Development Finance: The Basics
1. Marketplace Overview
In the UK there are around 40 specialist non-bank development finance lenders, plus the banks. There are also other types of lenders that we will cover later.
The lenders mentioned above are commonly known as senior debt lenders, that is they lend the priority debt and take the 1st charge like a bank would. They are the cheapest lenders and typically lend on full planning only. These are the ones we will focus on primarily.
Across these lenders they have varying products and appetite across a range of criteria including sector, geography, developer experience, leverage and minimum/maximum lending amounts.
Firstly, though, we will start with the key components in a standard senior debt development finance product.
2. What A Development Finance Product Looks Like
The key components are:
1. The Net loan
This is the cash the developer will actually receive. Lenders calculate the amount against the future value of the site, known as the Gross Development Value (GDV), based on a valuation conducted during the application process.
Other calculations considered are the Loan to Cost ratio (how much cash is the developer putting in), and the Day 1 LTV if the site is being purchased.
Lenders typically fund 100% of the build costs, and what is remaining is provided to fund the site purchase (if required).
Interest, unlike a typical bank loan, is rolled up and not serviced monthly. The interest is either retained or paid from sales at the end.
3. Interest Rate
A percentage usually and one of the more mystical elements. The rate can be calculated at least 3 different ways, and lenders use a variety of projections and methods to come up with their calculations. The lack of standard practice on interest is one example of why comparing lenders is so difficult.
4. Arrangement Fee
Lenders usually charge an arrangement fee in the 1% to 3% range, calculated against either the gross or the net loan.
5. Exit Fee
Lenders often now charge an exit fee in the 1% to 3% range, calculated against either the loan or GDV.
Anything from 3 months up to 36 months. Unlike a commercial mortgage, development finance is short-term funding focused exclusively on the project timeframe.
Other aspects to note are as follows:
Security - Lenders will take the 1st charge over the site, so any other debt on the site when it comes to applying will need to be cleared. Lenders will also take a debenture over the site, which preferably sits in a clean, separate Special Purpose Vehicle (SPV), usually a limited company.
Partner Security - Lenders want further protection when it comes to the contractors, building and service providers involved in the project. Appointment Letters, JCT Contracts, Professional Indemnity Insurance, Collateral Warranties and Homes Insurance are required.
Timeframe to loan completion - the average transaction is around 8-12 weeks.
Working backwards, this is broken down into a minimum 2 week legal period, a 2 week valuation period, 2 weeks for credit, and 2 weeks for initially meeting, site visits and info collection. Lenders do vary in speed, so the above is an average.
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3. How Lenders Assess Developers
When applying to lenders, the standard areas they will consider, to decide if they are interested, are as follows:
The Project Numbers
Do they work for the lender’s critieria (i.e. Loan to GDV %, Loan to Cost %, Day 1 LTV, project margins)
Some lenders will only look at London and the South East, some will go in England and Wales, and some all over the UK.
Viability Of Sales
The lender will want evidence that the GDV is achievable, which is gained from local estate agent letters confirming sales values.
Exit is by either sales or re-financing. Can the developer demonstrate the strategy is achievable?
Some lenders will work with new developers, some want only experienced firms. Either way they want to know “are you a safe pair of hands?”
Lenders vary as to how much they want you to put into the deal. They want to see the required level of cash is available.
Developer’s net financial strength
Lenders will require a Personal Guarantee in the region of 25% of the loan. They want to see the developer can support that amount.
Once the Build Period Begins
A couple of key points to understand once the loan completes, and the build period begins.
How funds are drawn down – funds are not usually given 100% over to the developer to do with what they like. A Quantity Surveyor or Monitoring Surveyor is appointed, and at regular intervals will inspect the work, approve, and then that portion of funds is released to either the contractor or sub-contractors.
Defaulting – lenders by and large are not that keen to default a developer if they can. Taking over the site is costly, but will be done if the developer is not playing ball. What most lenders say is if problems occur, be upfront and communicate with the lender. Lenders are in the money business, not the property business, and it is in everyone’s interest that the site completes. Lenders will work with developers, not against them, if communication is strong and heads are not stuck in the sand!
4. Other types of Development Finance
On top of senior debt, there are other financing options:
Mezzanine Finance – also known as second charge lending or junior debt, this concept is essentially top up funding. Sometimes the senior debt loan isn’t enough to cover the whole loan required, and a top-up funder can provide some, if not all, of the shortfall. This type of funding is far more expensive, from 1.5% per month up to 2.5% per month.
Equity finance – typically the most expensive funding, this can cover any remaining gap in the funding shortfall. This is usual the final 10-15% of the funding chain and in the 2.5% to 3.5% per month range.
JV finance – a form of equity finance, this is where the equity doesn’t cover 10-15%, but potentially the whole 100% required. Rather than an interest rate, JV funders look for a % of the profits at the end of the term.
Ultimately these are all different ways of cutting up the same funding cake, and depends on the what the project numbers look like, how much cash the developer has to put in, and how much he/she is prepared to put in!
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