How does property development finance work? An overview of the key features, how it’s used and the benefits of using a specialist development finance...
Every property development scheme has vast differences in scale, build type and budget, which means developers need different types of finance for each project. So, what are the different types of development finance?
|Table of Contents|
What are the different types of development finance?
Firstly, property development finance explained simply is a short-term loan for the construction, conversion and renovation of buildings. It’s repaid when the completed development is sold or refinanced. Whilst every lender has different parameters and eligibility criteria, how much can be borrowed is based on the same figures;
- GDV/Gross Development Value (the site’s value post-development)
- total project costs
- minimum borrower equity
- day one land cap (lender contribution towards land purchase).
The types of development can be categorised as commercial, residential, and semi-commercial. Whatever the build, a developer will use one or a combination of these types of finance:
- Senior debt – typically covers up to 100% of construction costs and part of the land, between 55-65% of GDV. Senior debt is the first-charge lender so repaid first on completion
- Mezzanine/Junior debt – a secondary, smaller loan from a different lender that reduces equity input, giving the developer more cash flow or ability to invest elsewhere. Mezzanine debt is a second charge, so repaid only after senior debt is cleared
- Preferred equity - higher interest charges than mezzanine, may involve a profit share and
sits above/in combination with mezzanine. It’s paid after senior and mezzanine, but before the developer/other shareholders (hence 'preferred').
- Stretched senior debt – a first-charge loan of up to 75% of the GDV
Refurbishment finance – used to buy and renovate run-down property, up to 75% of GDV (typically a bridging loan)
- Bridging loans – quick to arrange, terms as little as 1 month and typically used as temporary funding before arranging longer-term finance after adding value
- 100% development finance – rarely used, the lender provides all of the money required for a development and takes a profit share, usually 50%.
Residential development finance is specifically used to fund the building, renovation or conversion of a property that will be solely residential. It can be used for a single home development to a site that creates hundreds of new homes. It would also be used if a developer is changing the primary function of a building from commercial to residential.
Residential development finance can only be used for the renovation or building of property as a business venture, i.e. to generate a profit from sale or rental income. Whilst homeowners may undertake considerable property development projects for their own use, this would not qualify for residential property development finance – a self-build mortgage would be more appropriate. For smaller residential property developments, where work can be completed quickly, developers might use bridging finance rather than applying for a full development finance loan. Likewise, for residential auction purchases, or uninhabitable housing, a bridging loan would be more readily available.
Unlike finance for commercial builds, residential development finance can be regulated, if the developer, or his or her immediate family plan to live in one of the properties being built. When regulated by the Financial Conduct Authority (FCA), the borrower has protection if they’re sold an unsuitable product or given misleading advice from lenders or brokers, with possible compensation if eligible.
Funding costs will vary widely between residential development finance lenders, meaning that choosing the wrong lender can adversely affect the profitability of a scheme.
What is commercial development?
Residential property development is something we are all familiar with and pretty easy to grasp, but what is commercial development? Basically, any property or premises where the business conducted is classed as commercial. The most obvious examples are warehouses, bars and restaurants, shopping centres and retail spaces, gyms, offices, government or council buildings, workshops and art studios and nightclubs. Commercial development finance is loaned specifically for developing any of the above. Usually a pre-let or pre-sale (a business has pre-agreed to a rental contract or purchase) is required by lenders prior to completing the loan. Where the development is a mix of residential and commercial, even if the units are majority residential, a commercial development loan, rather than residential, would have to be used.
Less lenders offer commercial development loans because it’s considered more difficult to liquidate commercial assets in comparison to residential in the event that a borrower defaults on the debt. Therefore, it can be more expensive than residential borrowing. Funding can be arranged through either high-street banks, challenger banks or specialist lenders.
Once the development work is completed, the site can be refinanced on a long-term commercial mortgage. Whilst residential development finance cannot be used to fund a private home, commercial development finance can fund the development of a commercial property that will be used by the borrower as their business premises.
How to get finance for property development?
Whatever the project and the potential profits, knowing how to get finance for property development is central to getting started. Fortunately, there’s no shortfall of lenders – the property development lending market in the UK is bustling, with specialist lenders continuing to compete with high-street banks for clients. Whilst having options is great, it makes finding the best deal harder. The easiest way to navigate the market is using a specialist property development finance broker. They have the expertise and inside knowledge to source loans from the entire breadth of the market.
After connecting with a broker, the next stage in getting finance for property development is preparing an application that motivates lenders to invest. This means evidencing the project’s profitability and the developer and their team’s capability to complete. Start with a thorough Development Appraisal with costs and a realistic GDV. Also provide a Development Schedule listing all units within the scheme, their finished size, specification and their sale price. Lenders know the property market, so exaggerating sale prices will quickly lose lender confidence.
The lender will instruct a valuation report of the site and the GDV, and a QS (Quantity Surveyor) assesses the team’s ability to deliver the scheme on time and on budget. When all processes have been completed, the funds are sent to the borrower’s solicitor (lenders usually insist on a solicitor with expertise in construction). The current industry standard for completion is 5-6 months. At Brickflow, brokers using our software to search development finance lenders UK wide and apply for loans are typically completing for their clients in 5-6 weeks. Register with Brickflow to find out more about how to get finance for property development.
If you’re a broker, sign up today and have a DIP for the best development finance or bridging loans for your clients on your desk by tomorrow.