The UK property market is a massive and important economic sector with a total value of £8.1tn at the end of 2020 according to IPF Research. Their Size and Structure of the UK Property Market report estimates the value of the residential property sector at £7.2tn is almost 8 times the value of the commercial property sector at £918bn. In the commercial sector retail, office and industrial are similar sizes with commercial now being the largest due to a near 20% decline in the retail sector over recent years.
Every single property starts with the vision of a developer and will require, among other things, development finance. Funding a development usually requires a combination of investor equity and debt over the entire life cycle of the development from initial purchase of land or property to the completion of the eventual sale of the property or final unit.
In the UK there is a sophisticated property development marketplace with many players: planners, architects, surveyors, construction firms, sub-contractors, material providers, support services, advisers, investors and principal lenders.
The Blueray Capital Property Development Finance Guide is designed to help those who are considering a development loan to fund a single development or refurbishment to larger more complex schemes. Although there are some differences between the commercial and residential sectors, which are mainly to do with lender appetite and criteria, this guide applies to both. It is not meant to be definitive but covers most of the elements involved in the development finance process.
20 steps to property development success
- Types of development
Developments can be stratified into two categories.
- Ground up development where a complete property is built on vacant land.
- Refurbishment (commonly referred to as refurb) where an existing property is upgraded or re-purposed. Refurb may be light or heavy. The latter involves structural changes whereas the former consists of changes to fixtures, fittings and decorative condition.
Within these the development finance challenge could relate to a single unit or a scheme. The latter could be a multi-unit development within a single property such as a block of flats or HMO, or a housing development from 2-3 luxury dwellings by a private developer to the creation of hundreds of homes by a major house builder.
The criteria applied by lenders to a property development project or scheme that will be deemed acceptable to their credit underwriting process are many and varied. They include geography, property type, location, minimum and maximum value, developed value, build cost, liquidity and developer experience.
There are many reasons for a lender not to consider your project. They may exclude blocks of flats (or those above a certain size), HMOs (homes of multiple occupancy) (or those above a certain size), student accommodation (or those outside specific cities), care homes, pubs, hotels, farms etc.
In short, the better the quality of the scheme and the more experienced the principals involved, the more interesting it will be to development lenders.
- Exit strategy
Equally important to the lender is the strength and certainty of the exit route or re-finance plan. This typically takes the form of the sale of the units themselves or a BTL mortgage or other re-finance option on the completed asset. The lender will require comfort on the likelihood of the re-finance being delivered at the quantum required and, in the timescale agreed. If it’s a BTL mortgage, then a decision in principle (DiP) from the lender is normally required. If it’s sale of the units then the lender will factor in up to 50% of the build time for the marketing process.
Most development lenders look for an unencumbered property on which they will take a 1st charge for the extent of the development life cycle.
- Loan term
Most development finance lenders will lend up to 24 months although the timing is dictated by the development plan. A small, refurb project for an investment property aimed for the BTL market may be a 3-month term with a more complex heavy refurb or ground up development being over 18 months with 12 months build and 6 months marketing.
- Key metrics
Loan to value determines the gross loan amount the lender will consider based on the assessed value of the property. Borrowers usually want to borrow as much as possible on the strength of the asset value but lenders have strict minimum and maximum guidelines, normally in the 60% to 75% LTV range. LTVs for commercial properties are usually lower than residential (and interest rates are higher).
Loan to cost is the amount that the lender will contribute to the total build/refurb cost of the scheme. This could be between 75% and 90% with some lenders considering funding the entire build cost which usually involves a higher rate or a share of developer profit. The majority of funders won’t fund the entire structure.
Loan to gross development value is the amount the lender will commit compared to the final value of the refurbished property or completed schemes when all units are sold. LTGDV ratios are usually in the 60% to 85% range.
In each of the above the valuation report determines the values, not the developers estimates and for sizeable schemes a development appraisal should be submitted (see below)
During the turbulence of the last 2 years lender valuation requirements have adapted to accommodate travel restrictions and the shift to working from home. The preferred option is a valuation report by a RICS qualified surveyor. This involves a property visit, measurements & photographs resulting in a detailed report on the asset, its rental income potential and local sales comparisons to establish developed values. Lenders use a panel of surveyors usually offering 3 choices to the borrower who will need to pay the survey cost prior to instruction. Some lenders have begun to use desktop valuations and automated valuation models, especially for lower value assets or specific types of property. There can be surprises in the valuation outcome and so borrowers are advised to incorporate conservative values in their plans.
- Interest rate
The rate charged is normally expressed as an annual % rate as most development loans are repaid on a rolled-up interest basis. At the end of the term, or on completion of the project if earlier, the borrower pays back the principal + total applicable interest + fees. Interest rates are in the 6% to 10% range.
- Arrangement fee
A development finance lender makes its return on the margin of interest received over its cost of capital. It covers some of its application process costs through an arrangement fee, normally 1% to 2% of the gross loan amount. This fee is deducted from the gross loan amount and usually shared with the commercial finance adviser, or broker, who has introduced the transaction and supported the client through the process.
