Construction finance helps businesses fund their building projects and make their plans become reality. Also known as development finance, a borrower will borrow money from a lender to purchase and redevelop a property. Usually, the completed property is sold, or its rental income is used for investment purposes. In this article we’ll take you through how to finance a construction project, the parties involved, and the potential issues that may arise.
We'll be covering:
- What is development finance?
- How does construction finance work?
- Who are the parties to a construction project?
- What are the key construction and finance documents?
- What are the key issues when financing a construction project?
- How much will construction finance cost?
- How do I draw down money from a construction loan?
- What kind of security will a lender require?
- How Harper James Solicitors could support you with construction finance?
What is development finance?
Development finance is the provision of money to purchase and redevelop a property. The money borrowed is secured against both the property and the rights of the developer over the development documents. Typically, the completed property will be either sold or used as an income-generating asset.
Construction projects tend to be complex and obtaining finance for construction projects is no exception. Development finance involves a web of different parties and contractual relations. Navigating these contracts and complex terms can be challenging. Our construction solicitors can help you navigate these difficult waters to ensure that you obtain the right finance at the right time for your project.
How does construction finance work?
There are typically two parts to construction finance:
- Finance documentation
- Construction documentation
Construction companies sit at the intersection of these two areas and are party to both sets of documentation.
Typically, a special purpose vehicle (SPV) is used by the construction company to borrow a senior loan from a lender. The SPV will also receive subordinated debt and equity from its shareholders and/or junior creditors.
The borrower will then enter into a building contract with a contractor and appoint professional consultants (such as architects). The senior lender may appoint a project monitor to ensure that the construction proceeds smoothly. In many cases, the borrower will also enter into pre-sale agreements and agreements to lease with prospective purchasers or tenants.
Who are the parties to a construction project?
The main parties to a financed construction project are:
- The borrower
- The lender(s)
- Contractors and sub-contractors
- Architects and structural engineers
- Quantity surveyors
- Property managers
For syndicated loans there may also be:
- The arranger
- The agent
- The security trustee
- The hedging counterparty
What are the key construction and finance documents?
The key documents in a financed construction project are:
- Finance documents: The facility agreement, security documents, subordination and hedging agreements
- Development documents: Construction contacts, development agreement and operating agreement
- Other transaction documents: Property acquisition agreement
The finance documents govern how the loan will be provided and the security that the lenders will take in return for providing their loan. The finance documents may also include a subordination deed setting out the rights of creditors amongst themselves and may include hedging documents to control interest rate risk.
For more information on subordination please see our article on senior debt.
What are the key issues when financing a construction project?
A lender to a construction project will have three primary concerns:
- Step-in rights
A lender will wish to ensure that the cost of developing a property is within budget and not more than the value of the property after completion. In particular, the lender will want to ensure that the costs of designing, building, managing and letting or selling the property fall within budget.
A lender will also wish to ensure that the value of the site is comparable to the size of the loan. The unfinished property will be worth substantially less than the finished property and a lender may require significant levels of pre-sales or deposits before advancing a loan in full.
Another key consideration for a lender is step-in rights. A lender will want to ensure that they have the right to take over a property if a borrower defaults. This includes the right to take over the development and ensure that the works are completed. In effect, the lender will step into the position of the borrower and continue the construction until completion.
How much will construction finance cost?
The cost of construction finance varies depending on the current financial position of the company, including their existing debt and credit history. A borrower will be required to pay interest on the loan and a facility fee for arranging the loan. It is common for construction loans to charge a variable rate of interest so a borrower’s costs may go up or down depending on interest rates.
Interest and fees are often capitalised during the construction phase of a project and are added to the total loan. Once the loan enters the investment phase, the borrower’s costs should be met from property sales or rental income.
Many construction loans also require a large down payment before money will be advanced and the greater risk involved in construction projects normally attracts a higher rate of interest than other business loans. A borrower may also have to pay for site inspections carried out by the lender.
How do I draw down money from a construction loan?
Loans for construction projects are normally provided in stages. The first payment being used to fund the purchase of the site while later payments are used to fund the works. Receiving money under a loan is known as draw down.
Drawing down money is subject to the borrower meeting set targets negotiated with the lender. A borrower will have to demonstrate that it has hit certain milestones in the construction project before it can receive more of the loan.
For example, a borrower may be required to produce:
- A progress certificate certifying work is completed properly and in accordance with plans
- Copies of all invoices for costs
- A certificate confirming work is complete
- Evidence that shareholder equity will be provided
- Evidence that the borrower is on track to sell units
- Evidence insurance is in place
What kind of security will a lender require?
A lender will want to secure its loan by taking security over a borrower’s bank accounts, its rights under the building contract and any other key transaction documents (e.g. operating agreement). A lender may also take security over shares in the borrower, any obligor’s rights under subordinated debt agreements and any guarantees.
A lender will also wish to subordinate the claims of other creditors with a subordination deed. The subordination deed will prevent a borrower from paying interest to more junior creditors until the senior loan has been repaid.
How Harper James Solicitors could support you with construction finance?
Our team of experienced lawyers can help you obtain the best finance for your construction project. Our solicitors will help you negotiate the terms of construction contracts as well as the correct conditions to finance your project for success.