I work with a number of property development clients who take different approaches to development finance. As a consequence, I’m frequently asked to review the terms of finance arrangements to ensure that my client understands the legal implications and whether they may be incurring any personal liability, and to check for any particularly onerous or unusual provisions in the lender’s paperwork.

There are many different routes to obtaining finance for property development: traditional high street lenders, dedicated tertiary lenders, private equity houses specialising in development finance, business angels, and high-net-worth individuals. All of these will have different requirements, not least in terms of the interest rates they apply or the loan-to-value ratios they will accept, as well as in default provisions, such as requirements for personal guarantees or questions over whether security is granted over the development site itself or via a debenture or other group company assets.

Property development can take many different forms, for example refurbishment, conversion or ground-up development. Currently, we are seeing a large number of conversion projects, particularly those that purchase redundant commercial property for conversion into houses or flats.

What is development finance?

At its most basic, development finance is money lent from a third party to a developer in order to:

1. Assist with the acquisition of a development site;
2. Enable the developer to engage professional services for, among other things, detailed planning applications, architectural drawings and quantity surveying; and
3. Fund the actual construction of the development.

Following the completion of the development the lender will either be repaid their money from the proceeds of the sale, or some developers may seek to retain certain properties as a rental portfolio and re-finance the development to pay off the development finance and obtain more favourable terms.

Ring-fencing liability

Development clients usually want to de-risk the financing and completion of the development project as much as they can. However, this desire to de-risk is often countered by the lender’s desire to obtain as much security and assurance as possible in order to protect their money. The first step in de-risking is often to use a special purpose vehicle (SPV) to purchase the development site. An SPV is usually a limited company and therefore this protects the individual developer and other companies owned by the developer in the event that the development fails. Simply put, although there are a few exceptions, the use of an SPV means that the risk and liabilities of a single development are ring-fenced and cannot affect the assets and other developments being undertaken. If the SPV fails – due to increased costs, failure to obtain planning permission or other reasons – the assets of the developer or other SPV’s owned by the developer cannot be called upon to meet the debts and liabilities.

SPV’s are a very attractive way of de-risking a project for a developer…but not so attractive to a lender. If the SPV is part of a group of companies the lender may want a guarantee from a parent company, or even a personal guarantee.

The lender may, therefore, want to de-risk by reducing the amount they are willing to lend, thus requiring the developer to use more of their own resources to finance the development. Alternatively, they may delay or add more onerous requirements before a drawdown request can be made. For example, they may lend one tranche and release no further money until the first three properties have been constructed. 

Getting the right funding

Obtaining the right finance can be the difference between a profitable development and one that makes a loss.

High street lenders are not often used for property development, but when they are, most commonly it is for refurbishment projects. Generally perceived as relatively low risk, properties in this category would be purchased, refurbished and resold over a fairly short period of time, with the developer repaying the loan from the proceeds of sale of the refurbished property.

Dedicated tertiary lenders, such as Paragon or Shawbrook, offer a range of specialist financial services that cover the entire development process. Lenders such as these will often require a first charge over the development site and maintain a high level of control over the development project. You can often expect to find a large number of representations, warranties and covenants contained with their loan paperwork, ensuring that they are able to monitor the development closely and step in if they think things are not proceeding as planned.

Mezzanine funding may be used by a developer where there is shortfall between the amount of funding provided by a primary lender and the amount the developer requires to complete the development. This is often considered to be a riskier form of lending and, as such, high interest rates are often applied. A mezzanine lender is likely in a very weak position in terms of security and rights. The property being developed will usually have been charged to the primary lender and therefore only a second charge will be available. Furthermore, a mezzanine lender is often required to enter into a Deed of Subordination with the primary lender. This document creates a legal relationship between the primary lender and mezzanine lender and prevents the mezzanine lender from taking any enforcement action or receiving any repayment until the primary lender has been repaid in full. A mezzanine lender may therefore require a personal guarantee from the developer.

Private equity and business angels are gradually becoming more common providers of development finance. These offer a different way for developers to finance their developments. As is suggested by the name, private equity is often structured in such a way that the lender takes a direct stake in the SPV or obtains a profit-related share of the development sales. Given that there is an equity interest, we tend to find that these arrangements are far more involved and detailed than a traditional loan. It is not uncommon for a private equity lender to provide a proportion of the funds as a loan with the remainder as equity. The equity share needs careful negotiation as it will relate to the future sale of plots, pricing mechanisms, agreements on cost over-runs, management charges, accounting procedures, professional services engagements and monitoring provisions.

Finally, we have also seen syndicated lending by groups of high-net-worth individuals. This type of loan often carries the highest levels of interest for developers and is usually time consuming to put in place. It is also important to remember that financial services, including the provisions of loans, is a heavily regulated sector. Breaches of the Financial Services and Markets Act 2000 and associated legislation is a criminal offence, so great care is needed when looking at syndicated investment from high net worth individuals.

Security

For a lender, protecting money is vital. As a minimum, a lender will require a charge over the property or land being developed. The lender providing the majority of the finance will require a first charge and if other lenders are involved they will need to be subordinated to ensure that the primary lender has control over any insolvency event that may occur.

Whilst developers will often be content to provide a charge over the development site, issues arise when lenders require further security. Parent company guarantees are requested when a SPV has been used for the development and the parent company has a number of other subsidiaries or assets over which a lender may want to take security. Parent company guarantees potentially place at risk the entire business of the developer and therefore particular caution is required. A debenture over the parent company will give the lender potential control of all the assets, property and finance of the parent company in the event of default.

Personal guarantees are often considered to be the least attractive form of security for a developer.  But from a lender’s point of view this ensures ‘buy in’ from the developer. Essentially, a personal guarantee means that the developer becomes personally liable if the development company fails to adhere to the terms of the loan. Should the worst happen, the developer could end up being made bankrupt, losing their personal assets and wealth as a result of one development failure. Negotiating a cap, where possible, in relation to any personal guarantee is always recommended.

This article has touched upon some of the methods of funding developments and the issues that can arise when funding is arranged. Some lenders will be receptive to negotiating their terms, whereas others adopt a ‘take it or leave it’ stance. No matter which approach is taken by your lender, the most important thing, as a developer, is that you know exactly what you are signing up to, what your obligations are, how you will meet the covenants in the agreement, and how you can avoid a technical breach of the loan that could jeopardise the entire development. We are able to guide you through all the loan paperwork and report back to you on a detailed, overview or summary basis, as well as negotiate with lenders on your behalf.