Development Finance | The Smart Guide
An essential read for borrowers in the property development game
This guide is designed for corporate development finance, companies, and incorporated entities only. The application is not open to individuals or unincorporated partnerships.
- Market Overview
- Getting Started
- The skills and experience you need to be a (really good) property developer
- Essential Knowledge
- The Capital Stack
- Calculating Development Finance
- Interest Rates
- Personal Guarantees
- How to Stretch Your Equity Further
- The Application Process
- Pitfalls to Avoid
- Using Brickflow for Smarter Development Finance
Download a PDF verison of the guide to read offline.
Since 2008’s financial crash, tightening regulations have loosened the grip of the High Street banks on the development lending market. In the first half of 2019, (54%) of the £23 billion lent by the UK’s Commercial Real Estate (CRE) market, was by non-UK banks . And the picture is similar across Europe, where last year 18 of the top 40 CRE lenders were non-banks.
Having said that, the ‘big 4’ UK High Street banks (Barclays, Lloyds, HSBC and NatWest) still make up a significant part of the market, although have become more cautious, and the majority of their loans are now for existing clients or experienced developers rather than new ones. This means it’s more important than ever for borrowers to gain access to the entire market, and the best available deals.
The rise of ‘alternative lenders’ has therefore been a phenomenon for the property development market as a whole, bringing a more flexible and accessible way for borrowers to secure funding. As a result, the appetite for lending and borrowing has increased, and crucially for developers, if they find the right lender, it takes far less time to secure a loan, meaning they can close a deal far quicker.
Development Finance: The Challenges
Opening up the market brings more choice, and options are always a positive, but poor visibility within the market poses its biggest challenge.
Many developers simply aren’t aware of the breadth and depth of non-bank lenders that exist, and/or lack the relationships to access the key decision makers within those organisations.
Poor transparency, little or zero marketing capability and a subsequent lack of brand awareness mean that credible, alternative lenders with large and flexible lending funds are often missed, along with the opportunities they proffer.
Most developers can identify around five lenders, when in reality there are many more options. It is however critical to be cautious. A lot of new lenders have entered the market in the last few years, so it’s questionable whether they’ll be around during and after the next economic downturn. It’s important to understand how lenders are funded, and whether their backers are likely to withdraw their funding lines at the first sign of trouble.
There are examples already of lenders taking on too much risk, (remember Lendy?) but others are close to the line. If prices fall due to an economic downturn, more lenders will disappear, meaning serious repercussions for developers who may have invested their life savings in a scheme. If the leverage offered seems to be higher than the rest of the market, or a rate seems too good to be true, it probably is, especially if the operator is new to the property finance market. It’s essential to work with trusted lenders.
Choosing your Lender
To maximise equity, mobilise quickly and ultimately get ahead in the property development game, borrowing from the big UK banks isn’t always a viable option. Rates are low but deposits are big, which means paying away profit shares or limiting yourself to smaller sites. Working with a broker with the right expertise, knowledge and relationships to navigate the market, can help you mitigate risk and find the lender that’s right for you.
Quicker still, you or your broker can search for trusted lenders yourself on Brickflow, the UK’s first search engine for development finance loans. We provide instant access to the development finance market, in real-time, and you can both search for loans and apply online, making it the quickest and easiest way to secure development finance.
Starting out in property development for the first time is not an easy game. It’s by far the riskiest of all property loans for lenders, despite the potentially big returns, so borrowing opportunities can be difficult to secure.
Experience is key, but if you can’t secure finance, you can’t accrue experience. So, what are the essential skills you need, and how can you convince a lender you’ve got the right experience to make a development scheme a success?
Like most projects, managing a property development has multiple strands, and different skills are needed for each stage. If you’re a champion builder or a seasoned QS, it doesn’t mean you’ll naturally be a good developer.