- Exit fee
At the end of the process there is normally an exit fee, usually 1% to 2%, which is deducted from the gross loan amount and forms part of the redemption statement. A shorthand for the 3 main cost elements of a development finance facility is: “2% In , 8%, 1% Out”, meaning 8% interest rate applying over the term with a 2% arrangement fee and a 1% exit fee.
- Other costs
Development finance lenders have different pricing policies, but other costs typically include:
- Administration/Commitment/Acceptance fee
- Monitoring fee
- Early repayment charge, or ERC. Usually expressed as a minimum term. Given the complexities of development it is more likely that more time is needed than less!
- Surveyor fee, the borrower pays for the valuation report directly to the surveyor firm
- Legal costs, the borrower pays for the lender’s legal costs
All costs are detailed on the development finance quote, indicative offer or term sheet before proceeding to the valuation and legal stage. At this point in the process there may be a small, but non-refundable, commitment or acceptance fee which is deducted from the administration fee on completion.
- Gross loan
The gross loan is the amount the borrower will need to repay at the end of the term. It is derived from the property value (as confirmed in the valuation report) taking into account the lender’s LTGDV and LTC policies.
- Net loan
The net loan, often referred to as Day 1 proceeds, or the draw down amount, is the facility available to the borrower on completion of the legal documentation. It is not paid out to the borrower, rather deployed monthly in line with the progress of the build program. The net loan is the gross loan less all the deductions which include the arrangement fee, monitoring fee and the retained interest for the full term.
- Decision in principle
A DiP, Quotation or Term Sheet details all the costs and terms of the development finance lender. Once accepted by the borrower, the surveyor is instructed to produce the valuation report, final credit sanction is obtained and the legal process started.
Know your client
KYC is a security process all lenders are required to complete for fraud prevention purposes. By gathering full identification details and completing various credit checks they can ensure the borrower is legitimate with sufficient credit status and not on any sanctions list. Some lenders are moving to electronic systems which are online and automated while others require certified copies of a driving licence or passport and a recent utility bill. The process is normally completed after the valuation report once a credit-backed final offer is received, and the legal process is underway.
All lenders want to minimise their risk of default which is why the operate within specific lending criteria and closely review each application. Most lenders prefer to lend to experienced developers and property professionals. Some lenders will consider first-time developers. For the inexperienced developer the key is to start small, maybe a modest BTL refurb. Even with 1 or 2 projects under one’s belt, an application for £5m to support a 60 unit ground up development will not gain traction if the applicant’s prior experience includes a £250k refurb of a BTL property and a £1m development of a detached dwelling.
- Development appraisal
This is a detailed document containing all the elements of the proposed scheme. For larger, more complex schemes lenders will not consider an application without an appraisal. It will include full property details and costs, development values, build costs, timetable, exit plan, comparable valuations and team bios. The quality of the appraisal can often mean the difference between lender acceptance and decline.
- Monthly valuations
Once the development loan application is approved and legals are completed the developer may begin accessing the facility. A monitoring surveyor (MS) will have been appointed whose role is to validate the deployment of the facility to the contractor involved. This is done on a monthly basis via a site visit and meeting where progress is agreed. The MS will notify the lender via a report and a draw down will be sanctioned which will enable the contractor to be paid.
It is important to note that VAT is not funded by the lender facility. VAT costs are usually reclaimed by the developer, but sufficient cashflow needs to be allowed for in the build program to ensure this process is covered adequately.
- Redemption statement
To settle the development loan obligation the borrower will need to activate the designated exit route as described above so that the required funds are available to repay the gross loan amount. At this point the lender will create a redemption account showing any additional costs (exit fee/penalties) or reimbursements (refund of retained interest). Once the lender is fully satisfied the loan is settled, the charge on the property may be released. Note it is prudent for the borrower to confirm release of the legal charge.
Development lenders compete across all the lending criteria and time to complete is one of the important differentiators. Due to the sequential nature of the process (enquiry-quote-valuation-final offer-legals) and the number of firms involved (lender, surveyor, solicitor, borrower and borrower’s solicitor) the process normally takes between 4-6 weeks. Smaller refurb projects will complete in less time.
- Why use a development finance adviser?
As outlined in this guide, there are numerous aspects to development finance and navigating them effectively will increase your chances of success with development lenders. There are good reasons to use a specialist advisory firm, such as Blueray Capital, to achieve this success:
- We have relationships with all the leading development lenders. We know their lending criteria and application process requirements and provide prompt response on appetite and indicative terms.
- We make the process easier for the lender and they trust us. Applications introduced by advisers have greater chance of success than a direct approach. We will have done due diligence on the client, established the transaction is robust, prepared relevant information and will present it in a lender-friendly format.
- For good quality deals it’s likely that multiple lenders will express interest which provides the client with more choice and potentially enhanced terms. A key adviser role is to establish lender appetite quickly and help achieve optimum terms.
- Our fees are paid by the lender as part of their arrangement fee and so our service does not represent an additional cost to the borrower.
The development finance process usually starts with a conversation with Blueray Capital. We can efficiently assess the options available and usually provide indicative terms in minutes. We will then work with you exclusively to submit the application to selected development finance partners and guide you through the process to a successful and prompt completion.