Development Finance Explained
What Is Development Finance?
Development finance is the funding provided for the development or refurbishment of commercial, residential or mixed use properties. It is short term lending, typically 3-36 months, to cover the term of the development project. Lenders expect the loan to be paid back once the project is completed through either sale or refinancing.
Sources of Development Finance
Depending on the complexity of the project, funding may come from a number of different sources. These different types of capital are placed in a priority order of repayment and is known as the ‘capital stack’. Essentially there are two types of capital; equity and debt. Equity represents an ownership in the asset, whereas debt is a loan to the owners, secured against the asset or other assets of the equity owner. Here we explain the different types of debt and equity in order of seniority.
This sits at the front of the queue in the capital stack, meaning that when it comes to repayment the senior debt lender will be first to receive monies owed. Should a project go wrong and repayments cannot be serviced, the senior debt lender will typically have the right to take ownership of the property and liquidate it. Being first in line means that this funding is at the lowest risk in the capital stack and is therefore rewarded with the lowest returns. Senior debt will typically be up to 60% Loan to gross development value (LTGDV) / 70% Loan to cost (LTC) (lower thereof).
Experienced developers may also have access to 'stretched senior debt', which can typically provide up to 75% LTGDV / 90% LTC. Rates are typically higher than traditional senior debt, accounting for the increased risk for the lender.
This is second tier debt funding designed to sit behind the senior debt. It is commonly referred to as junior debt for the obvious reason that it is junior to the senior debt. Junior debt is typically subject to the agreement of the senior debt holder. Mezzanine finance typically adds a further 15-20% of the funds required, leaving the developer to find the final 10-15% of project costs. Because of the increased risk of not being first in line to receive payment, mezzanine finance attracts a higher interest rate than that of senior debt.
Preferred equity is typically the hardest to understand of all the funding types, because there is the opportunity for a flexible approach, ranging from ‘hard’ to ‘soft’ options. Hard preferred equity is typically similar to that of mezzanine finance in that it offers a fixed coupon with a set maturity date. Soft preferred equity typically offers investors the chance to share some of the upside of a project. Potential rates of return are generally higher for soft preferred equity as there is a higher risk attributed.
This is the riskiest form of funding as investors sit as the lowest priority when it comes to repayment within the capital stack. Because of the associated risks this form of investment attracts the highest potential returns. Unlike preferred equity, the investment is uncapped meaning returns can increase and decrease in line with performance. Because equity investors are owners, there is no set term for the investment; the full repayment only occurs when the asset is sold or the equity owner sells their investment.
Although there are no set parameters on the structures for common equity, the two that you will commonly see are:
Joint Venture/100% Funding
This is where there is an agreement between the developer who provides their experience, and an investor, who provides the the majority of the capital. It is typically expected that the developer will put some money (commonly 2-10%) towards the project and the investor will provider the rest. Through this 100% funding for the cost of the total project works can be achieved. In return there will be an agreed share of the profits which is set on a case by case basis.
Structured Property Finance
This is for developers with complex funding requirements. Ownership structures might include UK based or overseas trust structures, multiple Special Purpose Vehicle’s (SPV’s), offshore SPV's, mature borrowers, funds and executors. Lenders tend to be high net worth individuals (HNW’s), boutique private banks, family wealth offices, private equity funds and institutional funds. Developers are expected to be experienced with a good track record to secure this type of funding.
Montpelier Private Finance is experienced in securing funding in both debt and equity structures. However, in explaining development finance, we focus predominantly on securing debt.
Types Of Development Projects
Development finance can be secured against a wide variety of projects. These include:
Ground Up Development
The largest project where you start with just a plot of land or where there is an existing building to be demolished.
Where certain projects are allowed to be undertaken by developers without the need for full planning permission. These are commonly extensions, the development of outbuildings, refurbishments, home improvements, in some cases change of use, and in more recent years change of use from office to residential.
Where developers are looking to improve a property. This falls into two categories with lenders; ’light’ and ‘heavy’ refurbishment, although each lender will have their own interpretation.
