Development Finance Myths

1. Who is this aimed at?

Before we get into the myths, however, I’d like to define what I mean by development finance and who it’s for.  

Typically here we are talking about debt and equity funding for developers who purchase land and build from the ground up, or work on large conversions like permitted development schemes, with loans from c. £500k up to £20m+.  What we are not typically discussing is refurbishing one property and trading up, unless it’s a large PD scheme, although much of what we discuss will apply to that market too.

2. The myths broken down..

There are 8 main myths we will discuss about development finance and they generally split into 4 areas:

Searching for Lenders and what the Marketplace looks like

Myth 1 – there aren’t many decent lenders available

Myth 2 – the best lenders are all found online

How you go about selecting lenders

Myth 3 – the cheapest lender is the one with the cheapest interest rate and fee structure

Assumptions about who can and can’t get funding

Myth 4 – if your bank declines, you can’t get funding

Myth 5 – if you have zero funds, you can’t get funding

Myth 6 – if you have credit history issues, you can’t get funding

Myth 7 – if you want to build much bigger projects, you can’t get funding

Worries about using Lenders

Myth 8 – lenders default and repossess you at the drop of a hat

3. The first myth: there aren’t that many decent lenders available

Many developers think there are the banks and only 5 or 10 other development finance lenders, mainly because of who appear early in Google, or who they have been recommended to use by their accountant or architect.  So it’s common for developers to give up looking once they’ve tried a few options and either get declined or decide they are too expensive.

There are in fact over 50 decent lending options in the development finance space, and who vary massively in terms of what they offer.

Lending products vary based on:

• Minimum and maximum lending amounts
• Geographical appetite
• Property sector appetite
• Credit History flexibility
• Maximum Loan to Cost Ratios
• Maximum Loan to GDV Ratios
• Maximum Day 1 Purchase LTV Ratio
• Interest Rate
• How the Interest Rate is applied and calculated
• How the Interest is cash flowed
• Arrangement Fees and Exit Fees
• Fees as a % of the Gross Loan, the Net Loan, or on GDV
• Whether the lender will includes other fees such as QS monthly reports

So there are plenty of good lenders out there, who vary quite wildly depending on what they can offer and who their target market is.

4. The second myth: the best lenders are all found online

It’s commonplace today that if we search for something, we look at a couple pages of a search engine and feel that this provides enough options to be working with. 

However, what the first few pages of a search engine really tell you is who has paid the most for their advertising, or has the best search marketing strategies, not who are the best options.

It may be surprising to know that a number of lenders either don’t actively advertise or don’t advertise well, and are therefore hard to find.  Most lenders get around 50% of their business from brokers, and several prefer to concentrate on that channel than spending a lot of money online.  If you want to get a better selection derived from the entire marketplace, a good quality broker is well placed to help.

5. The third myth: the cheapest lender is the one with the cheapest looking interest rate and fee structure

In today’s marketplace, just having an interest rate and fee structure % and assessing that against other lenders is not enough to guarantee you have the cheapest lender.  It may be amazing to hear this but it is true, and has huge ramifications for how you select your best lender. 

The issue is today it is not enough information.   The interest rate alone can be applied in different ways that results in different levels of interest.  You can have 3 lenders with the same interest rate, who in reality charge different amounts of interest because they apply the rate in different ways.  As a result, the headline rate on its own cannot be used as a comparison point.  

Not understanding the interest rate at a deep enough level can cost you thousands due to selecting the wrong lender.

6. Some more detail on the different way the rate can be calculated and applied.. An example of the above..

The interesting fact about development finance lenders in general is there is little in the way of standard practice, which makes comparing much harder, and it’s not just the interest rate.

Term sheets that lenders provide are very different, some lenders include fees that others do not, some charge arrangement fees on the gross loan and some on the net loan.  There are various ways they differ and comparing properly requires paying extra attention to detail and knowing where to look.  It’s really important to understand the little differences between lenders when you are searching, shortlisting and selecting.

Back to the rate though:

There are three main ways lenders apply the rate, which is either:

To the total facility, the drawn balance, or an equity based IRR model, which requires a certain return to be reached.  

So if the rate is the same (and assuming fee structures are equal too), the difference in finance costs paid between the drawn balance model and the total facility model can be as much as 30%, based on a 12-month loan.

This fact alone can have an enormous impact on who you shortlist and select.

7. An example of the above..

So let’s use a bridging lender charging 1% per month as the numbers are easy.  

Typically to understand the annual rate, most would multiply by 12, and most would say the lender is charging 12% per annum right?  That is right if the lender is charging 1% per month, applied to the total facility.

If the lender however is charging 1% on the monthly drawn balance, the annualised rate is nearer 8%, if you assume equal drawdowns over a 12 month loan.  

The calculations work in the same way as a credit card.  The interest is charged on what you have used so far, not what the total amount being borrowed is.  So the difference on large loans can be substantial.

What it means is this: you have to delve much deeper than just the headline rate if you really want to select well.  Not only that, you also need to have a good handle on your likely drawdown requirements in your cash flow.  The less you draw down earlier, the cheaper the loan becomes, and vice versa.

Some cheaper lenders have expensive exit fees, and some more expensive lenders have zero or low exit fees, so it’s often not as straightforward as it first looks.

So the three keys when comparing lenders are:

1. How do they apply their interest rate
2. Can the lender demonstrate how their calculations work
3. How does that fit in with my cashflow

Ultimately, your key constant is not the cheapest headline interest rate to calculate cost, but your cashflow, and then being armed with the right info about the lender’s calculations.

