Property developments are financed by a developer borrowing money to fund the purchase of land and the construction of buildings. Development finance requires a number of contractual considerations and instructing a property finance solicitor is essential to ensure you get the right finance for your development.
Here we'll be covering:
- How does development finance work?
- When might finance be necessary for a development project?
- What are the types of property development finance available?
- What do lenders look for?
- How to prepare your property finance application
- The application process
- How can a commercial property finance solicitor help you?
- Exit Strategies
- Summary
How does development finance work?
A development finance transaction works by a developer borrowing money from a lender (or lenders) to finance the acquisition of land and the subsequent property development. After the building is completed, the property will be sold or used as an income source for investment purposes.
The money borrowed is secured over the property and the rights of the developer.
When might finance be necessary for a development project?
Large projects will require ground-up development finance that covers all costs involved with the purchase and construction. Finance will be taken over many months or years, in intervals, up until the completion of the project. The property development finance will likely be 70-80% of the building cost. The balance of the cost will normally be met through subordinated loans and or equity.
What are the types of property development finance available?
Development Finance
Development finance is specifically designed to fund construction and development projects. It provides the necessary capital to cover land acquisition, construction costs, and other project-related expenses. Development finance can be obtained from banks, specialised lenders, or development finance institutions. The loan terms and interest rates may vary depending on factors such as the project's feasibility, your track record as a developer, and the collateral provided.
Bridging Loans
Bridging loans are short-term financing solutions that provide developers with quick access to capital. These loans are typically used to bridge the gap between the purchase of a property and a long-term financing solution, such as a mortgage or refinancing. Bridging loans are often favoured for their flexibility and speed of approval, making them suitable for time-sensitive projects. However, they usually come with higher interest rates compared to traditional loans. Before committing, you should carefully consider the terms and repayment structure of a bridging loan with the help of an experienced commercial property finance solicitor.
Private Equity
Private equity involves raising capital from private investors or investment firms to finance property development projects. In this arrangement, investors provide funds in exchange for a share of ownership or a return on investment. Private equity can be structured in various ways, such as through limited partnerships or special purpose vehicles (SPVs). With private equity, you benefit from the expertise and financial resources of the equity partners, while investors seek potential profits from the project's success.
Joint Ventures
Joint ventures occur when two or more parties collaborate to develop a property project. It can involve you partnering with an investor, another developer, or a landowner. In a joint venture, the parties pool their resources, skills, and capital to share the risks and rewards of the project. The specific terms of the joint venture, including profit distribution and decision-making authority, are usually outlined in a joint venture agreement. Joint ventures offer the advantage of leveraging complementary expertise and diversifying financial responsibilities. However, effective communication, mutual trust, and a shared vision are crucial for successful joint venture partnerships.
Mezzanine Financing
Mezzanine finance is commonly used by property developers to fill the gap between their equity contribution and the senior debt provided by traditional lenders. This can be for several reasons, for eg to reduce the amount of deposit you need to put down upfront, to bridge a funding gap or to obtain top-up funds for a project. It is typically structured as a second-charge debt with higher interest rates.
Crowdfunding
Crowdfunding has gained popularity as an alternative financing option for property development projects. It involves raising small amounts of capital from a large number of individuals through online platforms. You can present your proposed project to potential investors who contribute funds in exchange for a share of the project's profits or other rewards. Crowdfunding can be an effective way to access capital quickly and tap into a broader investor base. However, it requires effective marketing, and a compelling project proposal to be successful.
It's important to note that the suitability of each finance option may depend on factors such as project size, risk appetite, timeframe, and your specific commercial goals and needs. You should conduct thorough due diligence, seek professional input, and carefully consider the financial implications and the legal requirements of each option before making a decision.
What do lenders look for?
While each lender will have their specific criteria, common features include:
Developer's experience: evidence of successful past involvement in projects, relevant expertise, and a good understanding of the development process gives lenders confidence. Similarly, an experienced professional team of architects, surveyors, solicitors, and contractors who will support your application and project enhances credibility.
Project feasibility: lenders may estimate the project's potential profitability and the developer’s ability to complete it on time and within budget.
Financial viability: a developer’s financial standing, creditworthiness, proposed equity contribution, cash flow projections, and any pre-sales or leasing agreements in place impact the overall financial feasibility of the project.
Security: the value of the security or collateral put up for the loan, and whether it is sufficient for the loan amount requested is an important factor.