Light Refurbishment - where there is no need for planning. Examples might be re-wiring a property, new windows, decoration or fitting a new bathroom or kitchen, but importantly no structural changes.
Heavy Refurbishment - where structural changes are required, such as for extensions and conversions. Planning permission and/or building regulations would commonly be needed for such projects.
This is finance on a piece of land typically without planning. There are fewer lenders that offer such products as there is increased risk that the project may not achieve consent. Rates tend to reflect the increased risk and Loan To Value (LTV) will typically up to 50%.
This is typically used where planning is in place but is subject to enhancement/alterations or any other value add proposition pre commencement of the development.
What Criteria Is Used By Lenders In Making A Decision?
A lender, in deciding whether they are interested in funding a project will commonly look at the following areas:
Do the numbers add up?
Gross Development Value (GDV) - This is the future value of the site on the open market once the development has been completed. Lenders base this on a valuation that is carried out as part of the application process. A lender will then determine the amount they are prepared to loan as a % to the GDV. Lenders commonly loan 55-60% of GDV, with stretched senior debt lenders offering as much as 80% of GDV.
Loan to Cost (LTC) % - This is used to evaluate the size of the loan against the the total cost of the project, including purchase cost (if applicable). The lender will typically fund 100% of the build costs leaving any remaining money for the site purchase and other costs, subject to the lenders criteria around Loan To GDV (LTGDV). It is important to note that all lenders will lend up to the lower of the GDV or LTC maximum.
Day 1 Position - Money will be released by the lender in stages as the project progresses. The amount that is required upfront on day 1 to get the project underway will be considered. Generally lenders will be prepared to release 65-70% on day 1, with more sometimes available if additional securities are offered.
Lenders will want to know that the loan will be repaid on completion of the project either by way of re-financing or sale. The developer will need to demonstrate that this is achievable, for example, with proof that future lending is in place once the project is completed. Where the intention is to sell the lender will seek assurances of the viability of sales through the use of local estate agents and local market information, and the valuers comments.
Lenders will want to see that the developer has the experience to successfully carry out their project. A history of smaller/comparable projects which have achieved a healthy profit will typically be required. It must be pointed out that this does not count out new developers, but the scale of the project needs to match the developers experience. In addition the lender will want to see the experience of the build team including the architect, surveyors, engineers and contractors and project manager. An experienced team can often strengthen the case for a less experienced developer.
Developers Financial Strength
Lenders will want to know that a developer has the financial viability to fund the remainder of the project not covered by the loan. The developer’s personal or business cashflow will be reviewed to see that there are funds available and that there is good compliance to repayments of existing financial commitments. There will also typically be a Personal Guarantee required which ranges from 20% of the debt up to full guarantees, which lenders will want to know can be supported.
What Is A Development Loan Commonly Comprised Of?
The Net Loan
Put simply, this is the cash the developer actually receives. As discussed above, the lender will consider a number of factors such as GDV and LTC ratio in determining the size of the loan. The loan will be structured so that money is released at agreed stages in the process. This will normally be monitored by a Quantity Surveyor or Monitoring Surveyor acting on behalf of the lender, who will inspect the works and then approve that the next portion of funds are released.
Interest rates vary from lender to lender and there is no set calculation. Each lender will form their own rate based on the factors discussed above. This is the primary reason to use a development finance broker, as understanding the best facility for your project is time consuming, confusing and potentially stressful! In addition to understanding the best rates, the broker will understand how best to present the submission to the lender, taking into account the developer’s experience, financial position and merits of the project.
Interest rates are presented as either monthly or annual pricing. Typically the repayments will either be rolled up or retained and repaid at the end of the term, rather than monthly.
Also known as a facility fee, this is the fee often charged by the lender to set up the loan. The fee is commonly between 1-3%.
A development finance broker may charge a fee for arranging the loan which helps to ensure complete independence in any advice given.
Many lenders charge a fee, which could typically between 1-2% repaid at the end of the term. This is calculated either as a percentage of the gross loan or the GDV. It is important to understand how the exit fee is calculated as the differences can be significant.