It’s rare to be able to do all three, which is why the majority of development deals involve more than one stakeholder. For instance, if you have a DM or PM background, you’ll probably be able to manage a scheme to delivery, but it’s unlikely you’ll have the same follow-through when it comes to the planning or sales processes.
Lenders like lending to experienced property developers. It normally takes three relevant schemes to be classed as ‘experienced’ by a lender. Most appreciate that previous projects might be smaller in size and value as you gradually build up to bigger schemes, but it’s relevance that is key.
If you’ve completed a loft conversion, a side return and split a house into two flats, for example, it doesn’t follow that you’ll easily secure funding to build 20 new-build houses.
You also need to consider whether your development involves specialist areas such as basement digs or a listed building, as your lender will almost always want to see direct experience from either yourself or an associated contractor.
If you still don’t think you’ve got enough relevant experience, nor will a lender, so consider bringing in outside expertise.
Property development often works best as a collaborative effort. Start by considering the skills and experience you do have. You might not have direct development industry experience, but if you’re an established estate agent, planner or valuer, it’s likely that you’ll be good at finding the best sites at the right price, or have the knowhow to exploit the planning process to your advantage.
Be honest and realistic about your weaknesses and identify the areas where you need some help. You may have the experience within your family, close friends or wider network. If you don’t, look outside to bring the right people in.
As well as making a stronger case for a lender, working with partners with skills and experience you don’t have allows you to grow, meaning once you’ve done a few schemes together, you can work on bigger sites sooner, have more equity between you and eventually go out on your own.
Lenders actually like a partnership if stakeholders are incentivised. For example, you purchase a site or an option but don’t have the experience to secure funding, so bring in a PM as a contractor. He takes a 20% share of the scheme, so is incentivised to deliver on time and to budget, making for a happy lender. See our guide on how to become a really good property developer
The Capital Stack
The Capital Stack is the structure of your development finance, or the different layers that fund a scheme. The typical stack has three layers, and normally includes senior debt, mezzanine debt and equity.
Strategically determining the best Capital Stack for your project allows you to minimise your equity investment and maximise your profits.
- Debts are repaid from the bottom up, so the higher up the lender, the bigger the risk they incur and the more expensive the debt
- Equity is always at the top of the stack, followed by mezzanine or 2nd charge, with senior lending (1st charge) at the bottom
- Lenders will want visibility of your capital stack to see where they fit in your hierarchy of funding
- This lets them determine the potential ROI vs. level of risk
- Not all lenders require a big deposit, so don’t always default to your trusted lender, and shop the market to keep your equity longer
- Deposit requirements typically range from 10%-35%, so for a development with costs of £10m, a deposit could vary by as much as £2.5m, creating a huge opportunity cost from lost equity if your deposit is 35% rather than 10%
- When a lender requests a large deposit, an obvious route is to secure an investor on a profit share basis, but this will often prove to be a false economy
- Experiment with different loan structures to avoid hefty profit share payments
Calculating Development Finance
Development finance is the most complex property-based loan to calculate. To maximise profit, you need to maximise debt, which cracking your Capital Stack will enable you to do.
A loan is calculated like this:
- The lender lends the lower of a percentage of the GDV and a percentage of the total costs
- The lender sets a minimum deposit, or amount of equity required, making sure it doesn’t exceed their internal day one leverage cap
- The loan is broken down into two component parts; land loan and build loan
- The build loan takes priority and is allocated from the total loan first, so essentially the lender works backwards
- The lender covers the finance costs, professional fees, build costs and contingency first
- The residual (leftover) loan is the land loan, and is available to borrow against the land value, providing it respects the day one LTV cap and minimum client equity.
You also need to think about:
If you’ve purchased the site already and enhanced the value through planning, this may be considered as part of your equity. This is called Sweat Equity because you’ve essentially done all the hard work to add value. Every lender has a different way of calculating sweat equity, some are more generous than others, and some can use 100% of sweat equity, creating a ‘cashless deal’, so again, shop the market.
