A Complete Guide to Development Finance

Important to know

A mortgage is a loan secured against your home. Your home may be repossessed if you do not keep up repayments on your mortgage or any other debt secured on it.

One of the most pressing issues in property development is getting enough money to execute projects. From the acquisition of land and construction costs to regulatory compliance and market fluctuations, every stage of the development process demands a large amount of financial resources. 

Access to reliable and flexible financing solutions is necessary for even the most promising ventures to reach their full potential. This is because the natural uncertainties of property development emphasize the need for careful financial planning and strategic risk management. 

Empower yourself with a comprehensive understanding of how development finance works. This knowledge will help you avoid problems like overspending, running out of money, or project delays. 

This article delves into what development finance is, its challenges, and strategies to overcome them, equipping you to achieve your property development goals confidently. Let’s dive right in. 

What is Development Finance? 

Also known as property development finance, development finance is a short-term loan arrangement used to support the construction, conversion, or renovation of buildings. It is a secured short—to medium-term credit facility commonly used for the development of several property-related projects.

These projects can range from minor renovations to large-scale developments, such as office block conversions or the acquisition and construction of projects on vacant land. Development finance can be accessed by individuals, developers with multiple properties, and small and large companies.

How Development Finance Works 

Lenders play a pivotal role in development finance. They determine the loan amount based on the project’s value and costs, using a development appraisal to assess its feasibility. The minimum loan amount varies by lender, with some starting at £50,000 and others requiring deals over £1 million for the best rates. 

Unlike regular loans, interest is included in the total loan amount, so monthly repayments are not required. Funds are first available for buying land or refinancing. Construction costs are paid as the project progresses, overseen by a monitoring surveyor appointed by the lender.

The Changing Face of Development Finance

Since the 2008 financial crash, stricter regulations have shaken the development lending market, causing traditional banks to lose their grip on it. Fast-forward to 2022, and Challenger and Specialists banks had a stellar year, lending a whopping £35.5 billion and clinching about 55% of the market share (according to the British Business Bank).

However, the ‘big 4’ UK high-street banks—Barclays, Lloyds, HSBC, and NatWest—still play a significant role. They’re more cautious now, mostly lending to existing clients or seasoned developers. This means borrowers need to cast a wider net to access the best deals.

The evolving landscape of development finance has not only brought about challenges but also opened up new opportunities for the property development market. The emergence of ‘alternative lenders’ has been a game-changer, offering more flexibility and accessibility in securing credit facilities. This surge in lending and borrowing means that, as a developer, you can close deals faster when you find the right lender, fostering a sense of optimism for the future of your projects.

What Development Finance Can Be Used For

Development finance as a short to middle-term loan can be used for the following property-related projects: 

#1. Commercial Property Development

Development finance is perfect for building or converting properties for offices, retail outlets, or leisure spaces, including mixed-use developments. Lenders often prefer having tenants lined up beforehand to ensure the project’s success, but some are open to considering proposals without pre-let agreements.

#2. Renovation Projects

When it comes to light renovations or refurbishments that involve minor structural changes, alternative short-term funding options like development finance may be more suitable.

#3. Residential Property

Development finance is very handy for various housing projects. These projects include constructing new homes, transforming office blocks or retail spaces into residences, erecting apartment complexes, or sprucing up existing houses. Developers looking to sell or rent out their properties can take advantage of development finance. 

The Benefits of Development Finance

Below are some benefits of development finance:

  • Quick access to credit facilities: Development finance provides quick access to funds, enabling you to kickstart your projects without delays.
  • No lengthy repayment period: Unlike traditional loans, development finance typically offers shorter repayment periods, allowing you to complete your projects faster and move on to new ventures. This means that with its shorter repayment structure, you’ll be free of long-term debt.
  • Roll-up interest: With roll-up interest, you can defer interest payments until the end of the loan term, easing financial pressure during the development process.
  • Low-interest rates: Development finance often comes with competitive interest rates, which reduces the overall cost of borrowing and, therefore, increases the profitability of your project.
  • Access to more projects: Development finance allows you to undertake more complex projects that require substantial upfront investment. It also helps you to manage multiple projects simultaneously, increasing your portfolio and revenue streams.

The Challenges of Development Finance 

Development finance is not without its downsides. The following are the challenges associated with this type of property financing. 

#1. Poor Visibility

Development finance options suffer from a lack of visibility, which poses a significant market challenge. Many developers remain unaware of the extensive range of non-bank lenders available. They often lack the connections needed to engage with the key decision-makers within these institutions.

#2. Lack of Transparency and Credibility 

The lack of transparency and credibility poses significant challenges in the market. While most developers are familiar with only a handful of lenders, brokers recognize the many options available. 

