Development Finance

Why is development finance important?

In the UK, the development finance sector is currently worth around £9 billion annually.

It is the crux of almost all property development. Not many people have millions of pounds lying around spare, so for most projects to actually go ahead, developers need access to funding. 

This niche funding specifically supports the property development process, with lenders taking the time to understand the project in detail and tailor loans accordingly. 

How does development finance work?

Development finance works in two distinct phases, these include:

• Phase 1: Acquisition of land
• Phase 2: Funding the construction process

Phase 1 is straightforward enough, a loan is provided to secure the land.

Phase two is a segmented approach, with payments made in tranches at key points throughout the construction process. 

The specifics of the tranches (how much and how often) are agreed from the outset with the lender’s Independent Monitoring Surveyor (IMS) to align with the building schedule. This can change as the project evolves, but accuracy is essential when planning the build costs and schedule to ensure that there is adequate cash flow throughout the project.

Lenders will monitor the progress of the build, ensuring it corresponds to what was presented in your loan application and that the project is staying on track. Paying development finance loans in stages mitigates risks for the lender but also works for the borrower by avoiding funds being ‘drawn down’ to sit unused in the bank, accumulating interest charges.

How much can someone borrow?

Development finance loans are complex to arrange, which makes them resource-intensive to the lenders due to the man-hours and team of professionals engaged. Based on this, most lenders won’t consider applications below £150,000.

Similarly –  due to economies of scale –  lenders prefer working with bigger loan amounts as it takes a similar level of resource to underwrite a £500,000 loan as it does a £5m loan.

How much can be borrowed depends on four key metrics:

• Gross Development Value (GDV): A % loan cap against GDV (what the site is expected to be worth on completion)
• Total project costs: A % cap against total project costs (including loan interest & loan arrangement fee)
• Borrower equity: A minimum % input of client deposit / equity
• Day one land leverage: A % cap on day 1 land leverage 

The lender will complete professional valuation reports of the site and building plans and calculate Loan to GDV (LTGDV) and Loan to Cost (LTC) to determine their lending limits. The loan amount needs to respect all four of the above percentage caps and whichever cap is hit first determines the gross loan amount.

The criteria and lending parameters will differ across development finance lenders in the UK. 

How is the loan repaid?

The loan repayment, or exit strategy, is established from the outset with it being key to securing a development loan. After all, the lenders want to know how you plan on repaying their investment! 

The repayment of a loan generally happens in one of two ways:

• Sale of the project: An outright sale will repay all loans, mezzanine investors and equity input
• Refinancing of the project:  If the developer keeps the build for rental, they will refinance on a longer-term loan.

In either scenario, the lenders receive what is owed to them.

Residential vs commercial development finance: What’s the difference?

Depending on your project, you will either have a commercial or residential development finance loan. 

As the name suggests, residential development finance is used for developing residential housing or flats that the developer will then go on to rent or sell (think Redrow, Taylor Wimpey, etc.). They are not designed to be used by people building their own homes  (a self-build mortgage can be used for this).

Commercial development finance is used by the borrower to develop commercial spaces to rent, sell or use as their business premises. Examples of commercial property include:

• Offices
• Warehouses, storage & logistics space
• Student accommodation
• Retail space, restaurants & leisure centres
• Medical facilities & care homes
• Hotels

* Where the borrower intends to keep the commercial building for their business premises, they must demonstrate they can refinance on a commercial mortgage. If a tenant will occupy the building, lenders will require a formal pre-let or, if the plan is to sell, a pre-sale agreement.

Types of property development finance

Funding a project will likely involve a combination of different types of property development finance, requiring an upfront equity (deposit) contribution from personal funds or private investors. Any financing gaps may be filled with secondary (smaller) loans, forming a Capital Stack typically with three layers: senior debt, mezzanine finance, and equity. Let’s explore in greater detail below:

• Senior Debt: This primary funding source covers 50-70% of site costs and up to 100% of build costs.. As the first-charge loan, it's prioritised for repayment.
• Mezzanine Finance: Serving as a second charge loan, it reduces equity needs and carries higher rates due to its repayment after senior debt.
• Equity Finance: Normally structured as ‘preferred equity’, so the investor is paid out before the borrower(s), equity finance fills the gaps between the debt and the purchase price or value; it normally involves profit-sharing and is repaid after senior debt and mezzanine loans.
• Bridge Loans: Although not development finance per se, they offer short-term funding solutions typically used for initial land acquisition or to repay development finance, or for lighter build / refurbishment work, with rates starting at around 5%. Interested in finding out more? Take a look at our bridging finance page for more information.
• Joint Venture Finance (or 100% finance): This partnership offers 100% funding for projects, involving a profit split between investor and developer. This can be a good option when a borrower's funds are limited or invested elsewhere.

To learn more, take a look at our short guide that covers the different types of property development finance.

Example of Funding Structure

The following example demonstrates how to finance property development:

• £500,000 land/site costs
• £800,000 build costs
• £2,000,0000 GDV

Total development funds required: £500k + £800k = £1,300,000 plus lender costs. 

If the lender offers 100% of build costs and 60% of the site, the senior loans would be £1.1m 

The £200,000 shortfall, plus added lender costs, is funded by the developer’s cash.

Alternatively, they can look to reduce the deposit further by arranging a mezzanine loan or equity funding.