Again, if you already own the site, and you’ve met ongoing site costs (debt servicing, security, maintenance, etc.) you can legitimately assign them to the project and the lender will take them into account for their calculations, so keep a ledger.
Read more on our post calculating development finance
Debt is always cheaper than equity (unless you’re sitting on a big pile of cash). But due to the lack of transparency in the market, even experienced developers struggle to make the best use of their equity.
We see developers borrowing from lenders at a low LTGDV at cheap rates, but then giving away huge profit shares to plug the equity gap. What feels like a good deal is a false economy because they’re giving away 40% or 50% of their profits to secure the investment they need to mobilise the deal. Paying slightly more for your debt will normally mean a smaller deposit, and the potential for 0% profit share to be paid to investors.
If you run the two scenarios through Brickflow, smaller deposit and more expensive debt beats cheaper debt and larger deposits every time.
What can I expect to pay?
Like any financial product, development finance interest rates are dictated by risk (or implied risk). Size matters. Risk and leverage are inextricably linked, so the higher the leverage the more risk there is for the lender. One of the most common questions we get asked is what kind of interest rates developers can expect to pay. The simple answer is there is no simple answer.
Every lender has a different way of calculating development loans, which is why it’s so important to shop around for your funding. If you send the same project to 10 different lenders you will receive 10 different loan amounts and 10 different lots of interest rates & fees.
If we break down the market by lender type and leverage ranges, we can however apply some typical loan interest rates.
Typical Rates for Loans Over £1m
|Lender Type||Typical LTGDV||Typical LTC||Typical All-In Rate*||Comments|
|Mainstream Banks||50-60%||65-75%||4-6%||The most conservative and therefore the cheapest. Generally more conservative on LTC (remember they will lend the lower of the two figures).|
|Challenger Banks / Specialist Development Funds||60-70%||75-90%||6-9%||More aggressive on leverage and LTC and slightly more expensive, but generally more flexible than mainstream lenders.|
*All-in means the total rate paid, i.e., the lender margin and the cost of funds (such as Libor or base rate).
These rates are based on loans of £1m plus. When you start borrowing less than £1m, borrowing costs will increase due to the resource required and relative costs of underwriting a development loan.
The labour cost to a lender of sourcing and underwriting a £10m development loan is much the same as a £2m loan but with five times the return, so they prefer to focus on the larger loans. For a lender to analyse 10 £1m loans, it would take roughly 10 times the resource but earn the same return as one £10m loan, so the higher cost of underwriting smaller loans needs to be passed on.
Loans up to £1m
The smaller loan market is still covered by mainstream banks and challenger banks, but the biggest presence is with specialist development funds and bridging turned development lenders.
Pricing is around 1.5%-2.5% higher, so typical All-In Rates would be:
- Mainstream banks – from 5.5%
- Challenger banks & specialist development funds – from 7%
- Bridging lenders – 9.5%-12%
As a rule, any loan below £1m that carries an interest rate of less than 10% is good.
In addition to interest rates, the total cost will normally include an arrangement fee of 1.25%-2% and an exit fee of 1%-1.57% of the gross loan. It’s therefore very difficult to compare lenders on a like-for-like basis because of the three different costs.
Most lenders have a minimum annualised rate of return on their capital, and it’s the combination of the three costs that are used to meet this. If a lender is charging a lower interest rate than their peers at the same leverage level, expect to pay higher arrangement and exit fees (AKA In & Out fees).
True Monthly Cost
Brickflow employs what we call ‘True Monthly Cost’ as the best way to compare fairly:
(Interest Rate / 12) + (arrangement fee + exit fee) / number of months
E.g. (9% / 12) + (3.5% / 18) = 0.94% per month
When you use the Brickflow platform, you will see the TMC displayed next to every lender to make comparing lenders side by side as easy as possible.
