Property development finance
Property can be viewed from different perspectives by owners:
- A means to an end, providing space for a business to generate an efficient working environment with economic overheads.
- A ‘safe-haven’ investment vehicle.
- A corporate asset that can be used as collateral to raise money.
- A development opportunity where a profit can be realised by means of added value.
The prime concern of any party lending money for property development is the ability of the borrower to repay the loan under agreed terms and conditions. Therefore the first requirement of a developer seeking finance is to produce a funding prospectus setting out the project‘s financial requirements and persuading potential lenders that the proposed project is viable.
The lender will be concerned with what will happen in the case of default; whether the property is to be owner occupied, sold on, or retained as an investment. Its value at all stages of development is critically important since it becomes the security of the loan and may be repossessed by the lender in the event of default by the borrower. This should be set out in a lending agreement.
 The market
The property investment market has to compete to attract money with all other alternative forms of investment. This means that investment decisions will reflect comparisons of returns and security in other markets.
Securitisation, unitisation and Real Estate Investment Trusts (REIT's) are examples of vehicles established to increase security for the investor and so to attract institutions to the property market. As a result, it has become increasingly rare for a single commercial loan to be raised against a single purchase. More often finance is raised by corporate entities such as property companies using their existing properties and other assets as collateral for additional purchases.
It is important that investors fully understand issues such as; valuation, the nature of leases, repair and renewal conditions and other complex property matters, and this means that the property market tends to attract the expert institutions rather than the individual small investor.
 Sources of funds
The main lenders in the UK are:
- Insurance companies and pension funds.
- Clearing banks.
- Merchant banks.
- Finance houses.
 Debt finance
Generally favoured by banks, such loans are secured beyond the property being developed.
Interest on the loan is charged on a fixed or variable basis. Well capitalised developers with a strong track record can negotiate non-recourse loans where the loan is a loan on property without recourse to outside collateral.
Historically, funds from banks have been available up to 70% LTV (loan to value ratio), however in volatile markets the banks may revert to a LTC (loan to cost ratio), in order to reduce their exposure. Highly geared (debt to equity ratio) companies will find it hard to obtain loans in a falling market increasing the need to look at equity funding from the borrower or mezzanine finance. Banks normally take first charge over a developer’s site before advancing funds on a draw-down basis against a project programme and its cash flow requirements.
The loan agreement will set out interest rates, which may be fixed or set at a margin over LIBOR (London Inter-Bank Offered Rate). The loan agreement will set cost limits and completion dates as well as allowing interest to be rolled up until after completion. Any cost overruns will fall to the borrower for payment.
The gap between the costs of development and limited recourse loans (the senior debt) is often filled by a mezzanine loan. Because it takes second charge over the assets it carries more risk and therefore attracts a higher rate of interest. Sometimes the mezzanine lender will take an equity stake in the project or a share in any surplus over development costs (overage).
 Criteria for lending
The following aspects of a proposed development agreement will dictate the terms of a loan:
- Design quality.
- Mix of use and demand.
- Pre-letting and covenant of tenants.
- Track record and experience of the borrower.
- Credit worthiness of the borrower.
- Size of the loan.
- Duration of the loan.
- Collateral (with up to date independent valuation).
- Borrowers equity stake (its own money) and its source.
- Lease terms providing revenue for repayment to the lender including; length and break clauses, rent review provisions, amount of Income stream, repair and maintenance obligations.
It is possible to hedge against the borrower’s exposure to adverse interest rate movements. Financial instruments of capping are an 'insurance policy' against a rate rising above a level at which the cap is agreed – effectively creating a ceiling. The premium for such a policy is reduced if a collar is agreed where the borrower compensates the hedge funder if rates fall below an agreed level.
 Related articles on Designing Buildings Wiki
- Buy to leave.
- Buy-to-let mortgage.
- Cash flow.
- Construction loan.
- Construction organisations and strategy.
- Cost plans.
- Design quality.
- Development appraisal.
- Discounted cash flow.
- Equity and loan capital.
- Equity in property.
- Funding options.
- Funding prospectus.
- Partnering and joint ventures.
- Private Finance Initiative.
- Real Estate Investment Trusts.
- Shared equity / Partnership mortgage.
- Shared ownership.
- What is a mortgage?
- Working capital.
- Property development appraisal and finance, by D.Isaac, J O’Leary and M Daley. Palgrave Macmillan.
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