Development Finance - exploring a variety of options

Michael Fleming
What options do you have in development finance?

Since 2008 Banks have been more selective in providing development finance. This change has occurred due to a combination of uncertainty in the market, regulatory changes on the amount of capital banks must maintain in reserve and a current 'softening' in the rate of increase of sales prices for residential assets. Further to this, fundamental changes in the high street (with big name insolvencies and/or store closures) have resulted in an increase of vacant retail space. Banks have therefore adjusted the percentage they lend in their loan portfolios from shopping centre developments to other asset classes, to reduce risk. 

While acknowledging banks continue to be active in the property development sector, it is worth while looking at other options which may be available. 

 

Senior Debt

This is the traditional route to fund costs with senior debit being provided by a 'funder'. Examples of a funder apart from a Bank include Insurance Companies and Pension Funds. Banks typically provide shorter term development funding. Long term development loans, repaid from an income stream (such as retail or commercial units), are usually provided by Insurance Companies and Pension Funds.

The amount that funders will provide is based on several factors including the location, target market of the asset, height of the asset, the borrower's experience and financial covenant. The proportion of debt to equity will need to align with the funder's Credit guidelines for the type of asset class. The amount lent will typically be a percentage of either the GDV or build costs.

These types of funders will selectively lend to residential assets with repayment from the sale of the asset. Purchasers for the assets will be sourced by the borrower during construction. For retail and commercial assets, a pre-let needs to be in place prior to funding, with a tenant who has a good covenant. 

Forward Funded Type Arrangements

At Faithful+Gould we have seen these in a variety of forms.  Forward Funding typically concludes a sale and purchase agreement between the parties at an early stage (this can even be before planning has been secured). The purchase price is usually paid to the Developer in a series of tranches (e.g. planning, completion of ground floor slab, superstructure etc) with the final payment on Practical Completion and execution of the lease. The benefits to the developer are that the forward funding results in a significant increase in the IRR.

We have seen variations of the format, particularly where a forward funding arrangement is not in place for the entire development. Examples include purchasers of residential assets paying in tranches after exchange (particularly for smaller developers), Build to Rent in the PRS market, payments by the Registered Provider for affordable units (the so called 'Golden Brick' - and any subsequent payments required by the development agreement) and the sale of retail units to a fund once they have been pre-let (but prior to the completion of construction).  

Mezzanine Provider

While we would not go as far as to say the market is crowded, over the years there has been a significant increase in the number of providers.

The traditional role of these providers has been to either make good the shortfall between developer equity and senior debt to finance development costs, or to provide short term (albeit relatively expensive) bridging finance.

Some of these providers are now acting in the role of Senior Debt providers. They will sometimes lend a higher percentage to a development than the more traditional funders, particularly via their 'stretch' products. 

Private Funding

At Faithful+Gould we have acted on some developments where the parties formed a Limited Liability Partnership Joint Venture (JV) vehicle. Development costs were then financed from their own respective sources. The sources typically comprised retained profits generated from their other business operations. The parties to the JV typically comprise a pure investor, with the other party being a contracting type of organisation. The latter can be appointed by the JV to deliver the construction of the asset.

The JV element allows the parties to share the risk. Each JV party should check that the IRR of investing in the asset should exceed the IRR gained from their usual business operations, to ensure that a satisfactory return on capital is achieved.

The JV parties typically share the profits in the same proportion to their equity contributions to finance the asset's development costs.   

Bonds

These are generally split between Minibonds, Retail Bonds and Wholesale Bonds.

There are online Minibond providers in the market targeting individuals to deposit monies with them, to earn returns which are often higher than more traditional interest earning investments. This creates a pool of funds which are lent to a portfolio of property developments. Such loans to developers are secured against the assets in the same way as other finance.

Unlike Minibonds, Retail and Wholesale bonds are tradeable and are offered in a regulated business environment.  They are offered similarly to a share offering by a company - a prospectus is issued, but the investor in a bond receives an interest payment instead of a dividend. 

Government Organisations     

We have been involved with a number of projects which at the outset are difficult to get started due to extensive site abnormals. Government organisations are often able to assess funding Infrastructure, for example, to derisk this abnormal element of the works at the start of the development and enable the developer to proceed with the project.

Michael Fleming is both a former Banker (he is an Associate of the Chartered Institute of Bankers) as well as being a Chartered Surveyor.  He heads up Faithful+Gould's Fund Monitoring team.  Faithful+Gould has provided Fund Monitoring services for almost 20 years to a variety of lenders, including banks, joint ventures, freeholders and government agencies on projects in the UK, Europe, Africa and the Middle East on assets with a range of construction costs of between £4m and £500m. 

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