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How does development finance work?

Development finance can be used both for the purchase of land (if required) and building construction costs.

Loans range anywhere from £50,000 to £50 million, and the term of the loan is typically 1-3 years.

Once the development is completed, the loan is paid off either by the sale of the property(s) or by refinancing. Or part-sale, part-refinancing.

How are development finance loans calculated?

Every bank or commercial finance provider sets it's own criteria and parameters around how much it's prepared to lend, and at what interest rate.

Calculations are complex and based on the following metrics...

Loan to Gross Development Value (LTGDV)

GDV is the anticipated open market value (OMV) of the project once construction is complete.

The maximum loan is typically capped at the lower of 65-70% of GDV or a percentage of Loan-to-Cost (see below).

Loan to Cost (LTC)

The maximum loan amount expressed as a percentage of the total project cost. This includes construction costs, professional and legal fees, sales and marketing costs, interest and finance fees and, if applicable, land purchase costs.

The loan-to-cost is typically between 75 and 85 percent LTC. Usually 100% of the build costs are funded by the lender, with milestone payments made in arrears, once the lender's monitoring surveyor has signed off the relevant stage of the build.

Borrower Equity

The minimum deposit from the shareholders that the lender will accept. Calculated as a percentage of the total project cost.

Day One land leverage

How much the bank will lend on day one to purchase the site. Capped as a percentage of the GDV.

The key components of a development finance loan

Property development loans are broken down into three key components.

1 - The lenders fees and interest.

At the outset, the lender's arrangement fee, other fees, and interest charges, are deducted from the gross loan amount.

The balance is the net loan amount which the borrowing party receives to use for the construction costs and towards the land purchase (see below).

Interest is retained, so the borrower has no monthly payments; the loan is paid back by selling or refinancing the scheme once construction is completed.

Fees include the lenders arrangement or facility fee (usually 1.25-2% of the gross loan) and loan exit fee (1-1.5% of the gross loan), a.ka. the in and out fees.

2 - Finance for the construction

After the lender's arrangement fee and interest is deducted, the net loan finances 100% of materials, labour costs, professional fees and contingency etc for all the building work.

3 - To purchase the land and/or existing building

Finally, whatever's left over can be used to fund the purchase of land, with or without a building or detailed planning permission in place.

An important caveat is what's called day one land leverage. This describes the lender's cap on the amount of the loan, as a percentage of the gross development value (GDV), that can be used for the land purchase.

Who is eligible for development finance?

Individuals can apply for developent finance, but most property developers either use a LLP or Limited company, usually designated as a Special Purpose Vehicle (SPV).

An SPV is legal entity setup for a specific business purpose. In this case, property development and ownership.

The benefits of an SPV limited company or LLP for property development

Setting up an SPV provides many benefits to the developer, including:

Asset protection

Experienced developers often have a parent trading Limited company, but setup a new SPV (Special Purpose Vehicle) subsidiary company for each property development they undertake.

This one SPV per development model, means that should the project go wrong and incur liabilities, the assets of both the parent company and other subsidiary SPV's are protected.

Raising equity with Joint Venture partners

Every development project is different in terms of the amount of equity (deposit) required from the directors/shareholders.

Setting up a new SPV for the development therefore makes it simple to provide shares to outside investors who come on board as Joint Venture partners.

Tax-efficiency

Profit (income and capital gains minus expenses) made by the SPV is subject to corporation tax at the appropriate rate.

The SPV can however offset against corporation tax any relevant business expenses in running the company, including development finance interest and directors wages.

The SPV is still subject to stamp duty land tax (SDLT) on the initial purchase of the site, with the 3% surplus also applying to the purchase.

Providing a Personal Guarantee for development finance

Before providing funds, development finance lenders require detailed information on the directors and shareholders behind the company. They'll examine their:

• Development experience, including whether they've carried out similar types of projects before.
• Individual finances. Lenders will request a Statement of Assets and Liabilities (A&L) from each director/shareholder.

Lenders will often ask for a Personal Guarantee (PG) from the shareholders in a Limited company or members in a LLP.

A personal guarantee is an undertaking to take responsibility for a proportion of the loan, typically up to 25%, if the Limited company or LLP fails to meet the development loan payments.

Lenders assess the level of personal guarantee they require based on the Loan to Gross Development Value. The higher the LTGDV percentage, the larger the personal guarantee required.  

A legal charge is often taken over the director's main residence and/or other personal properties to provide comfort to the lender should the personal guarantee not be honoured if called upon.

First, second and equitable charges

Security could take the form of a first charge if you're home is unencumbered, or a second charge if not.

Some lenders will consider only taking an equitable charge on the property, rather than a second charge.

As equitable charges don't require the consent of the first-charge holder, the loan can often be issued faster.

Nor does an equitable charge give the lender the right to sell your property if you default on the loan. But the lender can enforce their interest in your property via a court order.