Development plan and key documentation: a solid development plan, supported by architectural drawings and evidence of planning permissions, plus other key contracts and agreements in place for the development shows the project is well-planned and viable.
Exit strategy: a viable and realistic exit strategy is crucial for lenders to mitigate their risks.
Market conditions: the supply versus demand, stability and profile of the specific type of market the development caters to or is located within can impact a lender’s decision.
How to prepare your property finance application
While specific requirements may vary between lenders, having a clear idea of the core aspects of your project can help you prepare a thorough and compelling application. You may be asked to provide some or all of the following:
Project details: clearly articulate your property development project, including its purpose, scope, location, and expected outcomes. Outline the development plan, including details such as the type of property, construction timeline, and target market.
Financial requirements: calculate the total costs of the project, including land acquisition, construction, professional fees, contingency funds, and other associated expenses. Identify the amount of finance you require and how it will be allocated throughout the development process.
Business plan: outline your project's objectives, financial projections, market analysis, and risk assessment, as well as a realistic strategy for achieving returns, and a clear exit strategy.
Financial documentation: gather all the necessary financial documents required by lenders. This may include personal and business bank statements, tax returns, financial statements, proof of income, and details of any existing liabilities or assets. Ensure that your financial records are up-to-date and well-organised.
The application process
Once your application is submitted, the lender will evaluate your project and conduct a thorough due diligence process. This may involve site visits, financial analysis, and risk assessments. Be prepared to answer any additional questions or provide further documentation during this stage.
If your application is approved, the lender will provide you with an offer letter that outlines the proposed loan terms, including interest rates, repayment schedule, fees, and any specific requirements.
How can a commercial property finance solicitor help you?
Involving experienced commercial property finance solicitors at the outset is crucial to obtaining finance that is right for you and your project. Our role is to guide and support you through the finance application process, ensure compliance with legal and regulatory requirements, and protect your interests in the transaction. Our expertise is essential in navigating the complexities of commercial property financing. In particular, we help with:
Choosing finance: through our technical expertise, commercial insight and industry know-how, we can advise you on the available and suitable financing options based on your specific requirements, financial situation, and project needs.
Loan application: we can support you with the loan application process, in particular by reviewing the terms of the loan offer carefully, highlighting any onerous terms or conditions to you and negotiating if necessary to minimise your exposure.
Loan documentation: once you have decided to proceed with the loan, we will assist with the necessary loan documentation. This typically includes drafting or reviewing and negotiating the loan agreement and security documents with the lender on your behalf. We aim to ensure that the terms are not onerous and protect your interest. This may involve negotiating repayment terms, covenants, and other financial and legal conditions.
Compliance: we will also review and address any compliance issues during the process, such as anti-money laundering regulations, data protection laws, and financial regulations.
Communications: throughout the process, we act as the primary point of contact between you and the lender. We provide all required documentation, respond to lender queries, and facilitate communication and negotiation between both parties.
Closing the transaction: once the lender approves the loan, we assist in coordinating the closing of the transaction. This involves finalising the loan agreement, executing the security documents, and ensuring all legal requirements are met for the loan to be released.
Registration: importantly, we attend to all post-transaction formalities such as registering the security interest with Companies House and any Land Registry filings. Failing to register can lead to serious consequences for both parties.
Exit Strategies
Planning exit strategies for property development
When embarking on a property development project, you will no doubt have an end-goal in mind as to how to make a return on your hard work and investment. A well-planned exit strategy, including how and when to repay any finance borrowed, can maximise your returns. Common exit strategies include selling the completed development, letting and holding onto it, refinancing or releasing equity.
It is important to note that the terms of the property development finance itself can impact the timing and method of exiting a project. For example, the cost of property development finance, including interest rates, fees, and other charges, affects the overall profitability of a project. Higher financing costs can reduce profit margins, and you may then prioritise a quick sale to minimise interest expenses. Another example is that if your borrowing is comprised of a higher loan-to-value ratio (ie the percentage of the property’s value which is financed), then it may be more challenging to pursue certain exit strategies, such as refinancing or equity release.
It is crucial that you carefully consider the financial implications of your chosen exit strategy and work closely with lenders, financial advisors and property finance solicitors to ensure that the strategy aligns with your project's financial goals and obligations.
Transferring ownership in joint ventures
Joint venture parties often agree on transfer of ownership provisions in the joint venture agreement. This enables one or more parties (depending on the number involved) to exit the joint venture by transferring their ownership interests. It is common for there to be tight restrictions and controls surrounding transfers and exits so that the remaining parties are not disadvantaged. Transfer mechanisms and controls commonly used include:
- Preemption rights or right of first refusal - giving the remaining party or parties in the joint venture the right to purchase the existing party’s ownership interests before offering them to third parties.
