important to remember that they will want to secure relevant charges on the site and guarantees as security for the funding they're providing.
WHY USE DEVELOPMENT FINANCE
Remember, if you are new to development, then you may also benefit from joint venturing with a more experienced developer. This may then enable you to obtain more preferable terms with other lenders you might not ordinarily have access to.
Using Development Finance may also be beneficial as you can utilise the teams with whom the development lender works with i.e. their valuer and QS, their in house Asset Managers and their Underwriters. These are experienced groups of people who can sense check a development to ensure that it works. This is particularly beneficial for first time developers or those with limited experience and require the Onceguidance.you have successfully completed one or two development projects and your experience grows, you will start establishing healthy relationships with the Lenders and their teams. This can then potentially lead to you borrowing at a higher leverage and at lower interest rates on future projects.
STEP TWO:
THE DEVELOPER'S JOURNEY
STEP ONE: FIND THE OPPORTUNITY
Building relationships with Agents is also key as the market is extremely competitive and relationships will give you the competative edge. You should also provisionally check with local authorities about the likelihood of planning permission for particular sites and understand the scale of developer contributions (Section 106, Community Infrastructure Levy) which may be required on certain development projects.
Small sites make up the minority of housing delivery identified in local plans. Developers should make use of any resources they can to identify suitable small sites, including the local plan and the brownfield register.
PURCHASE LAND AND GET PLANNING PERMISSION
Once you have identified a site, purchasing and obtaining planning permission are the key next steps. With the backlog caused from the pandemic, obtaining planning permission can take some time. A good planning consultant is therefore key.
Ensure that you approach your Broker in plenty of time as Development Finance can often take 3-4 months to put in place. By doing this, you ensure that you can commence with the build work as soon as possible, rather than having to wait 3-4 months post approval to get the finance arranged.
STEP THREE: THE INEVITABLE PLANNING ISSUES STEP FOUR: OBTAINING FINANCE
Most development lenders will not lend until planning has been granted, so there may be a requirement for an Option Agreement with the vendor or a holding bridge to purchase and secure the site.
Consider the need to pay Community Infrastructure Levy (CIL) and water infrastructure charges. Again, a good Planning Consultant is key here as they can manage the process and ensure that reports are completed and professionals are onboarded to deal with any hurdles with the planning. Discharging planning conditions can take longer and prove more difficult than might be expected.
STEP FIVE: THE BUILD
For many Developers, this can be the toughest part. With the costs of materials on the rise and potential delays during the build, this can make or break a development. Ensure that your Contractor is liquid, to reduce the risk of their business collapsing mid development. A good Contractor and a good Project Manager are worth their weight in gold.
STEP SIX: EXIT STRATEGY AND REPAYMENT Sales assumptions can sometimes prove misguided and lenders normally have a mechanism to step in if things don't go to plan. It is imperative that the relationship with the development lender is managed and it is important to be aware of alternative options available to you if units are not selling as originally expected. Ensure that you speak to your Broker. Ensure that you have a contractor on board as soon as reasonably possible as the Lender will need to instruct a QS to provide an initial report on the project and associated costs schedules.
There's also the option of retaining some or all of the units by refinancing them on to a longer-term mortgage. This is particularly popular with developers who are also property investors.
However, if the development facility is coming to the end of its term and you need more time to sell them, then a development exit facility is may be the answer and provide you with that extra valuable time. This option may also free up some equity in the development to help you either with cash flow or funding for your next project.
STEP SEVEN: RINSE AND REPEAT
Hopefully, some of the units will be sold off plan amd all units sold within your targeted timeline.
Once the refinance or sales have completed, and the loan is repaid, and the profits in the bank, then it is time to go again! This re-invtested capital can increase the amount of 'own funds' in place for future projects, which can assist with lowering the interest rate that the Lenders charge as the leverage requirement is lowered
The lenders will assess your scheme on a basis known as a “fully funded” approach. This is a method to ensure that across the lending and the Developer's equity contribution, there is enough to cover the purchase price, the build costs and all associated soft costs. Lenders will be very keen to understand your experience and/or your team's experience on previous projects, in order to give them confidence that the scheme can be delivered. Lenders may seek to understand and challenge your business plan/development appraisal in areas such as:
The projected sales values for house types (depending on size/specifications) by comparing sale prices on other nearby sites and properties in the Projectedarea rate of sales, and whether this is Therealisticprojected land values Forecast build costs Professional fees
WORKING WITH THE LENDER
On a new build development this needs to be a minimum of 10% of the build costs Pedigree of the Contractor and the Project Manager. Have they delivered a scheme similar, and are they liquid according to Companies House. Lenders do not want to see Contractors with a cashflow issue The exact approach of each lender will vary, but all providers should be able to outline broadly their requirements on request.
Finance costs for arranging the loan and for interest on the amounts being drawn Which Warranty provider is going to be used The Level of profit within the deal. If the profit is too low, then they may not lend Contingencies.
Lenders will seek as much certainty as possible that the loan will be repaid in full and on time. If they have any doubt around this, then often they will avoid lending. The Lenders will reduce their risk by taking a first charge over the security and a personal guarantee from the Directors and Shareholders of the Borrowing Entity. Lenders will usually want to keep close control over the release of funds, and will often agree a drawdown schedule with the QS and Contractor before lending. They will ask the developer to put all their contribution in first – usually to buy the land and directly fund the first elements of the development phase. This is to ensure that the Developer has their own 'hurt money' in the deal early on. Lenders will not normally release funds in alongside the developer in the early stages of developments and will typically only release funds after the QS has visited the site to confirm that works have taken place. Different lenders will typically apply their own criteria on drawdown requirements, so it is important to understand this. Lenders will each have their own timescales for drawing funds, so again it is key to understand this for cashflow.