What Can Development Finance Be Used For?

Development finance can fund a huge range of property development projects, from single dwellings or commercial spaces to the ground-up construction of 400+ residential units.

Whether commercial, residential or mixed-use developments, what is developed is partly determined by local community needs and the physical restrictions of the site. 

Examples of what development finance is generally used for include:

• Land Acquisition: Land purchase for residential, commercial, or mixed-use development that has planning and is shovel-ready. (If the site is pre-planning, a bridging loan would be used).
• New Builds: Construction of new properties, including single-family homes, apartment buildings, office spaces, retail centres, gyms, warehouses and more.
• Renovations and Refurbishments: Renovating, restoring, or upgrading existing properties to increase their value
• Conversion Projects: Converting properties from one use to another, such as turning commercial buildings into residential units or vice versa.
• Property Expansion: Adding or expanding existing properties, such as adding new floors, extensions, or additional buildings
• Infrastructure Development: Development of infrastructure related to property development, including roads, utilities, and landscaping.

The Cost of Property Development Finance

The cost of property development finance varies with every product, project and lender – and it doesn’t just come down to the interest rates. Different lenders use diverse criteria to assess risk, leading to various loan amounts, interest rates, and fees. Brickflow aims to simplify this complexity, offering instant, live loan results for more accurate borrowing cost estimates.

Interest Rates & Fees

Interest rates for development finance are currently between 8% and 14%. The rate you secure depends on several factors:

• What percentage of the land/site value you are borrowing (Loan to Value)
• What percentage of the build costs you’re borrowing (Loan to Cost)
• The value of your finished project (Gross Development Value)
• The level of risk for the lender, considering your experience and CV as a developer, the project, your exit strategy, your marketing budgeting, your financial situation, and your level of equity contribution

You can read more about how lenders assess applications and determine their lending criteria and rates in our guide on Building the Perfect Property Presentation.

Understanding Costs Beyond Interest Rates

Interest is usually charged monthly on the outstanding loan balance, allowing for potential savings if the loan is repaid early. Additionally, loans include various fees:

• Arrangement Fees: Charged at setup, typically 1-2% of the loan
• Exit Fees: Charged upon loan exit, based either on the loan amount or GDV, impacting overall cost significantly
• Valuation Fees: Vary with the project's size or GDV, lender-instructed independent project valuation
• Professional Fees: Covering expenses for architects, surveyors, project managers, and solicitors

Chasing the lowest interest rate can be misleading, as it may come with lower lending limits. Specialist lenders might have higher rates but offer up to 90% Loan to Cost (LTC) ratios, significantly decreasing your deposit requirements.

Impact of LTV and LTC Ratios

Below we explore the impact of LTV and LTC Ratios

• LTC (Loan to Cost) Ratio: Compares financing against total project costs, influencing interest rates based on risk
• LTV (Loan to Value) Ratio: Assesses loan against land purchase price, affecting land leverage
• LTGDV (Loan to Gross Development Value) Ratio: Compares loan against expected project value upon completion, with higher ratios indicating higher risk and rates

Lower ratios may achieve lower interest rate results, but securing a loan with 65% LTC compared to 90% frees up your capital, potentially allowing you to invest in another project simultaneously. Having simultaneous projects at different stages of the development cycle can earn you far more than the savings made by opting for a loan with a lower interest rate.

Calculating Overall Finance Costs

Most borrowers lack frequent market interaction, leading to a gap in understanding optimal borrowing strategies. 

Brickflow offers a platform for quick comparisons of loans, interest rates, equity requirements, and what we call ‘true monthly costs’, which we believe is the best way to compare loans fairly. 

Here’s our formula for calculating true monthly costs:

• (Interest Rate / 12) + (arrangement fee + exit fee) / number of months.
  • E.g. (9% / 12) + (3.5% / 18) = 0.94% per month

What are the pros and cons of development finance?

As with any type of financial loan, there exist pros and cons to development finance. 

The Pros of Development Finance

• As a tailored finance solution, it can fund an array of projects, with the only limit being the strength of the project
• First-time developers who present a viable project with the right due diligence can access finance
• Incremental release of funds ensures adequate cash flow throughout construction and helps keep the project on track
• Lenders can be flexible when there’s a close working relationship, and you have maintained honest communication throughout 

The Cons of Development Finance

• Securing development finance is a long process that requires a comprehensive application covering project details, developer and professional team’s CVs and thorough market research (Brickflow’s lender-favoured online application covers everything lenders need and like, to know so they can make quick, confident decisions)
• Interest rates and fees can be higher than other property loans due to the implied lender risks

Other Risks and Challenges in Property Development Finance

The ‘cons’ are known from the outset, but there are also risks with property development that are harder to mitigate against;

• Market Risks: Economic downturns and changes in real estate market trends can have a significant impact on the outcome of a project
• Project-Specific Risks: Projects often overrun on budget and time. But delays can mean overpaying for materials, missing the opportunity to deliver to a prime market, and extra borrowing costs, all of which eat into your profit
• Financial Risks: If you do run over, extending your development finance loan can be costly, with penalty fees and exposure to interest rate fluctuations

Whilst you can’t control the property market, you can keep your project on track by working with the right professional team – a breakdown in the relationship between the developer and the main building contractor can be disastrous for a project, so make sure you know your team inside-out.