The entry of new lenders in recent years has resulted in high levels of doubt about their longevity through economic downturns. Therefore, it is important to exercise caution and understand the funding sources and potential risks associated with lenders.

Lack of transparency, minimal marketing efforts, and low brand awareness often lead to the overlooking of credible alternative lenders and the opportunities they offer. Lenders’ instances of taking excessive risks underscore the need for vigilance.

If there is an economic downturn, the disappearance of lenders could have severe consequences for developers, potentially exposing their investments to danger. Any unusually high leverage or seemingly too-good-to-be-true rates should raise red flags, particularly when dealing with newcomers to the property finance market. To play safe and avoid losses, partnering with reputable lenders is your best bet.

#3. The Presence of Transaction Cost

Transaction costs, including legal fees, valuation charges, and administrative costs, pose a significant challenge in accessing development finance. 

For developers, these expenses can quickly accumulate and reduce the project’s overall profitability. For this reason, developers must carefully budget for these costs to avoid financial strain and potential project delays.

Furthermore, the complexity and variability of transaction costs can make it challenging for developers to forecast and allocate resources accurately, further complicating the financing process. Therefore, thorough planning, strategic decision-making, and effective negotiation are necessary to optimize project profitability. 

What to Consider When Choosing Lenders

If you want to make the most of your investment, move fast, and succeed in property development, going straight to the big UK banks might not be your best bet. While they offer low rates, they often require hefty deposits, which can eat into your profits or restrict you to smaller projects.

Instead, it’s key to team up with an experienced broker who knows the market’s ins and outs. They can help you find the perfect lender and financing options tailored to your project, giving you the edge you need to succeed.

The Must-Have Competencies as a First-time Developer 

Entering property development as a first-time investor isn’t a walk in the park. Lenders consider it a risky venture, even though it holds promise for substantial returns. This makes it tough to secure borrowing opportunities. 

Experience is crucial for success, yet without financing, gaining that experience becomes a challenge. Here are the key abilities a beginner developer must showcase to persuade lenders they have what it takes to make a project thrive.

#1. Solid Skill-set

A solid skill set gives you a significant advantage and helps you secure funds faster. This comprises a wide range of abilities, such as understanding market trends, ability to identify promising opportunities, project management, and financial acumen. 

Lenders want to see you have the expertise to navigate the property development market and successfully execute your project. Your ability to demonstrate your skills and expertise will instil confidence in lenders that you can complete the project and deliver a return on their investment. 

#2. Experience 

Lenders prefer to fund developers who have a track record of success. Typically, it takes about three completed projects for a developer to be considered experienced by lenders. While previous projects don’t have to be large-scale, they should be relevant to the current undertaking.

For instance, if a developer has completed a loft conversion or renovated a house into flats, it doesn’t automatically guarantee funding for a much larger project. Lenders also pay close attention to specialized projects like basement construction or work on listed buildings, where direct experience is crucial.

While lenders prefer direct experience under the developer’s name, experience gained through other roles, like project management or advisory positions, may also be considered. Industry-related experience, such as working with builders, quantity surveyors, architects, or project managers on multiple projects, can also strengthen a developer’s case for funding.

However, if a first-time developer lacks sufficient relevant experience, lenders may hesitate to extend financing. In such cases, bringing in outside expertise or partnering with experienced professionals may be the best way forward.

#3. Readiness to Collaborate 

In property development, teamwork often leads to success. Developers should leverage other people’s skills and experiences. It’s crucial for developers to be honest about their strengths and weaknesses to identify areas where they may need assistance. 

Lenders prefer partnerships where all stakeholders have a stake. For instance, if a developer lacks the expertise to secure financing, they can bring in a project manager as a partner. The project manager, taking a share of the project, is motivated to deliver on time and within budget, which pleases the lender.

Working with the right team not only strengthens the developer’s case with lenders but also speeds up their progression to larger projects. As developers gain experience, their equity grows, enabling them to undertake projects independently.

Structure of Development Finance 

The Capital Stack is like the financial blueprint for your project, showing the different layers of funding involved. It is the structure of development finance. Typically, it includes senior debt, mezzanine debt, and equity. Deciding on the right financing mix helps you minimize your upfront investment while maximizing potential profits.

Here’s a breakdown

Debts get paid back starting from the bottom, meaning higher lenders take on more risk and charge higher interest rates. Equity sits at the top, followed by mezzanine debt and senior lending at the base. 

Lenders want to see your capital stack to understand their place in the funding hierarchy, which helps them weigh the potential returns of a development project against risks.

How to Calculate Development Finance 

Out of all property loans, development finance is the trickiest to figure out or calculate. To make the most profit, you usually need to take on more debt. And getting the Capital Stack right is the key to doing just that. 