THE LENDER'S SIDE
The Lender will be keen to understand the source of the equity and the ratio of the Developer's own cash v. Investors.
SOURCE OF DEVELOPER EQUITY
This might mean providers asking more questions than in previous applications you may have made, including seeking to understand Individual wealth. While this can be frustrating, it is common, and you should be prepared to discuss this with the Broker and the Lender.
As well as seeking to ensure that developers have sufficient funds for the initial investment (whether through personal funds, private equity investment or other forms), all lenders have responsibilities under anti-money laundering rules to ensure they are satisfied that contributions come from legitimate sources. This will normally be established through the Solicitors during the Legal process
The Lenders will also want to understand where the Developer's cash has come from. If this has come from a build of profits from previous developments then this is the best case scenario. However, be prepared to supply bank statements, completion statements and any other financial documents.
Remember that lenders cannot approve every Developer's lending application. This may be due to several factors, including appetite for exposure in a certain geographical location. However, there are many sources of finance you can consider. The Market is incredibly competitive, with new Lenders often coming to the table with new and diverse offerings. This is why it is key to ensure that you have a knowledgable broker to source the most appropriate lender and development facility that's tailor made for your project. This will also reduce the chances of your application being rejected. Whilst some Lenders may turn you down at application stage, some may also turn you down at valuation or legal stage, if something that they are not keen on arises. Whilst this may be frustrating, it is often unavoidable. A new Lender may be able to rewrite any valuation or QS reports that have been done previously, so often, switching Lender at a later stage does not have such a negative impact on the timescales.
IF YOUR FIRST LENDER TURNS YOU DOWN
A TYPICAL DEVELOPMENT LOAN The following example shows what a typical development facility might look like in simple terms: THE PROJECT Site in Derbyshire with planning approval for 5 x 3 bed detached houses. Purchase price for the site: £200,000 Build costs: £450,000 Professional fees and finance costs: £125,000 TOTAL DEVELOPMENT COSTS: £775,000 GROSS DEVELOPMENT VALUE (GDV) : £1,000,000 (aggregate of 5 x houses at £200k each) DEVELOPERS PROFIT: £225,000 (GDV Total development costs)
THE DEVELOPMENT LOAN
Typically, the development lender can lend up to 65% of the GDV or 85% of the total development costs, whichever is lower. In this instance, the lender would lend 65% of the GDV i.e. a total loan facility of £650,000.
The lender will always want to cover 100% of the build costs, professional fees and finance costs. Whatever is left, then goes toward the purchase of the site: 100% of the build costs, professional fees and finance costs = £575,000 - Residual loan funds to go toward the purchase of the site = £75,000
GLOSSARY • Challenger bank A smaller retail bank set up to compete with the more established Big Five banks of Barclays, HSBC, Lloyds Banking Group, RBS/ NatWest and Santander • Collateral Assets (for example, property) pledged by a borrower which act as security for bank facilities • Crowd funding A method of raising funding for a project by obtaining small amounts of capital from a large number of investors • Development appraisal Financial assessment of the viability of a development scheme which will detail each line item of cost and value, also allowing you to derive scheme profit • Draw down report A report supplied by an Independent Monitoring Surveyor which advises the lender of the progress of the works on a development site and approves the drawdown of funds requested by the Borrower •
First legal charge – A legal charge is the means by which lenders enforce their rights to a property. The holder of a ‘first charge’ has the legal right to make the first call on an asset in the event that the borrower defaults on repayments.
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• Leverage
Percentage of debt in the capital structure to either the development or current value of a project or business
Subordinated financing which sits between senior debt and equity, carrying a higher rate of interest than the senior debt facility with all collateral ranking behind the senior debt provider costs Expenses associated with the ongoing monitoring of a development, which typically involves the appointment of an independent monitoring surveyor who carries out due diligence on a regular basis on behalf of a lender lending – Lending provided to and secured only by the assets and the vehicle which are being funded
structured to ensure that all costs of the development are committed from the outset of the agreement by a combination of the borrowers’ equity and the funders facility enterprise / Joint venture An arrangement entered into by two or more parties to create a separate entity for the purpose of carrying out a particular project or business activity, in which each party shares ownership and associated risks and rewards
• Joint
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Mezzanine finance
Fully funded approach Development financing
• Monitoring
• Non-recourse
• Personal guarantees A written promise from a business owner or director providing the lender with recourse to them for a specific circumstance, which would be outlined within the guarantee wording • Private equity Entities concerned with the investment of equity into companies or projects not listed on a public exchange • Recourse lending – Lending secured both by the assets being funded as well as other assets of the borrower. In an event of default, the lender is entitled to claim other assets owned by the borrower in order to satisfy outstanding debts. •
Senior debt Outside of an administration process, the highest ranking creditor in the event of default, usually backed by a debenture, guarantee and / or legal charge over specific assets Step in rights Grants one party the right to take over the rights of another in a contract between two third parties. For instance, in an event of developer insolvency, step in rights may grant a lender the right to assume the role of the developer in contracts with consultants and building contractors
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