Development Finance
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Development Finance
Scott West explains all about development finance.
What is property development finance and how does it work?
Development finance is a step up from refurbishment finance. For most people it funds ground up development, where you’ve found land, you’ve got planning permission and now you want to build on it. It might be flats or houses – anything from the ground up.
Some conversions might fall into this. If you’ve got a big office block that you will convert into residential that can be funded with finance as well. The primary one we deal with is where people buy land fairly cheap and hold it while they obtain planning consent. Once that’s in place, they approach us for development finance.
The lender will give you 65% as general rule on day one and then they will give you 100% of the build costs. These are paid in arrears, much like the refurbishment bridging loan we discussed before.
How much can I borrow with development finance?
As much as you like! The bigger the deal, the more you’re able to borrow. The limiting factors will always be the Gross Development Value (GDV) and the Loan to Cost ratio.
Imagine you were going to buy a plot of land with planning permission at £500,000 and build four houses on it. Your build costs are going to be £800,000 but your final value when finished will be £1.5 million – but those numbers don’t stack up. Your profit margin will be relatively small and you need to look at the overall saleability at the end.
Even if the intention is to refinance those properties, we need to look at a profit margin. A lender will be interested in this. A profit margin of 20% is a good number to bear in mind, but it depends on the product and the property location.
100% of the build costs will always be factored in. Then, working backwards, you can determine your day one loan. More often than not it’s 65%. If you have a large build, where you bought land really cheap and are putting up 50 houses – then the lender might restrict your day one loan because the bulk of the money is going to be in your build costs.
Can I get 100% development finance?
You can, as long as you’ve got other assets somewhere that we can cross charge. The build costs are always 100% percent financed and paid in arrears. You can receive this in as many or as few charges as you like. Most people aim for every two or three months but if your cash flow is quite tight it can be made monthly.
On the land acquisition side, if the lender is going to give you 50% or 65%, if you have equity in other securities in your portfolio, we can cross charge the shortfall. Even if they’re in different legal entities, a personal name or different links to companies, we can effectively give you 100% finance on your development.
Who is eligible for development finance?
Everybody’s eligible for development finance. Your credit isn’t a huge part of the consideration so it really comes down to the project, how profitable it is going to be and your exit strategy.
Everybody’s eligible in essence, but if you’ve never done any developments before, not even a home refurbishment, the lender is going to be hesitant to lend you a significant amount of money. You need to start small with a couple of projects and build up a bit of a track record of completing projects on time, to a good standard and exiting effectively – whether that’s sale or refinance.
As you develop a track record, lenders will lend you more money on bigger projects. Even if you’ve got significant experience, lenders often require you to have a specific size of building firm involved, or an experienced project manager on board. This applies to big developments with maybe 30 or 40 houses.
How much does development finance cost?
It’s not too dissimilar from bridging finance. Interest will start from 0.8% to 1.2% per month depending on the project’s projected profitability. If you’ve got a project that’s going to be squeezing that quite tightly, at perhaps 15% to 20% total profit at the end after build and finance costs, you might find a lender puts the rate up closer to 1.2%. The same goes if you’ve got credit issues.
If you’ve got a project with fantastic profitability, you have your own building firm and you’re very experienced, the lender is going to be much more comfortable with the risk so you’ll get closer to 0.8%. Risk is the deciding factor on how much your borrowing is going to cost.
When do I need to repay a development finance loan?
The repayment is on the exit. The term will be decided up front, depending on the project size. If it’s a small one, such as building a home at the bottom of your garden, a 12 month term is plenty. The lender will give you time to build and then a reasonable period to either refinance or sell. The repayment of the loan comes from that sale, or the new lender coming in with a mortgage.
With larger projects, if you’re building 30 or 40 homes – I’ve got one going on potentially with 250 houses on a single site – the lender will give you two or three years to do that. They’ll probably stage the funds into different tranches. Phase one might be the build, phase two of could be the sale of the first hundred houses, and so on. Each phase will be repaid on exit.
You might use the sale of those properties to repay the loan or if you refinance again, the new lender comes in and just replaces the development finance as a whole.
What are the pros and cons of development finance?
I’ll start with the cons because they’re not really cons, to be honest. You’re borrowing someone else’s money and there’s a cost for that, which reduces your profitability.
Everybody looks at houses as a potential fixer-upper. But when you consider the other mitigating factors, the profitability on those projects decreases significantly.
But that’s the best thing with development finance. When you build up 12 months worth of costs and you throw in some legal fees or a valuation fee, the costs on paper look fairly significant as a percentage. But you can largely offset those things against your tax bill, with your accountant’s advice.
Development finance lets you do a project that you couldn’t fund yourself. The big pro is that you can run a project with very little cash input, and still make a profit margin based on its gross value.
If you get 100% of the build costs and you get a 65% day one loan, you’ve only put 35% into your purchase. And if you achieve a 20% total profit that’s a great return on your cash investment. So that’s the pro – to cash flow a project that’s outside your reach.
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How do you apply for development finance?
The process is similar to bridging but there are far more numbers to crunch. We need a much larger understanding of the build costs and the timescales. When are the building firms coming in? Are you going to have other subcontractors in, such as plasterers, carpenters and electricians? We need to understand all the costs – including fittings. I had a client recently who had to go out and get a quote for 37 ovens, 37 bathrooms and 37 kitchens.
Buying in bulk does make you a saving, but you have to factor in every element of that build from the taps to the doors. Your costing needs to be very specific – it’s not like when you refurb your home and you ask your lender for £10,000 for a new kitchen. It’s more in depth.
There’s a lot more for us to package and present to the lender in the right way – that’s a key driver for them offering terms.
Probably 20% of the development loans we look at go through to the client making an offer on some land. That’s because we do our due diligence first. We look at the entire profitability of a deal, the finance costs and the total profitability. That’s what allows a client to go away and make an offer. Most of the clients we deal with won’t even engage with a seller until they completely understand what profit they’re going to make.
What if I have bad credit? How does this affect me getting development finance?
Similar to bridging, it is a factor but it’s a lesser one, because the risk is partly removed by the fact that the lender is going to provide you all of the build costs. By doing that they are ensuring there are no cash flow issues that stop the build from completing.
They can always sell something that’s finished, even if you can’t refinance it. That’s a really important part to consider. If you have bad credit we need to have a very honest discussion about the feasibility of an exit. If your credit’s bad, and you aren’t keeping the finished project, perhaps we can’t exit. We have to find you a lender that is cost effective – but we can have that conversation upfront.
From the development side, it is a factor. They may price you slightly higher if you have really bad credit, but it won’t stop you getting the finance.
What else do we need to know about development finance?
The first few projects you find you probably won’t want to go ahead with. But if you come across something you like the look of, send it to me as a case study and let’s have a discussion. Once we’ve done that and you understand the costs, it might be that this project is slightly too big – but it gives you a really clear understanding of what the process looks like, the cost and how you would exit.
Once you have that as a case, you can replicate it and find other things that fit you better. Start looking at development projects near you, have a look at them as they’re going through. We’ll quote them up and illustrate how the whole thing looks. That gives a much clearer image of feasibility. Most people think this is an inaccessible product to them, but it’s not.
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