- 'Drag-along’ and ‘Tag-along’ rights.
Drag-along right: this allows a majority or controlling party in a joint venture to force the minority or non-controlling party to sell their ownership interests along with the majority party's interests. In other words, if the majority party receives an offer from a third party to acquire their ownership interests, they can 'drag along' the minority party, requiring them to sell their shares on the same terms and conditions.
The purpose behind such a provision is that it enables the controlling party to facilitate a sale of the entire joint venture or a substantial portion of it, even if the minority party does not want to sell. As such, potential buyers interested in acquiring a controlling interest cannot be obstructed by a monetary party.
Tag-along right: this protects the minority or non-controlling party in a joint venture. If the majority party receives an offer to sell their ownership interests, the tag-along right allows the minority party to 'tag along' and sell their shares on the same terms and conditions as the majority party. Essentially, it gives the minority party the right to participate in the sale and sell their shares alongside the majority party.
The purpose of a tag-along right is to ensure that the minority party has the opportunity to sell their ownership interests if the majority party decides to sell. It prevents the minority party from being left behind or disadvantaged if a sale occurs.
Both the drag-along right and tag-along rights therefore can help protect the interests of both the majority and minority parties in property development projects.
As experienced property development finance solicitors, we can help you negotiate and define the specific terms and conditions of transfer of ownership provisions in your joint venture agreement to ensure clarity and avoid disputes further down the line.
Legal implications of property disposition
Property disposition refers to the transfer of legal title to land or property from the owner or seller to another person or entity. When you dispose of property, you are under an obligation to provide full disclosure of information relating to the land or property. This includes any known material defects or issues with the property. Failure to do so can result in a legal claim for misrepresentation.
If there are any existing contracts or agreements that you entered into relating to the land or property, such as leases, easements, covenants etc. these may need to be considered and addressed during the disposal process.
Sellers often assume that once disposed of, they no longer have any liabilities relating to the property, but this is not the case. For property developers in particular, be mindful of:
Structural defects: property developers can be held liable for structural defects or construction issues that manifest after the sale. Under the Defective Premises Act 1972, developers can be responsible for defects that render the property unfit for habitation. Buyers may have the right to seek remedies or compensation for such defects.
Warranty obligations: property developers often provide warranties, such as the NHBC Buildmark warranty, which covers defects for a specified period after the sale. Developers may remain liable for addressing defects covered by these warranties even after the property is sold.
Common areas and infrastructure: in certain developments, you may be responsible for the maintenance and management of common areas, such as roads, parks, or communal facilities. Even after the sale, you may retain liability for the proper upkeep and management of these areas until they are transferred to a management company or residents' association.
Tax implications
When purchasing the land or property for development, it is likely you will have paid stamp duty land tax on the market value at the higher rate. When it comes to disposing of the developed property, there may be further tax implications.
For taxation, it is important to understand whether you are classified as a property trader or investor. Property traders buy land or property to develop and sell for a profit, whereas investors acquire and hold onto property for long-term gain while generating rental income in the meantime.
For property traders, income tax is payable on the profit made on final disposal of the property (whereas Capital Gains Tax (CGT) applies to investors). If you hold the property within a limited company, the profit from the sale may be subject to corporation tax instead of income tax.
If a loan is taken out for business property development, the interest paid on the loan is generally considered a tax-deductible expense. It can be deducted against the taxable profits generated from the property development activities, reducing the overall tax liability.
In addition, newly constructed buildings or properties that have undergone significant renovations are generally subject to Value Added Tax (VAT) at the standard rate. This means you will need to charge VAT on the sale.
Tax rules can be complex, especially concerning property transactions. Other considerations may apply to your specific circumstances, such as capital allowances or annual tax on enveloped dwellings (ATED). It is important to seek specialist advice from a tax professional to ensure you meet your tax obligations and make use of any reliefs or allowances available.
Summary
Whether you are new to property development or a seasoned developer, property development finance is a core but complex aspect of a project. Securing the right type of finance on the best possible terms for your particular project can minimise your exposure and maximise your returns. With several types of finance options to consider, a thorough application to complete, lengthy documents to agree, as well as several implications to bear in mind - it is vital to have a specialist legal team on board to help you successfully navigate the process.
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