A personal guarantee is your legal promise to repay loans issued to a business where you are a beneficial owner. Providing a personal guarantee means if the business becomes unable to repay a debt, then you accept personal liability, meaning you can’t just walk away.
They are standard practice for development finance and are required from all shareholders, or as a corporate guarantee. The Industry average is 15%-25% of total loan amount.
Normally, the higher the LTGDV, the higher the personal guarantee. Banks usually want twice the cover on a personal guarantee amount, so if the amount is £1m, they require evidence of a Net Asset Value (NAV) of more than £2m.
- Liability is joint and several, so if two of three shareholders do a runner, you will be responsible for the full amount, not just a third
- They are not charges over other properties. You will need to submit an Asset & Liability (A&L) schedule during the application process and the bank will look for sufficient equity value to cover the personal guarantee amount
- Personal guarantees include liquid assets and property assets (property is preferred as cash can disappear).
- Equity in your main residence can count towards the NAV but the lender may discount this as it’s harder to realise in the event of a claim
- The lowest level of personal guarantee is cost overruns, which are normally only allowed for loans with a lower LTGDV and/or a performance bond
Personal guarantees are conceptual security, rather than actual, alternative security. They’re there to ensure both lender and borrower are strategically aligned. Lenders don’t expect to enforce them and they only do as a last resort, but they exist in case things go wrong.
Each lender will take a different approach, but here’s how they might work in reality:
- If you’re unable to repay a loan (normally because a development is over time, budget or property prices are falling), you would first use the contingency built into your loan
- After the contingency is spent, you can ask the lender for more funding, but the lender may decline if you are already at their leverage limit
- Further shortfalls could be met out of liquid assets, but failing that the bank could look to enforce the personal guarantee (through the courts if necessary)
Here’s how you may be able to reduce a personal guarantee amount:
- Increase your contingency, which is built into your loan. Industry standard is 5% of build costs, so look to up this
- Lower your LTGDV to below 50%, and lenders may make an exception
- Offer a cash deposit as an alternative, or supplement part of the personal guarantee with cash
- Get your contractor to secure a performance bond.
HOW TO STRETCH YOUR EQUITY FURTHER
If you don’t have a hefty deposit to help secure development finance, it doesn’t mean it’s game over for your ambitious development plans.
As well as getting your Capital Stack right, there are many ways to stretch your equity further and source the funds you need.
Shop the market (and why cheap debt is mostly a false economy)
The default setting for many developers is to stick to a tried and tested senior lender. But deposits vary from 10% to 35% of total costs (including land, build, finance and professional fees), so on a scheme with costs of £5m, the required deposit could be anything from £500K to £1.75m. A huge and potentially deal-breaking variance. If you only have a relationship with one lender who requires a deposit at the higher end of the spectrum, it could mean investing an additional £1.25m of equity, blocking investment for other schemes, and preventing you from progressing to bigger sites, sooner.
Leverage your network (smartly)
The best property developers have the ability to bring in the right partners to make a scheme work. This applies to obtaining finance for property development, and making debt work for you.
It’s unlikely that using a single source of funding is the most cost-effective route, so look to your friends, family and wider professional network to help raise equity where you can.
Having said that, if you need to partner with investors to make a scheme happen, don’t be too generous with your profit share. You’re the driving force behind the development and without you it wouldn’t be on the table, so remember this when assessing your funding options.
Consider a second charge
Second charge loans mean you can use equity in background portfolio properties as security for another loan, even if you have an existing mortgage, so they’re a great way to conserve cash. They offer flexible funding, and can normally be secured fairly quickly as second charge lenders are setup to work quickly, making them a strong alternative to re-mortgaging or draining your cash.
If you have some BTL properties in the background that are lowly geared, this could be an option. Lenders can even take a second charge over multiple properties to give you an overdraft type facility to use as and when you need to raise a deposit.
