For many property developers, no matter how experienced they may be, the prospect of sourcing funding for their next development scheme can elicit any number of negative emotions. The lending landscape is always changing, the due diligence process is long and can be arduous and valuations are often a minefield. Unfortunately, unless you have a significant amount of money waiting to be used, securing development finance is a process you can’t avoid. You can, however, help your business, by equipping yourself with the requisite knowledge to effectively navigate this world.
Hopefully, this guide can act as a good starting point. By the time you’ve finished reading it, you should have a good entry-level understanding of development finance, putting you in a better position to get your development schemes funded.
Terminology
The Capital Stack – The total amount of money required to complete the project, split into several levels to indicate level of risk/return. The capital stack is usually split into debt and equity, with debt being provided in the form of a loan, often from a bank, and equity being invested by the developer and/or an investor. Debt forms the base of the stack as it is secured with a first charge and therefore has lowest risk. Equity is at the top as the risk is higher. For a more detailed understanding of the capital stack, see our blog post – Understanding the Capital Stack.
(Senior) Debt – The most common requirement for property developers looking to fund projects is to secure a loan from a bank. This debt is called “senior” as the bank will take a priority (or “first”) charge on the site. This means that if something goes badly wrong during the development and it’s looking like you won’t be able to pay the bank back, they will take the site off your hands and sell it to another developer so that they can recoup their loan. Any money coming in after the senior has a much higher risk as they will not have the benefit of this first charge.
Equity – This is the capital deployed in a project which is regarded as an investment as opposed to a loan. This is most often the money committed by the developer themselves, and most senior lenders will have a minimum requirement of direct developer equity in each project (between 5% and 25%). However, another form of equity in a project can be provided by a third-party investor. This is often invested in exchange for a share of the profits.
Mezzanine (Junior) Debt – Occasionally, when there is a funding gap between the amount of money the bank is willing to loan and the amount of equity the developer can commit, mezzanine debt can be secured to plug said gap. This loan will be secured with a second charge, meaning that after the senior lender has recouped their loan by selling the site (in a worst-case scenario), if there is any money left on the table, the mezz provider can claim it. Their risk is clearly much higher than the senior’s and this is reflected in their interest rate.
Leverage – The amount of money a lender is willing to loan you is usually expressed as a percentage of either the total costs of the project, or a percentage of the GDV. Senior debt can reach as high as 65% Loan to GDV (LTGDV) or 80% Loan to cost (LTC). Any higher than this from a senior lender is usually classed as “Stretch Senior”. The higher the leverage, the more expensive the interest rate so it’s worth considering whether you want to prioritise high leverage or low rates.
Rates and Fees – Banks, lenders and investors are unfortunately not charities. They all want a return on their money. As stated above, what you will most likely see in the market is the lower the risk, the less expensive the finance. So, a low leverage loan, secured on a first charge from a high-street bank will be the cheapest debt available to you (4-5% pa), senior debt up to the max of 65% LTGDV will be available from 6%-9%, mezzanine will usually cost you between 15% and 25%.
The interest will be calculated as part of the total facility, rolled up and repaid on sale of the properties. This should be factored into your financial appraisal when you model your senior debt as the advertised leverage will end up being higher than the actual available funds to put to the costs of the project.
Equity, being the riskiest section of the capital stack, is the most expensive and often will involve some sort of profit share.
On top of the interest, most lenders will charge arrangement and exit fees. These vary lender to lender from 0.5% – 2% of the total facility.
Personal Guarantee – As well as taking a charge on the security, the lender will usually require a personal guarantee from the developer. This, on top of the developer’s direct equity in the scheme, give the lender comfort that the developer won’t walk when the going gets tough. Usually this is a percentage of the facility, and the lender will require that you provide a detailed asset and liability statement to prove that you are able to pay the guarantee if necessary. It’s worth noting here that banks very rarely come to claim their personal guarantee, it’s really a last resort in a very worst-case scenario.
Process
Appraisal – The first step on the road to securing development finance will be completing a detailed and accurate financial appraisal. The appraisal should include all costs including purchase price, stamp duty, build costs, professional fees, CIL/s106, sales costs and legal fees. It should also include a target GDV and this should be used to calculate the profit in the project. Most lenders want to see a minimum profit of 21% of the GDV. A good appraisal will also include an estimate of finance costs including interest and fees and use this to calculate post-finance profit margins (20% profit on cost post-finance is a good goal)
Enquiry – Once you have completed your financial appraisal, you should have a good idea of the costs of your project and, combined with an understanding of the equity you have available, you should be able to determine the leverage you need to fund the project. This will allow you to reduce the pool of senior lenders to contact as they each have max leverages and different rates and other specifics that will fit your project best. Your enquiry, when you are ready to make it, should include the following:
- Your financial appraisal
- A narrative description of the scheme
- Details on the planning permission
- Drawings and plans
- Pricing schedules from at least two local agents
- Comparable sales information
- Background information on your experience as a developer
- Details on your professional team
- Asset and Liability Statements from company directors
- Proof of funds for your deposit
Decision in Principle (DIP) – The above information should be enough to give the lender a decent initial understanding of the project and to come back to you either with a quick “no thanks” or with a decision in principle (DIP). Receiving a DIP means that the lender likes the look of the scheme and of you as a developer. It will contain details of the amount of money they would be willing to lend, along with rates and fees. However, this offer is subject to the bank completing their due diligence process and is not a guarantee that you will be receiving the funds. If the numbers work for you and the lender seems like one you want to work with, you can accept their terms (often this includes the payment of an acceptance fee) and progress with the lender’s due diligence process.
Valuation/Initial QS/Legals – The next stage of the process is the bank’s due diligence. This will involve a Redbook valuation to confirm the Residual Land Value of the site and the Gross Development Value of the project, an Initial Q/S report to assess your proposed build program and confirm that all your costs are reasonable and a legal process to produce a Report on Title and to draw up the loan agreement.
Completion – Once the solicitors and surveyors have completed their work and everyone is happy that the project is viable, you are ready to complete on the loan. The lender’s solicitors will at this point be liaising with your solicitor. A completion statement will be produced detailing the amount of money to be drawn down from the lender on day one to purchase the site and the amount of equity to come in from the developer. The developer’s solicitor will collect the funds and complete on the purchase. Congratulations, you now own your site.
Drawdowns – Monthly drawdowns of your facility usually happens in arrears. This means that you will need to either fund the first month’s costs yourself up front or set up credit arrangements with your various suppliers. Every month the lender will send their monitoring surveyor out to monitor your progress and costs and give approval for your monthly drawdown.
Exit – As you draw near to the end of your loan term, hopefully having completed the build, it comes time to consider how you will be paying back the lender. The two main options would be exit through sales and exit through refinance on to a long term BTL loan so that you can retain the units as an investment. If you have picked the first option but your sales are going a little slower than you had expected, you could consider refinancing on to a development exit product from a different lender. These will usually have cheaper interest rates and will give you more time to complete on your sales and fully exit the scheme. Hopefully this isn’t the case and you will simply be able to pay back the lender from the first few sales in your scheme and then take the rest as your profit.
So, there you have it. Hopefully reading this guide has given you an insight into the process of securing development finance, from start to finish. My final tip would be this; manage your expectations. Getting a bank to lend you a large amount of money, especially as an early-stage developer, can be a difficult process and it can take a long time from initial enquiry to loan completion. Plan accordingly to avoid unnecessary stress.