Different ways to fund a property development
There are various methods of finance for property development and the options available will depend on the type of project, the amount of funds being put into the project by the developer plus the past experience and expertise of the people involved in the project. These different funding options include bridging loans, development finance, joint venture funding and mezzanine finance. Most developments will use one or a combination of these options in order to provide the funds required to carry out and complete the project.
A popular method for financing new building and refurbishment projects are bridging loans, which are particularly useful for people who are looking to fund their first project. Bridging loans are a useful method of raising the short term finance required to modernise or refurbish an existing property that is already owned by the applicant. They are also commonly used to build new property that is on the applicant’s existing property, having obtained planning permission to build within their grounds. An important reason why bridging loans are a popular source of funds for this type of project is because they are more flexible when it comes to the past experience of the applicant, whilst providing a cost effective short term method of finance that will be repaid once the property has been completed and sold or refinanced.
For more experienced property developers an alternative method of raising funds is through development finance. This is similar to a bridging loan only more tailored to property development in that the amount of money that can be raised can be greater because funds are released based on the existing value of the development, build costs and the value of the property once it has been finished. In addition development finance can prove more cost effective because funds can be released in stages as they are required, therefore saving in interest charges.
When looking for development finance a lender will require an investment from the developer. This can be through capital put into the project or equity from another property that can be used as security. When there is a shortfall in the funds required to carry out a development project this can sometimes be solved through the use of mezzanine finance. A mezzanine finance provider will only invest if they can see that a project looks like it has an excellent chance of being profitable. This is because they are taking second charge behind the development finance provider and are therefore taking a much greater risk. In return for their investment they will either charge a higher rate of interest, or take a percentage cut of the profits once the development is finished. Providers of mezzanine finance will usually only consider lending to developers who have considerable experience and a proven track record of producing profitable developments.
Similar to mezzanine finance is joint venture finance or funding. This will involve a third party putting in capital and in return taking a percentage of the development’s profits. Joint venture finance can be limited to experienced developers, however if a project looks particularly attractive packages can be put together for developers with little or no experience, that involve development finance providers together with joint venture finance, because the joint venture provider will also supply the experience required.
Finding the finance for development projects
Available throughout the UK are great deals to be had for development land that can be used for both residential and commercial developments. These deals can be even better for sites where planning has lapsed or in the process of being provided. However, buying a development site, building on it and then selling the residential properties or commercial units once completed isn’t as easy as often thought and more importantly those hefty profits that can seem very apparent at the start can quickly disappear!
Anticipated building costs can quickly increase, right from the start of the project if ground works turn out to be more expensive or problematic than expected. Any unforeseen problems will quickly add to the build cost and therefore reduce the anticipated profit.
If the cost calculations and budgeting was optimistic and worst of all very tight, then a development project can quickly run out of money and grind to a halt. Hence the reason why there are so many development projects throughout the UK that are for sale part way through the project.
When looking to fund a development project, the options available are refinancing other properties and assets through commercial and buy to let mortgages, or raising finance using the development site itself through the use of bridging loans or development finance.
A bridging loan provider will base their lending on the open market value of the plot. As building commences and the value increases there is the opportunity to increase the amount being financed. Rather than using bridging loans as a method of funding, development finance is more tailored to suit this type of lending. A development finance provider will lend based on the value of the land, the build cost and the end value of the project. This is very useful to developers because it allows them to raise a higher proportion of the finance required. With development finance, funds are released at the start to help fund the purchase of the land if it is not already owned, then in stages during the build process.
For projects where the amount of money being put in is limited by the developer there may be the possibility to raise mezzanine finance. This is a facility that would be used in addition to the money being provided by the principal development finance provider who would be taking first charge on the property. The mezzanine finance provider will take a second charge. Both finance providers will charge interest on the money being lent to the development, however mezzanine funders will tend to charge a smaller amount of interest but will also require an agreed percentage of the development profit in return for providing the mezzanine finance.
Lenders who provide development finance will usually only lend to experienced developers, or for projects that are employing or involving a suitably experienced developer. Mezzanine finance providers tend to only lend to experienced developers with a successful track record.
Having completed the development it is then important to either sell the properties or find an end user as quickly as possible, remembering that for as long as the development finance facility is still outstanding that interest is being charged.
Funding construction and renovation projects through bridging and development loans
When looking for finance to fund renovation or new build projects, bridging loans are often a popular option. Bridging lenders will lend according to the current value of a site or property and many bridging loan providers are happy to lend on land, building sites and property that is in need of restoration. Because other lenders are reluctant to lend on property that is in need of construction or restoration, this is an important reason why bridging loans are often used to fund building and restoration projects.
Once the work has been completed a developer will either sell the completed property and the proceeds used to repay the bridging loan, or alternatively they may refinance it with a more traditional method of finance.
Bridging loans are arranged based on the current market value of the property. When construction and refurbishment work is carried out correctly the property is likely to increase in value as work progresses. However any bridging finance taken out to fund building and restoration work would have been taken out based on the property value at the time of receiving the finance. This can often restrict the amount of funding that can be received for a project.
Development finance is similar to bridging but is a more specialist method of finance used for funding building projects. With development finance the lenders will take into consideration the value being added to a project as work commences and progresses. This allows them to release more funds than would have been available through bridging finance. In addition development finance allows for funding to be arranged over longer periods than is possible for bridging, and can also save customers interest charges because funds can be drawn down from the lender as they are required.
Developers will also need to contribute finances into any project. This could also be in the form of equity owned in the land being used for development or perhaps equity in other property. When a developer is unable to contribute the amount of equity required by the development finance provider, there may be the option to use mezzanine finance.
Mezzanine finance is available to experienced developers and is a method of raising additional finance for new build developments, major restoration and conversion projects. A mezzanine finance provider will provide funds and take a second charge behind the principal development finance lender. At the end of the project they will expect their money back in addition to a small amount of interest and also a percentage of the project profits. Their share of the profits would have been agreed before hand, and will be in proportion to the amount of risk involved.
Bridging loan to development finance with some mezzanine funding
Construction and development projects are often funded using some method of short term finance. This is because the finance is only required to help fund the purchase of the land, any existing buildings and the build cost, then once the project has been completed the new development will either be sold or refinanced and rented out. If keeping a development to rent out, refinancing is usually required because a suitable long term method of finance will be required. The long term finance facility, such as a commercial mortgage, can’t be put in place at the beginning because of the nature of the security property. Long term finance facilities require completed developments.
Because development funding is therefore only required for a short period of time finance is often raised through the use of bridging loans. These bridging loans can be secured on any property that the developer owns and would like to use as security, including the development itself. Bridging loan providers are usually flexible about the type and condition of the security property, which combined with the short term nature of bridging finance, makes this a popular option for developers.
Another alternative is development finance which is specifically designed to facilitate funding new construction and development projects. The main advantages of development finance are that funds are released in stages as the development progresses. This is beneficial because interest is only charged on the money that has been released. In addition this type of facility enables more capital to be released than with other options, because it takes into consideration the increasing value of the development as work progresses.
For developments where there is a very limited amount of capital available from the developer an option known as mezzanine finance may be available. Mezzanine finance providers will lend on a second charge basis behind the first charge lender. They may lend to very high loan to values depending on the project. Mezzanine finance will usually have a nominal interest charge, but the agreement with the mezzanine lender will normally be based on them having a share of the project’s profits. The higher the amount of money invested by the mezzanine lender, the greater the risk, then the higher their share of the profit.
Mezzanine finance is normally only available to experienced builders, and to obtain this form of finance a lender will need to be attracted to the project and confident with the ability of the developer.