You may find, as a result, that you change your view on which lenders are expensive, and which are cheaper than initially first thought.

8. The fourth myth: If your bank declines, you can’t get funding

There are a number of myths that stop fundable developers from taking advantage of the opportunities in front of them.  Beliefs about how lenders will look at you, if you’ve been declined by your High Street Bank, is one of them.

It depends on why you’ve been rejected but it is true that the banks have a greatly reduced appetite for development since the 2008 crash.  The government’s requirement for them to hold more reserves have meant that more illiquid funding, which in your bank’s view includes development, are not safe places for them to lend.  Rightly or wrongly this is the situation, a situation that has been this way for 10 years, and shows no signs in the short or long term of changing.

So if you have been declined by your bank, do take heart from the fact that there are around 50+ non High Street Bank options that take a more flexible view to development funding that are well worth looking into.  Just because your bank says no, it doesn’t mean you can’t get it elsewhere.

9. The fifth myth: you can’t get funding if you don’t have any cash to put in

Whilst it is preferable and more cost effective to put some cash in, you don’t need cash in order to qualify for development funding.  

There are a number of avenues that can provide 100% funding for your project, either against additional assets, or on a joint venture basis with a profit share at the end.  Clearly a profit share arrangement is more expensive than traditional debt finance, but if you haven’t got that 10%-15% of project costs to put in, this type of funding is a viable option.

Ultimately, 100% funders are useful for those developers with zero funds, or those developers with cash tied up in current projects.  Either way, developers don’t have to miss out on opportunities and the profits that would otherwise pass them by.

10. The sixth myth: you can’t get funding if you’ve been bankrupt or have credit history issues

This isn’t true either, provided it’s for the right reasons!  

For example, if bankruptcy occurred because of the 2007-8 Recession, i.e. there was nothing else a developer could do to stop the problem, then most lenders are flexible and will take a view.  The reality is a lot of developers went bankrupt then, and if lenders didn’t take a view, they would be lending a lot less money!  

However, if bankruptcy was because of over trading or some type of criminal activity like fraud, then you won’t find a lender who will lend.  

As a further point on this, it is important to be upfront with lenders about any credit history issues.  Many will take a view and respect/appreciate the honesty.  If you have problems and think you can cover them up, those issues will come out in the due diligence and legal phase, at which point the lender will usually feel entitled to decline, through wondering what else they haven’t been told.  As a result it’s a waste of everyone’s time.

11. The seventh myth: you can’t get funding if the project is bigger than you have done before

Again there are lenders out there who will take a view. 

The more conservative lenders, and therefore the cheapest, like to see that you’ve done similar projects recently, so it is difficult with that market segment. 

However, the lower mid-market has a number of lenders who will look at growth projects, so don’t feel you have to miss out!  Reaching for the stars is not a total non-starter.

12. The eighth myth: Lenders look to repossess developers at the drop of a hat

We are often asked about default scenarios by developers who are worried about being repossessed as soon as there are any problems in the build.  Some of the more experienced developers are justified in feeling cautious, wary and perhaps cynical because that is exactly what happened to many developers when the banks defaulted them in their thousands in 2007-8.

The reality is today’s breed of development finance lenders really do not want to repossess borrowers because it’s not in their interest to do so, and will only do it if the developer is really messing them around.

First of all, lenders all know that problems during the build always occur, like delays in materials arriving late from a supplier.  It’s par for the course, and provided communication is good between the builder, surveyor and lender on a monthly basis, lenders honestly work with the developer to ensure problems are minimised that are beyond the developer’s control.

Secondly, it is important to note that a lender rarely wants to repossess if they can help it.  Interest is rolled up and most lenders are paid back at the end out of the sales.  Because they lend funds on the future value of the site, they won’t get their money back if they dump a half completed site in an auction, and it’s a costly exercise to complete any development themselves.

However, lenders will look to get legal and potentially default if the developer is not playing ball for a reasonable period of time.  This might be repeatedly not informing lenders of any issues that arise, if he sticks his head in the sand, refuses to communicate or flat out disappears.  The reality is regular visits from the QS for drawdown tends to keep the lender informed as to progress.

The golden rule, as in any relationship or partnership, is honesty and good communication.  Every development project has some sort of hiccup and lenders know this.  What’s important is that the developer keeps the lender up to date and if they foresee any issues, let’s them know as soon as possible.  Lenders are far more accommodating than many developers realise.

As long as the partnership is based on good will and communication, lenders will work with developers, not against them.

13. In summary

Firstly, speak to industry professionals if you aren’t sure about something.  We’ve pointed out myths about what the marketplace looks like, as well as common misconceptions when searching for funding, selecting lenders and assumptions about the availability of funding and on what basis.

Secondly, a lot of these myths either discourage developers, or mean they miss out on great opportunities that come their way, which is a shame. 

What I would say to developers is be encouraged about the landscape.  There are ways around certain situations and please don’t assume you can’t get funding until you’ve spoken to some decent industry professionals about your situation.  You might be surprised that the marketplace is different to what you imagined and you can get funding when you initially thought that you couldn’t!

To continue with the section, click on any of the sections below:

• The Basics
• Preparing for Funding
• Assessing Lenders
• Explaining Jargon
• Did you Know?
• Asset & Liability
• Lender Comparison Data