Leverage the planning process
If you buy or option a site without planning permission, you will add value during the planning process in the form of sweat equity. This places value on the time and effort put into a project. Securing planning permission isn’t easy, so good lenders will take this into account when assessing a funding application for a property development loan, and lending opportunity.
Every lender will place a different amount of value on sweat equity, so make sure you search the market to find one that appreciates the value you add as an experienced property developer.
An added benefit of buying during the pre-planning phase comes if you need an investor. Providing you add enough value, you can repay your equity when you raise the development finance for the build stage, meaning you’ll only need to pay your investor a percentage of the profit on the uplift in value during the planning process, not on the total profits at the end.
Request a deferred land payment
When a developer is looking to buy a piece of land, the landowner can agree to receive part of the payment once the properties have been built and sold (usually at a higher price as the trade-off). This is known as a deferred land payment, and it’s worth asking the question if you’re short on equity. The lender providing the development finance has first charge over the land and lends all of the build costs, plus a portion of the land acquisition costs.
As the buyer, you would be giving the lender security over a site that is worth more than you paid for it (so far). This de-risks the lender and allows you access to greater value projects with smaller deposits, so it’s a full circle win. The landowner will normally request a second charge behind the lender and would have to agree to be repaid only after the lender. Not every vendor will agree to this, so you need a good relationship in place. You could also offer a small profit share to further sweeten the deal (if needed).
Read our full guide to Making your Equity Work Harder, for worked examples and case studies.
THE APPLICATION PROCESS
You will need to provide the below key elements to apply for your loan.
Your skills, professional qualifications and previous development history.
An essential tool for developers and lenders to assess the land value of any piece of land, site or building. You will no doubt have this info ready, which should include all costs (acquisition, build and sales) and expected GDV.
A detailed list of your properties/units with square footage and sales prices.
Asset & Liability (A&L) schedule for shareholders and personal guarantees
A list of your personal assets and liabilities, required to demonstrate adequate cover for your personal guarantee(s).
A valid identity document (passport, driving licence etc.) and proof of address (utility bill, bank statement etc.)
Source of wealth
A summary of where you obtained your funds, with relevant supporting documentation.
Valuer, QS and Solicitors engaged
Once the lender receives all of the above, they will confirm credit-backed terms and instruct their Quantity Surveyor (QS) and valuer. You will need to cover these fees upfront or agree to cover the cost even if the loan does not complete.
The valuer will:
- Confirm site value and suitability for security
- Run a high-level sense check on the build costs
- Confirm the GDV of the end units
- Provide a report within 10 days
The QS will:
- Closely examine costs and construction methodology, working with the valuer
- Assess you and your ability to deliver the scheme on time and within budget
- Agree a drawdown schedule with you
- Provide a report within 2-4 weeks
Once the reports have been assessed by the lender, solicitors will be appointed. They can be appointed at the same time as the QS and valuer, but we recommend waiting to avoid incurring unnecessary costs.
- You will need to cover the solicitor costs
- Most lenders will insist that your solicitor has construction expertise in-house
- The solicitors will deal with the construction and loan documentation
- The process will take up to 4 weeks
PITFALLS TO AVOID IN DEVELOPMENT FINANCE
With smart decision-making at the core of property development, there are few more important ones to make than choosing the right development loan. But, there are some common mistakes that even the most experienced developers frequently make. See our post regarding pitfalls to avoid
Failing to shop the market
If you speak to 10 lenders about the same deal, you’ll get 10 different answers. That’s 10 different loan amounts and 10 different pricing structures.
Just by the law of averages, if you only speak to one or two, perhaps your ‘go-to’ lender, there’s almost zero chance that you’ll be offered the best available deal on the market.
By shopping around and speaking to different types of lenders, including challenger banks, debt funds and specialist lenders, you’ll have far more visibility of the best available deals.
Putting down a large amount of equity as a deposit can be avoided, simply by finding a more generous loan offer with an alternative lender.
