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The Development Finance Paradox:
Why cheap development finance is a false economy
Unlike regular mortgages or personal loans, when it comes to development finance the cheapest is rarely the best. Many property developers fall into the trap of focussing all their efforts on finding the lowest interest rate and overall debt cost.
A no-brainer you might think, but this is the paradoxical nature of development finance. Unless you have unlimited equity or you’re not looking to grow your business (anyone?), cheap debt is almost always a false economy.
Let’s explain this:
A cheap loan is only possible if the risk to the lender is low.
Low lender risk means more equity (a bigger deposit) from you.
Equity is more expensive than debt (actual costs and opportunity costs).
Putting in more equity doesn’t increase your GDV
Putting in more equity doesn’t decrease your build costs
The only thing that changes is the cost of your finance
Every development lender has a different way of calculating what they are willing to lend on a site. If you speak to 10 different lenders about the same site, you’ll be offered 10 different loan amounts. The range of deposit varies from 30% for the cheapest loan, through to 10% for the most expensive. This is a huge spread and can therefore make-or-break your chances of future success.
If you choose a lender that requires 20% or 30% deposit each time, you’re putting yourself at a significant disadvantage. No matter how strong your projects prove, it’s going to take you two or three times longer to get to the same level of profitability as the developer that goes with a lender requiring 10% equity.
In summary, your mission shouldn’t be to find the cheapest loan. Your main aim must be to find the loan that maximises your return on investment, which Brickflow does for you.
Here’s an example:
- Let’s assume we have two identical sites and two developers.
- John and Ajay both have a £1.2m deposit
- The GDV of the sites is £5m
- It will take 2 years to develop and sell the sites
- The total cost to purchase and build the sites is £3.3m
- The pre-finance profit is £1.7m
When we run these numbers through Brickflow, you can see the huge differences in the market, and how this could affect your future success as a developer.
- John chooses cheap debt and an all-in loan rate of 5.25%
- The minimum deposit for the lender is £1.2m
- The total lender costs for John are just over £200k
- Pre-finance profit is £1.7m
- Subtract the £200k and John makes £1.5m in profit.
- Ajay opts for more expensive debt, with an all-in rate of 7.3%
- The minimum deposit for the lender is much smaller at £400k
- The total lender costs for Ajay are £400k
- Pre-finance profit is £1.7m
- Subtract the £400k and Ajay makes £1.3m in profit.
John has made more profit, so he has the best deal, right? Wrong.
Ajay exceeded John’s return on investment by 260%, in just two years.
Whilst John invested all his cash in one site, Ajay had the money available to run another two sites identical to this one (or a site three times the size with the same amount of money).
Based on the same margins as the previous deal, he has made £3.9m in profit, versus John’s £1.5m, over the exact same time period. Ajay exceeded John’s return on investment by 260%, in just two years.
Fast forward another two years, and if they both make the same lender choices as before, the gap widens even further. When they’ve both been through the cycle three times, John is still a developer, whereas Ajay has achieved financial independence and has the freedom to dip in and out. If Ajay does choose to take on a project, it’s now three times the size of John’s.
Time is Money
If you’re putting 20% or 30% into your development deals, you’re wasting your most precious commodity. Your time. Ultimately, it will take you two or three times longer to reach your property development goals.
If all developers were created equal in terms of their skill in buying and building sites at the right price, then some would still be far more successful than others. The more successful would be those that understood how to make development finance work for them.
Our example makes it very clear. The same sites and the same starting deposit; the only difference was that Ajay understood how development finance works, and John didn’t.
The cheap rates might look good, but do the sums, and we guarantee you, you’ll be worse off every time.
If you’d like to chat to us more about this blog, Brickflow or development finance in general, please give us a call on 0203 488 1674.
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