Unlocking Success: Navigating the Maze of Residential Development Finance

Development finance refers to the financial resources and strategies needed to fund and manage real estate developments (i.e., the construction or renovation of buildings). The purpose of this type of financing is to create large-scale profits so that once a property is developed, it can then be sold, or the property itself can be used to generate income.

Developers face numerous options for securing the capital needed to bring their developments to life, each with its own set of considerations. This article acts as a continuation from our previous article, “Development Finance – What are my Options?”. In this article, we aim to demystify development finance by providing further information and practical examples as to when these options may typically work best.

Development finance has been increasingly popular as it affords developers the capital to complete their developments, providing larger scale loans to purchase land, as well as covering the associated costs.

What shall I consider?

Choosing the correct financing option is crucial, particularly due to rising interest rates, increased borrowing costs, higher construction prices, and heightened lender caution amid this economic downturn. Whilst we would strongly suggest you seek legal advice before entering into any type of development financing, the below is a non-exhaustive list of preliminary considerations, making sure you choose the right type of development finance for you:

1. Clarity on the nature, duration and scale of your development.
2. Budget: Create a comprehensive budget to include all relevant development costs to determine financing needs.
3. Risk Strategy: Decide whether you would be more comfortable to borrow from a lender with a high-risk profile that will lend you more money or a higher loan to cost ratio with high charges, or a lender with a low-risk profile with a lower cap on their loan to cost ratio with less charges. Consider whether to choose a mix of lenders to take advantage of their different risk profiles and charges for the risk.
4. Possible Equity and Debt Ratio for the development: Decide whether this is appropriate for your development.
5. Creditworthiness: Assess you and your development’s credit standing.
6. Financing Costs: Compare interest rates, fees and overall costs.
7. Repayment Terms: Ensure repayment terms align with cash flow.
8. Security/Collateral: Determine assets or collateral to secure financing.
9. Flexibility: The adaptability of the financing option during the development phase and your exit strategy for financing.
10. Market conditions.

Benefits and Disadvantages of the Main Types of Development Finance:

1. Senior Debt Finance:

Senior Debt, often associated with a First Charge, is a common method of development finance. This secures a priority legal charge of the property being developed and so would be the first to be repaid once the development is complete.

Pros:

• “First Charge” security.
• Offers interest to be “rolled up” and so allows developers the opportunity to fund the interest costs from the profits arising from successful completion of the development.
• Less costs can be paid as the funds for the development phase of the development are released in stages and so interest is paid on the funds as you draw down.
• Flexible for managing cash flow and expenses for developers
• May allow developers to obtain lower interest rates (dependent on circumstances).

Cons:

• Increased difficulty in obtaining this type of funding for less experienced developers, particularly if you do not have sufficient cash reserves to invest into the development.
• Market conditions (i.e. interest rates).

Example: You approach a bank to secure senior debt financing for your development of a residential housing complex that has an estimated combined value of £10 million. The bank approves a senior debt loan of £7 million for your development, with the developer contributing £3 million as equity. This loan will serve as the primary financing for your development and the bank has the first claim on the property if any event of default.

However, this straightforward example can suddenly become complicated if different issues start to arise. This could include unforeseen delays in construction, fluctuations in the market, changes in regulations and legal issues. These changes would impact your ability to make timely loan repayments and developers should be aware of these risks from the outset.

2. Mezzanine Finance:

Mezzanine Finance is a hybrid of debt and equity where a lender provides a loan with the option to convert it into equity under certain conditions. This acts as a specialist funding product that bridges the gap between the amount of funding the main lender has agreed to provide and the amount of cash you are injecting into the development.

Pros:

• Plug funding gaps: Many borrowers have turned to mezzanine debt to plug funding gaps. Mezzanine debt is not typically secured by real estate assets and is therefore ideal for borrowers who have existing charges over such assets. Preferred equity funds are rapidly forming to reduce the debt market strain on borrower capital stacks.
• Can help maximise total borrowing/capital: It is a second charge and can help developers who require additional capital to bridge financing gaps. This means that the developer can inject less cash into the development themselves.

Cons:

• Typically, it is more expensive than debt finance and the higher interest rates associated with this form of financing means that it is more suitable for developments with a strong profit potential.
• It may be difficult to obtain this type of finance as a less experienced developer as mezzanine lenders are more selective about the types of deals that they will help fund.
• If there are complications with the development, it may mean that the margins are much tighter for the developer when exiting the development.

Example: A developer needs additional funding for a large-scale residential development. They secure mezzanine financing of £2 million with a 10% annual interest rate. If the development performs well, the lender may convert the loan into equity, becoming a partial owner in the development. This may impact the developer’s return on investment, especially if the development faces delays or legal issues emerge and so it is important to obtain legal advice before pursuing this type of finance. For example, a mezzanine lender may seek to enforce covenants or security interests and so it is important to ensure that your development plans align with this type of finance.

3. Development Exit Plan:

A form of bridging loan, development exit finance is granted to a developer after the development is complete, but not yet sold or refinanced with a long-term mortgage. This repays the costly development loan to the lender and remains until income from unit sales or a long-term mortgage is available to repay this exit loan in full, as the developer may not have been able to sell the property upon the development’s completion.

Pros:

• Typically attract a lower interest rate when compared to development finance to make this a cost-effective solution on completion.
• This tactic retains as much profit as possible, as it avoids having to wait for the sale of the property to repay the development loan in full.

Cons:

• Heavily dependent on the real estate market and economic conditions at the time of the planned exit: If the market experiences a downturn, such as a recession or a housing market slump, you may not be able to sell the property as anticipated or at the desired price. This can result in delayed exits, reduced profits, or even losses, which can be a considerable risk for developers who have heavily relied on this method for financing.

Example: You have entered a joint venture with an investment partner who provides the capital needed for land acquisition and construction to construct residential units. In return, they receive a share of the profits upon the development’s completion and sale. Prior to this, you have undertaken extensive market research. As the development nears completion, you have listed the residential units for sale with favourable market conditions and begin to generate profits. Legal advice would be hugely beneficial on whether this form of finance is suitable for your development, navigating the complications and obtaining assistance with the individual plot sales.

Conclusion

Selecting the right development finance option in the current socio-economic climate requires a comprehensive understanding of the economic landscape. The effectiveness of each option depends on the type of developer, development, and specific goals. It is also important to choose to work with a lender who supports your proposed development plans, and may seek to assist if there are any unforeseen issues with the development.

At Herrington Carmichael LLP, we are here to provide guidance and legal support throughout the development finance process and in making informed choices that align with your unique development requirements. Please contact us for further advice regarding your development financing needs.