On top of the loan there are other costs that you need to give consideration to:
A valuer will need to attend the site to determine the key values needed as part of the funding assessment.
Solicitor costs for the applicant and the lender will be paid for by the borrower.
Lenders will typically have admin fees built into their terms.
Draw Down Fees
As explained earlier, funds are normally released in a staged process. Given that interest is charged on a monthly basis, this is good in terms of cost control. However, lenders will sometimes charge a fee to release the funds at each stage, which need to be considered.
The draw down of funds is subject to a Quantity Surveyor or Monitoring Surveyor inspecting the works to date and that everything is progressing satisfactorily. The cost of the surveyor will be paid for by the borrower.
Telegraphic Transfer Fee (TT Fee)
Given the large sums of money being transferred the bank will typically charge a small fee to complete the transaction which will be paid for by the borrower.
What Documents Support The Application?
Whilst not exhaustive, there is a pretty standard list of required documentation that will accompany an application for development finance. These are:
Known as the residual method of valuation, this is an objective viability appraisal of the development project. Put simply, a development appraisal calculates the value of the land or property as the final output, taking into account the all associated costs and revenue. In order to ensure accuracy, the anticipated costs and revenue will need to have been stressed tested against the local market conditions.
Planning details and technical drawings
This will give the lender the opportunity to understand what the project is about and how it will look on completion. Regarding planning, commonly a link to the relevant planning portal will suffice.
Details of any S106 and CIL payments
S106 agreements are legal agreements between local authorities and developers concerning the mitigation of the impact of new housing and details any affordable housing requirements on local communities. The Community Infrastructure Levy (CIL) is a charge on new developments to contribute to the cost of local infrastructure such as schools and roads. Lenders will want to know the cost of these and its impact on the profitability of the scheme.
Schedule of works
This details what works will be carried out in various stages. Not only does this give the lender confidence that the project can be completed within the set timescales but can also allow for a draw down schedule to be created for funds.
Details of developers experience
The lender will want details of previous projects to gain confidence in the developers ability to manage the project in a timely and cost effective manner. Typically the details required are the type of project, the cost, the profit returned and the timescales.
Details of team’s experience (architects, engineers, contractors etc)
The lender wants confidence that the team carrying out the project have the relevant credentials and experience to deliver the project. Details of the previous projects and their role will be required.
Projected GDV/Sales value
The lender typically wants to see that GDV is at least 20% higher than project costs after deductions made for interest, fees and professional party expenditure. At least two local Estate Agents are usually required to confirm the future sales value upon completion of the project.
Asset, Liability, Income and Expenditure Summary
Every application will be supported by this for the Ultimate Beneficial Owners (UBO’s). In completing this the lender will be able to see if the developer can financially support themselves during the project, and also to confirm that they can support a personal guarantee if the loan is made to a corporate structure.
Details of the Company Structure
Where applicable, details of the directors and the share split in the company.
Certified proof of ID, address and deposit
To satisfy the lender that there are no breaches to anti-money laundering rules.
Development exit strategy
As development finance is a short term loan, lenders want to know that at the end of the project there is a strategy to ensure they get their money back, either by way of sale or refinance.
How Can Montpelier Private Finance Help?
Our Knowledge - As a specialist development finance broker our expertise we will help you cut through the myriad of options to be able to make a well informed decision on what is the right funding for you. We will help you understand the whole picture not just the top line rate.
Our Experience - We know what makes a good application. It is a common mistake that applicants will try and embellish their figures or experience to gain funding. Accuracy is essential in an application, and we will help ensure it is then presented as clear and well thought through.
Our Reputation - We are trusted by lenders to carry out thorough due diligence, meaning that when your application reaches them you are already at an advantage in successfully gaining your funding.
Development Finance Solutions
80% of completed project value
Ground Up Development Finance
Permitted Development Finance
No Personal Guarantee option (full/Ltd)
Development Exit Finance
Pre Construction Loans
Structured Property Finance
Joint Venture/100% Funding