What is development finance? And how does it work? This article tells you the key facts about project financing and development loans.
What is development finance?
Property development finance is a type of business finance which is used to fund a residential, commercial or mix-use property development. It’s a fairly broad category that covers a multitude of lending arrangements. This can include term loans, mortgages, and bridging loans. However, development finance is predominantly concentrating on larger scale funding for developments from the ground up. In this context, we are typically talking about property development for apartment blocks.
Projects which require lighter work, such as internal refurbishment are probably better suited to bridging loan finance.
How does development finance work?
Development finance can be more complex compared to residential mortgages. Funds are advanced upfront and then at various stages throughout the build
At stage one, money is initially advanced against the value of the site. Typically, lenders advance up to 60-65% of the value. Though some lenders offer more.
Once the build has started, additional funds are released at agreed intervals. Lenders are often happy to fund up to 100% of the build costs. At the time of each stage release payment, the site will be re-inspected by a lender representative, or a third party surveyor. If the lender feels the work is progressing to plan, they will release the next stage of funds. Essentially, the lender is looking for confirmation that work is being carried out to a high standard and there is sufficient value in the site to warrant the next stage of funding.
This process of reinspection and further staged drawdown are then repeated a number of times. This cycle finishes when the development is completed.
How is the interest paid?
Interest is calculated differently compared to residential mortgages. Usually, the lender retains interest upfront at each stage of drawdown. This means there are no monthly payments to make. As soon as the development is complete, the loan is redeemed along with any accrued interest.
This way of doing things suits the borrower and lender alike. This is because cash flow can be difficult to manage during a development build. Removing the need for monthly repayments makes the loan easier for the developer to manage. The lender they have the security of interest upfront.
How much does this finance cost?
This is the million dollar question. And the rate charged will depend on a multitude of factors. The main factors are listed below.
- Loan size. Loans of £500,000 or more, typically cost 4-9% per annum depending on other factors. Larger loans can be as high as £100 million. Whilst small loans of a value below £500,000 will usually cost 9-12% per annum. However, if the deal is sound this cost could be reduced to 6.5% per annum.
- Gearing. A higher percentage of borrowing from the lender will result in a higher interest rate. This is because the lender has less security, so it perceives the deal to be riskier.
- Creditworthiness. Lenders look at the directors of the business and the solvency of the company and will make a decision as to risk. If a company is financially sound and so are the directors, then the lender will offer preferential rates.
- Experience. Lenders like a track record. If the management team is experienced, then this will give the lender confidence and will be reflected in the rate.
- Wider economy. Lenders will look at outside factors when determining how to price. They will look at things like the current base rate, inflation, as well as take a view on the strength of the property market.
There will be some other fees. The main ones include:
- Lender arrangement fee. This is typically 1-2% of the loan amount.
- Lender exit fee. This fee is not charged by all lenders. If it is, it can be 1-2% of the loan amount.
- Broker fees. Most brokers expect to earn 1% for arranging a property development loan. This could be paid directly from the borrower, or indirectly via the lender.
- Surveyor fees. These can vary widely and is in part determined by the requirements of the lender.
How much can I borrow?
Lenders use several key metrics to calculate the maximum loan for development finance. These metrics include:
- Loan to gross development value. Otherwise known as a loan to GDV, this is the maximum percentage of the loan that the lender is willing to offer. Gross Development Value is the anticipated end value of the development when the project is complete. So if a £10,000,000 scheme had a maximum loan to GDV of 70%, the maximum total facility would be £7,000,000.
- Loan to value (LTV). The loan to value ratio is used to calculate the maximum available advance at any given time. The monitoring surveyor will revalue the site throughout the build to ensure the lender is never overexposed.
- Loan to cost (LTC). – Lenders want you to put up a percentage of the money yourself. This way you share the risk. Loan to cost is used to calculate this. For example, a maximum loan to cost of 90% would mean that the lender will only put in 90% of the total cost of works into the scheme. This means you would pay 10% of the total project as a deposit.
A lender will combine all three of these factors to calculate the maximum loan. Where there is a discrepancy between these figures, the most conservative one will be chosen to cap the loan.
What happens when the project is completed?
When the development is finished the loan will need to be repaid. At this point, you can refinance to a term loan such as a mortgage, or switch to a specific development exit product until the development is fully sold. Restructuring finance at completion is a better option for maximising profit, as development finance is more costly compared to other lending forms.
We have composed a list of frequently asked questions about development finance. This will provide you with further information about how it works and whether it is the right option for you.
Our lending partner is well versed in development finance. They have helped many developers secure the finance they need, at very preferential rates. As a specialist broker, they have access to a range of funds outside of the high street. Contact your property consultant today to discuss your options.