There are many different types and sources of property development finance available and it’s certainly an area which we can get creative around. This is the beauty of property development, we have the ability to create a property development ‘finance package’ which is unique to the site we are looking at, and we are not restricted to one or two sources.
When it comes to actually paying for a development or construction project (both commercial and residential), the financing of it is usually in the form of some kind of advanced loan. This could be to cover the initial cost of buying the land, or for the actual conversion or modification of the building itself, or to cover all costs.
When it comes to actually getting the finance, it’s best of you’re a builder or property developer already and have the relevant experience. This is slightly off topic, but, to make the project more viable and increase your chances of funding the project, you need to have a professional team in place to carry out the work itself and it often helps to have a great finance broker on your side.
Property development finance can be split into two main forms… Debt or Equity.
Lets dig into this a bit deeper…
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Property Development Finance: DEBT
Debt is when we borrow money from a lender or investor with the intention to pay it back with interest added on top. The amount of interest will usually be fixed, and traditionally we will borrow a significant amount of our property development finance from a specialist property development lender.
Just like mortgages or any other loans, the amount you can borrow will vary depending on the lender and your own project plans, including the amount of equity that you have available.
Typically, we see borrowing between 50% and 75% of the total project costs using debt, which can include:
- Land acquisition and site finding
- Administration or other fees relating to the purchase cost (likely to be things like legal fees, stamp duty, agency fees etc.)
- Professional team and design fees
- Sales and Marketing costs
- Construction and build costs
- Finance (Fees and interest for the loan)
The length of term you can borrow for again varies between lenders and depends too on your individual circumstances.
It’s extremely important to factor in any unexpected issues too, such as supplier delay or budget over-run. Otherwise you may encounter debt problems you haven’t planned for, which could damage your changes of further development loans down the line and the profit of the current project. This is why we always include a healthy contingency in our numbers and forecasts.
It is also common practice to ‘roll up’ the interest costs of the loan, so that the total amount of interest payable to the lender is paid at the end of a project, not on a monthly or quarterly basis. This helps our cash flow and it keeps things simple.
Now let’s look at the main sources of debt finance:
No, it’s nothing to do with pensioners or the Bank of Mum and Dad. A senior loan is in fact a type of debt financing whereby the financial institution or lender that gives you the loan will have the benefit of first charge over the asset provided by the borrower as security.
This could be a borrower’s existing home or other high value asset. The reason it’s called a “senior” loan is because it’s the most important one in that it takes a precedence over all other unsecured loan claims against the borrower. Therefore, the Senior Debt is always paid back first before any lesser loans, which are know as “junior” loans.
In the event that the borrower defaults, the property used to secure the loan will be used to repay it prior to repaying any other creditors. Senior loans are typically of a medium to long term nature and can range anywhere from one to five years.
Mezzanine finance is a type of funding option which is used mainly by property developers to pay for some of a building development project’s costs and usually stretches the gap between a senior debt loan and the equity being invested.
Mezzanine funding is normally secured as a second charge behind the project’s main lender for the development.
Mezzanine lenders will invest in a development project having generally agreed with the developer that they will receive their initial investment back plus some interest. On top of this, some lenders will expect a certain pre-agreed percentage of the profit from the development. However, some lenders may just charge a higher rate of interest for the duration or have an agreed set fee.
Mezz finance is more ‘expensive’ than senior debt, i.e. the interest rates will be higher because they are lower down in the pecking order when it comes to repayment of loans.
Temporary and short-term, bridging finance is essentially a business loan designed to literally buy you time, fast. What makes it short-term, as opposed to permanent, is that you only have the loan until you can either clear the balance in full or secure a finance plan which is less temporary. That’s where the “bridge” idea comes in and it’s a useful tool to get you from one step of your project to another.
Short term hurdles, such as buying the property or renovating it, are important to lenders when it comes to your reason for needing a bridging loan. As property finance goes, a bridging loan can be for both commercial and residential purposes, as well as for new buildings from scratch or smaller renovations.
This type of property development finance is not so popular with new build developers, however, can be perfect for refurbishment projects or those sites with a short programme.
Very simple… a loan secured by a private individual, known as an investor.
There are many individuals out there willing to lend property development finance, and its a great source of funding for your developments. Many investors may not have the skills of a property developer and like a passive investment.
This is where your networking skills really need to flourish as seeking out these sources of property development finance can be extremely attractive.
Property Development Finance: EQUITY
As an alternative to the loan route, a property developer may decide to offer shares in the property development company to an investor. The main types of shares are Ordinary shares, Preference shares and Partnership shares.
It’s worth noting that the money raised from an investor will then mean they have ownership or part ownership of the project itself. This adds an element of risk to that money if the project fails or doesn’t generate the finance it was expected to.
It could be considered that investor equity is the less safe option compared to a loan. You should therefore make sure you’re totally clear about the rights and obligations your share holder(s) would have, as well as your own.
Essentially… we cant think about equity as taking a share in the company…
Lets take a look at the main share options:
The return on these shares can either be in the form of income (dividends), or by way of a capital gain if the shares are later sold. Ordinary shares are considered to be the most risky, as they’ll only give a return on investment if the development makes a profit. Essentially, there is no guarantee of a return on the amount invested.
Holders of these types of shares may not have a say on how the property company is managed so is in effect quite similar to a loan. The way Preference shares work is they allow for interest to be paid on a regular basis. However, if the company does not generate sufficient income to pay the interest, there is a certain amount of flexibility there which can prove useful. This is because although unpaid interest may still accrue, it only becomes payable when the company has enough income to do so. It’s worth knowing that this type of share will rank ahead of Ordinary shares if it’s decided the company should be liquidated.
Increasingly, developments are procured via Special Purpose Vehicles (SPV’s) which can often constituted in Limited Liability Partnership (LLP) form. This type of structure is increasingly popular, mainly because of the way in which it is treated for UK tax purposes. It’s particularly useful when one or more investors come from other countries, and so everyone involved has different tax liabilities.
Investing in a LLP for property development generally involves giving investors just a small shareholding. This then represents their capital investment into the venture, together with loan notes for the agreed amount. Throughout the duration of the project, shareholders do maintain certain rights, although the actual hands-on management is done by the managing partner.
We all know that a property development project usually needs a lot of money, which can be eye watering. We need to buy land, fund the design process, secure permissions, decontaminate the land, build the development and then finally sell it.
The good news is, though, that you can see from above that we have soo many different sources of property development finance. This is not like a BTL property where we can only get 1 type of mortgage.
We can be creative and put together interesting packages of property development finance. In some cases the success of our project comes down to how we structure the finance sources available to use.
But… as one parting piece of advice… use professionals when you can, especially during the early due diligence period.
Speak to your accountant and finance broker and make sure they are engaged in the process. They will be able to help at the critical points in the timeline of the project to make sure everything runs smoothly and the main risks are mitigated.
Hope that was of value, and all the best…