As you may have seen in the media, it is well documented that there is a housing shortage in the USA. Whilst estimates vary, the key message is that we need to be building more homes. And whilst we are all familiar with the large house builders, much of the property development in the USA is carried out by small and medium sized developers and housebuilders.
And of course, all development schemes need to be financed.
Property development falls into several different categories including new build projects, conversions, refurbishments, and extensions.
And regardless of the type of project or scheme you are looking to undertake, whether you are an experienced developer who has carried out many projects before or a first-time developer embarking on your very first project – the one thing you will need is property development finance.
And of course, that raises several important questions:
- What is property development finance?
- What are the different types of property development finance available?
- What are the pros and cons of the different types of property development finance?
- How should you use the different types of property development finance to complete your project?
What is Property Development Finance?
Property development finance is a type of funding that is used to finance the development of residential, commercial, and mixed-use schemes.
A property development loan is normally short term, with the term of the loan being linked to the estimated time frame to carry out the development.
The funds for the project will be released in stages, with the first tranche of funds being released to help fund the acquisition of the property or land being developed, with further funds then being drawn down in stages throughout the construction phase.
What are the Different Types of Property Development Finance Available?
When it comes to property development finance, there are essentially three types of funding:
- Senior debt finance
- Equity finance
- Mezzanine finance
Senior debt is the main loan used to assist with a development project. It will typically be secured by a first legal charge over the freehold of the property being developed.
As already mentioned, funds will be released in stages to assist with the purchase of the property or land you are developing, with the balance of the senior debt then being released in tranches, to carry out the actual development works.
Equity finance is the finance that you put into the deal yourself. It is effectively your equity stake into the deal. It normally takes the form of a cash injection; however, I have seen occasions where a client has used another freehold property as additional security which is in effect their equity injection into the deal.
Alternatively, a developer may decide to bring in a partner or an investor who provides the cash injection into the project and this is an increasingly common way for equity finance to be provided for a project.
Mezzanine finance is a specialist funding product that bridges the gap between the senior debt (the amount of funding the main lender has agreed to provide) and the equity finance (the amount of cash you as the developer are injecting into the project).
Most senior debt lenders will typically go up to a maximum of 65% of the end value or Gross Development Value (GDV) of the project. The mezzanine lender will usually provide the ‘top slice’ of funding that will take the total amount of funding from 65% of the GDV of the project and increase it to an overall loan equivalent to 75% of the GDV
What are the ‘Pros and Cons’ of the Different Types of Property Development Finance?
With options, comes choice. Therefore, when it comes to your project, how best to use the different types of property finance available.
Is it better to use mezzanine finance and reduce your equity contribution? Or perhaps, reduce the overall cost of borrowing by putting in more equity? Important questions that can only be answered by weighing up the ‘pros and cons’ of each type of property development finance and then making an informed decision.
Senior Debt
Pros:
- Senior debt can be used for all types of developments including new builds, conversions and refurbishments.
- Because the funds for the development phase of the project are released in stages, it means you only pay interest on the funds as you draw down, rather than on the total amount of the loan.
- Interest is ‘rolled-up’ during the entire period of the loan, meaning you don’t have to fund the interest costs from your own resources.
- The loan term is tailored to your specific requirements, taking into account the length of time the development works will take, as well as allowing for a period to sell the property once the project is complete
Cons:
- Many development lenders will only lend to experienced developers, making it more difficult for first-time developers to obtain funding to carry out their first project.
- If you don’t have any cash to inject into the project, then you may find it difficult to get a lender to help you.
Equity Finance
Pros:
- Injecting equity by way of a cash injection means borrowing less and therefore reducing interest costs.
- Senior debt lenders like to see equity from the developer going into the project. It can therefore make it easier to raise the debt finance required.
Cons:
- If cash is being injected, it means you’re equity is then tied up in this one project, which may limit your options if another deal should come along.
- Thought should be given to how the equity is being raised. For instance, are you using ‘life savings’? If so, is that something you want to do?
- Alternatively, you may be raising funds via another route such as the re-mortgage of another property such as your home. Again, is that a option you want to consider?
Mezzanine Finance
Pros:
- It can make the difference between a developer being able to proceed with a project or not
- It enables you to borrow more to undertake a project
- It means the developer has to inject less cash into the project
Cons:
- If the development doesn’t go to plan, and for instance there is a cost overrun or the project doesn’t achieve the hoped for sale price (i.e. the GDV comes in lower than anticipated) it means the margins are much tighter for the developer when exiting the project
- It is more expensive than debt finance
- Mezzanine lenders are often more selective about the types of deals they will consider
In summary, these are the main types of property development finance, how you can utilise them to carry out your next project and the pros and cons of each one.