This can free up funds for investment in other schemes and bigger sites, and prevent or reduce hefty profit share pay-outs to additional investors.
Falling short on due diligence
Navigating the fragmented development finance market of non-bank lenders inevitably brings increased risk, alongside greater opportunity. Whilst many of these lenders are credible and bring a different dynamic to the market, unfortunately some are less trustworthy. If a lender is offering far cheaper rates or more leverage than anyone else, question why, as they’re probably taking undue risk.
Remember how hard you’ve worked for your equity, and don’t risk your future by betting on a bad lender.
Make sure you dig deep. Ensure your lender passes the credibility test, and has the infrastructure to underwrite loans properly, especially if they’re new to the market. Also watch out for hidden terms, and ensure you have full transparency on the HOTs. For example, a lender may offer you a great rate but insist on a 100% Personal Guarantee, or additional charges on other assets, rather than the industry standard of 15-25% of build costs. Brickflow only lists lenders we trust, so we do the due diligence for you.
Choosing the wrong partners
Whilst joining forces with the right partners can strengthen your case for securing a property development loan, choosing the wrong ones can do more harm than good.
This includes everybody from contractors, to shareholders and lenders, to professional partners. We’ve all heard the stories of feuding partners and sites getting repossessed. Much like a divorce, a fallout will always be expensive, so choose your partners wisely.
When you do bring in others, make sure you discuss Personal Guarantees (PG) early on. If a partner doesn’t stand behind the PG it’s not necessarily game over, it just means that despite their experience, their value should be weighted slightly lower than another partner willing to commit to a PG.
Taking a micro perspective
It’s easy to get weighed down by the complicated process of securing development finance, but it’s also essential to take a wider view of the economic and political climate. The time that elapses between site acquisition and/or planning applications, and actual completion of a scheme is a minimum of 18 months, but is usually somewhere between two and five years; potentially even more.
Think how much has happened in the UK in the last two to five years with Brexit, the cyclical economy, changes in legislation, fluctuating currency and the Coronavirus.
A developer’s ability, or lack of, to acknowledge and plan for changes that are outside of his or her control could be make-or-break for a property development scheme, and a developer’s future success.
USING BRICKFLOW FOR SMARTER DEVELOPMENT FINANCE
Brickflow is revolutionising the development lending market by bringing it online. We know the market is old-school and slow, so we’ve created the UK’s first search engine for development finance, which will ultimately benefit our entire industry. Access to finance is key to delivering the housing that the UK needs, so our mission is to make it as quick and easy as possible.
How it works
Brickflow provides instant online access to the development finance market, 24/7. We search the market, including non-banks and specialist lenders, in real-time, providing loans from lenders you can trust in under 60 seconds.
We bring the market to you and broaden it
Visibility – you may know 2 or 3 lenders; we give you instant access to 18 (and counting), along with a response in seconds rather than months.
Opportunity – speaking to more lenders provides more loan options and makes sites you thought were out of reach, a possibility.
Foresight – you can check the loans that are available for sites online, before even seeing them. Brickflow does the due diligence for you.
We make it all quicker and easier
Application – multiple lenders doesn’t mean multiple forms. You complete one online form, there’s no paperwork and you upload all documents online, saving weeks on the current application process.
On-boarding – a big barrier to shopping the market is the pain of providing your information multiple times. We store it securely, so you can switch lenders seamlessly.
Completion – on average it takes up to 6-months to complete a development loan. We aim to complete all loans within 6 weeks, should you need it.
Flexibility – if your numbers change (site price, build costs etc), which they inevitably will, you can instantly see the effect on your finance.
Tracking – you can easily track the progress of your application online, at any time.
TALK TO US
Whilst we are leaders in technology, we want you to know that real humans are available to help you too.
If you would like to talk to us about smarter development finance or find out more about Brickflow, please get in touch.
0203 488 1674 – firstname.lastname@example.org – @Brickflow