Structuring Finance for Development
With over 12 years’ experience in development finance, I have seen a lot of different funding structures for property development.
I have seen projects go exceptionally well for both the developer and lender and equally projects that have resulted in both developer and lender losing money on projects.
As with any area of property development, there are some basic principles to consider when structuring finance for property development.
Focus on the right funding for what you are looking to achieve
The way I see it, there are two key starting points when looking to secure development finance and it’s important to identify which side of the fence you sit to find the right funder for your project.
● Do you want to put as little money as possible into the project
● Do you want to pay as little as possible for your funding
Now I know what you are thinking. You want to borrow as much as possible but pay as little as possible. Was I right?
The reality is that there are lenders with a higher risk profile who will happily lend you more money or a higher loan to cost ratio (LTC) but they will charge accordingly. It’s the age old risk vs reward payoff.
On the other side, there are lenders who will have a lower cap on their LTC that they will lend you; as the money they would be lending you is lower risk,and they can charge less for lending you the money because they are less likely to incur losses.
When embarking on a new project a good starting point is to work out how much money you or your business can comfortably put into the project and then work back from there to assess the funding options at your disposal.
For example, if a development had total development costs of £1m and a GDV of £1.25m – and you know that you can comfortably invest £200k in the project, and need to borrow £800k to complete the project – this means you will be looking for a lender who can consider lending you either 80% of total development cost (LTC) or 64% of GDV (LTGDV).
As a rule of thumb, most funders will want you to invest a minimum amount of equity of 10% of the total development costs into a development project.
Choosing the right lender or mix of lenders
Once you have identified how much money you need to borrow the next step is to work out if it’s best coming from the best lender or a mix of lenders.
As we already covered, different lenders have different risk profiles and charge accordingly for the risk.
● A low risk high street bank may provide up to 60% LTC and charge 3-5% interest
● A mid risk specialist lender may provide up to 70-80% LTC and charge 6-8% interest
● A high risk stretched debt lender may lend up to 90% LTC and charge 8-15% interest
You can also combine lower risk lenders with higher risk mezzanine lenders which will allow you to pay less on the bulk of your finance and pay more only for the higher risk portion, whilst potentially reducing your equity contribution.
For example you may structure a deal where:
● A mid risk specialist lender provides you with 70% LTC at a 7% interest rate
● A mezzanine lender provides you a further 20%, taking your exposure to 90% LTC and will charge an interest rate of 15-30% for that higher risk slice of money
● You will only need to put in equity of 10% of the total development cost and the blended interest rate is 11% (assuming the mezzanine charges interest at 20%)
Understanding the costs of finance
It is important that you truly understand the likely cost of borrowing the money for the development in a mix of scenarios. You can do this either by building your own spreadsheet or using a tool such as Aprao which lets you quickly model out multiple scenarios and understand the true cost of borrowing the money.
I would always assume a minimum of three scenarios:
● Base case – what you think is the realistic outcome
● Mid case – what happens if your build costs increase and sales take a bit longer that expected
● Worst case – you see a large rise in the cost of the project and the market slows down so it takes a lot longer to sell the completed units
Here is an example of three scenarios in Aprao:
You can also create a sensitivity table to look at many scenarios at a glance. Here is an example from Aprao, which automatically generates a sensitivity table for each project.
What to look out for
Despite what many people think, there is an abundance of finance available for property development for the right projects, even in a post Covid-19 world.
However, it is key to work with a lender who is aligned with your plans for the project and will stand by you if things don’t go quite to plan.
The key things to look out for are:
- Reputation: Make sure that you have spoken to another customer borrowing from the lender or lenders. You will quickly find out the truth about how they have performed on past projects.
- Hidden fees: Read the terms thoroughly and understand the fees in all eventualities. If the market drops during your project, you may breach one of the loan parameters which may mean you go into default. This will adjust your interest rate and may have other fees attached to it.
- Know your numbers: Plan your project cost with contingencies to make sure you have raised adequate finance for the project. Running financial appraisals and cash flow forecasts will ensure you stay on top of the project costs and avoid having to borrow additional money later on in the project.
About the author:
Daniel Norman is the CEO of Aprao, a cloud based development appraisal tool. Aprao is designed to help property companies improve the way they look at projects by reducing the time to review projects by up to 85% whilst improving accuracy, consistency and efficiency. Get 30 days free at aprao.com.