Here is how it is calculated:

  • First, the lender looks at a percentage of the property’s value or what it’ll cost to build.
  • Then, they make sure you’ve got enough money in the game. This is called equity. The loan is split into two parts: one for buying the land and one for building.
  • The lender covers all the costs for the build first, like professional fees and materials, and whatever is left over goes into buying the land.

Interest Rates of Development Finance 

The interest rates for development finance depend on how risky the project seems. The other side of this coin is that when you’re borrowing a lot, the lender may be more hesitant to lend.

Each lender figures out loans in their way, which is why it’s smart to check out a few before picking one. An expert mortgage broker can come in handy in finding the ideal lender for your situation. 

As a broad principle, there are two main types of lenders:

  1. Mainstream lenders: typically more conservative with their lending, in terms of the amount they are prepared to offer for a given project; and the type of development project they are prepared to consider. Because they are more selective, and because they lend less and to less risky projects, the interest rates they charge are typically cheaper than rates charged by specialist lenders
  2. Specialist lenders: they tend to be more flexible than mainstream lenders, on the type of projects they are prepared to consider, and the amount of money they may be prepared to offer. In technical terms we would say they can offer “more leverage”, and they have a higher “risk appetite” than mainstream lenders. Because they take on more risk, and more leverage, their pricing is typically higher than mainstream banks. However, for some development projects they may be “the only” type of lender available, and may also offer more flexibility to meet your financing project requirements.

Documentation You Need to Apply for Development Finance

Developers seeking a loan must provide several key requirements and documentation, which are:

  • Developer experience: This includes skills, professional qualifications, and a history of previous developments.
  • Development appraisal: This is crucial for both developers and lenders to assess the land value, including all costs (acquisition, build, and sales) and the expected Gross Development Value (GDV).
  • Development schedule: This is a detailed list of the properties/units with square footage and sales prices.
  • Asset & Liability (A&L) schedule for shareholders and personal guarantee: A list of personal assets and liabilities to demonstrate sufficient cover for personal guarantees.
  • Anti-money laundering (AML) documentation: This includes a valid identity document (passport, driving license) and proof of address (utility bill, bank statement).
  • Source of wealth: This is a summary of where the funds were obtained, all of which must be supported by relevant documentation.

Mistakes to Avoid in Development Finance

Regarding property development, making the right call on your development loan is key. Yet, even seasoned developers often fall into some common mistakes along the way. They include:

#1. Failure to Explore the Market

Relying on one or two lenders limits your chances of finding the most favourable deal. But when you consider various lenders like challenger banks and specialist funds, you gain access to better deals.

With alternative lenders, developers can secure more generous loan terms, avoiding the need for a huge equity deposit. This leaves more capital for other projects and minimizes profit sharing with additional investors.

#2. Making the Wrong Choice of Partner

Teaming up with the right allies can strengthen your prospects for securing a property development loan, but making the wrong choices can spell trouble. Partners include everyone from contractors and shareholders to lenders and professional associates. 

A split can be financially draining, so it’s very important to select partners wisely. When bringing others on board, developers should agree with Personal Guarantees (PG) early on. 

If a partner hesitates to back the PG, it doesn’t necessarily mean the collaboration should be called to a halt. It only means their value should be weighed against others willing to commit.

#3. Failing to Pass Lenders through the Credibility Test

Protecting your investment starts with choosing the right lender. When you’re dealing with non-bank lenders in the development finance market, you have to be aware of the risks. While many credible lenders offer great opportunities, there are also some less trustworthy ones to watch out for. 

If a lender offers unusually low rates or high leverage, it’s a red flag. They might be taking risks that could jeopardize your investment. Because your equity is hard-earned, it is crucial not to gamble on an unreliable lender. 

Do your homework and research each lender thoroughly. Ensure they’re credible and have a solid track record. Consulting an expert broker can come in handy. 

If they’re new players, ensure they have the infrastructure to handle loans properly. Don’t overlook any details. Look out for hidden terms and ensure everything, especially the Heads of Terms (HOTs), is crystal clear and transparent. 

Bottom Line

Development finance can provide the funds needed to carry out your development projects. However, the process, from choosing a lender to applying, can be tasking and time-consuming, especially for new investors. However, our experienced brokers can take the stress off you and ensure you access the best products in the market. 

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Luca Bertolino

Mortgage Expert

Your Mortgage Experts is led by Luca Bertolino with 20 years experience in financial services and in the property market. Through Luca’s wealth of knowledge and expertise, Your Mortgage Experts have become a trusted adviser that clients have come to rely upon for all their mortgage and protection needs.

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