What are the different types of development finance? A short guide looking at the options for funding property development and how to get finance.
Anyone involved in property development has, at some point on their journey, asked what is development finance? So, here’s a straightforward guide on development finance, how it works and how to apply.
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What is development finance?
Property development finance explained in straightforward terms is money loaned to developers for the purchase of land or sites and construction of new residential, commercial or mixed-use buildings. This includes ground-up construction and refurbishments or conversions of existing buildings.
Unlike homeowner mortgages, which can stretch over 35 years, development finance is short-term and typically repaid within 6-36 months, depending on building completion. Commercial development finance is much the same except loaned specifically for developing commercial properties like retail space or warehouses. Usually a pre-let or pre-sale (a business has legally agreed to a rental contract or purchase) is required by lenders.
Developers receive tailored funding for their project and building programme so the loans are complex and take up a lot of resources to arrange. Therefore, most lenders don’t consider applications below £150,000. Also, development finance is solely for developing property as a business, i.e. to generate a profitable sale or rental income and not for homeowner developments (these are referred to as self-build mortgages).
How much a developer can borrow depends on some key figures – the GDV (Gross Development Value), the projected build costs, equity contribution and day-one land cap (the percentage of the site value that can be loaned). 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 criteria and lending parameters will differ with every lender of development finance UK wide. The loan is repaid once the new development is sold, or by refinancing on a longer-term mortgage.
What are development funds?
If development finance refers to the loan package allocated by specialised lenders, then what are development funds? The precise meaning of development funds is the entire monetary contribution used for the property development project. Included within the development funds, would be the equity (deposit) paid upfront for the site, which could come via cash injections from private investors who receive a profit share. In some cases development funds could be non-repayable grants allocated by the government or local authority to initiate regeneration of public spaces.
These funds are brought together in what is called The Capital Stack, in other words, the layers of funding that make it possible to complete a scheme. Typically, capital stacks have three layers; senior debt (the finance package and largest proportion of money), mezzanine debt (a smaller additional loan or investor input that reduces the equity required) and equity.
Looking at an example of development funds is the easiest way to understand the various elements. Imagine a property development scheme with:
- £500,000 land/site costs
- £800,000 build costs
- £2,000,0000 GDV
Lenders typically offer between 50% and 70% of site cost and up to 100% of build cost, so the total development funds required are £1,300,000 plus lender costs. In this example, if the lender offers 100% of build costs and 60% of the site, the senior loans would be £1.1m (£800,000 build costs plus £300,000 against the site). The £200,000 shortfall, plus added lender costs, is funded by the developer’s cash funds or by arranging further mezzanine borrowing, or a combination of both. Senior debt is repaid first, followed by mezzanine and lastly the developer recoups their equity. Now that the question ‘what are development funds?’ is answered, we can look at how development finance works.
How does development finance work?
With so many variables in property development, exactly how does development finance work? Finance is typically arranged through either a large national bank or with a non-bank lender. Developers often seek funding through well-known banks, even though it’s not necessarily the best option, due to inadequate market knowledge. Big banks invariably offer lower interest rates but require larger deposits. Non-bank lenders sometimes offer 90% (or more) of overall costs, meaning less equity is required so Return On Capital Employed (ROCE) is much higher.
Since property development happens in stages, development finance is allocated incrementally. Phase one normally covers part of the site purchase costs and phase two is the building finance. Phase two is paid in segments, or tranches, as construction progresses to ensure appropriate funding is available at each stage. This avoids funds being ‘drawn down’ to sit unused in the bank accumulating interest charges. The specifics of the tranches (how much and how often) are agreed from the outset to align with how the works are scheduled but can change as the project evolves. Accuracy is essential when planning the build costs and schedule to ensure adequate cash flow throughout the project.
Repaying the debts depends on the developer’s plan for the finished build. An outright sale will repay all loans, mezzanine investors and deposits. If the developer keeps the build for rental, they will refinance on a longer-term loan to repay the debts. How the money is repaid is called the exit strategy and it’s also agreed from the outset, however, this can change according to market conditions. Having a clear and credible exit strategy is key to lenders offering development finance.
How to get development finance?
Naturally, anyone considering starting a property development venture will wonder how to get development finance? The critical factor is that your development will return a profit, the costs are realistic and you have a viable way to repay the loan. In addition, ensuring you or your team has the experience to deliver the project on time and on budget is of paramount importance to the lender. Using Brickflow’s Smart Appraisal™ tool ensures that every aspect of a development is meticulously considered and costed, including allocating adequate contingencies. Once completed, the appraisal is in a precise and definitive format that can be presented directly to lenders to ensure the best development loan is secured for every project. The same appraisal presentation can be submitted to all lenders on the platform, so time isn’t wasted filling out multiple paper application forms.
At Brickflow we want to make sure that anyone who has viable development plans isn’t prevented from building due to lack of access to funding, or funding that isn’t affordable. Access to finance is key to delivering the housing that the UK needs, so our mission is to enable more people to build and own property. We also want to help developers build more with less by eliminating inefficient equity deployment.
Whether it’s applying for funding on a site awaiting planning consent, or a first-time developer with big ambitions, our software will deliver the best property development finance options for your project. When using the Brickflow platform to source loans, lenders can be compared in minutes and a decision in principle (DIP) can be granted in under two hours – this process normally takes weeks. So, how to get development finance?