The YPN Guide To Small-Scale Property Development – Part 4 of 6
They say money makes the world go round, and that’s certainly the case when it comes to property development. Development projects typically need a lot more money than your average buy-to-let or a house refurb project, but here’s the thing that surprises most people; most of that money doesn’t come from the developer. In fact you’ll usually need to put in a lot less of your own cash than you would with a buy-to-let or flip, which makes it highly leveraged from a financial point of view.
So, how does the finance work? Let’s imagine you’re buying a shop for £400k that you’re going to convert into flats.
The total cost of doing the work (construction, professional fees and finance costs, etc) will be another £400k and you’ll aim to sell the finished units for £1m (the Gross Development Value or GDV), netting you a £200k profit. Typically, you’ll have two sources of finance; commercial lending and private money. The majority of the money you need will come from a commercial lender. These are the banks, family funds and peer-to-peer lenders that specialise in development – they’re not your typical high street mortgage lenders. Your commercial lender will lend you up to 70% of the asset (i.e. the shop) purchase price which in our example is £280k. Much to many people’s surprise, the same lender will also advance you 100% of the £400k you need to do the development work. So, of the £800k you need, a single lender is going to be funding £680k of it. Note that the development portion will be drawn down in stages during the project rather than given to you on one up front lump sum (just in case the lure of the local supercar dealership became too much for you).
Sounds good, but what about the remaining 30% (£120k) deposit you need to buy the shop? One of the big advantages of property development is that you’re able to borrow your deposit from private investors AND repay it in relatively short timescales. These loans will typically return an attractive 8-10% (annualised) interest rate, making it relatively easy to find investors (most people will be very happy to get a 10% return on their money). Your commercial lender may want you to invest a modest amount yourself, for example 10% of the deposit (i.e. £12k) rather than borrow all the money from third party investors – they like developers to have some skin in the game. They’ll also insist you target a profit margin of 20% of GDV (£200k in this example).
This is because they’ll want you to ride out any bumps in the road and still walk away with a healthy profit. And if you’re wondering if I really said that it’s possible to make £200k profit by investing just £12k of your own money, then you’ve read correctly. In terms of timescales, you’d expect a typical small-scale development to take around 18-24 months to complete, so the pay back is much quicker than with other forms of property investment.
Where can you find these commercial lenders? Most operate via a broker network which is great news for you, as it means your broker will be doing all the legwork to find you a lender. Lenders look at three key things when they assess a deal; can the deal produce a 20%+ profit, are your professional team up to the job, and only then will they look at you the developer. Not all lenders work with novice developers however many will, and your broker will find them. You’re actually far less important than the deal itself, so don’t worry if you’re credit rating isn’t perfect; just make sure you tell your broker everything, warts and all.
A few further things for you to consider:
- Never attempt property development on a shoestring budget. Yes, the leverage is amazing, but you should always have contingency funds on hand. Plus I would very strongly recommend that you get yourself trained before you start – a further one-off cost (which should pay you back many times over)
- You might incur some pre-sale costs such as professional fees, etc. that you’ll need to fund yourself, most of which can be reimbursed by the development finance later
- Commercial lenders will require you to sign a Personal Guarantee. This is their tool of last resort and is designed to stop people chucking the towel in or skipping town with the lender’s money. It goes with the territory as a developer, but you need to be comfortable with signing one
- Get a draft loan agreement from your solicitor that you can show to your potential private investors
- Stick to simple loans that attract a fixed interest rate rather than doing a joint venture where you split the profits with a private investor – it’s usually cheaper and less risky
- Make sure you know the FCA rules that govern lending – not usually onerous, but well-worth understanding them
- Aim to have a small number of major investors rather than a large number of minor ones
Many new developers worry that they won’t be able to find private investors for their deposit, but you’ll be surprised at how keen people are to invest. After all, there’s a lot more investment money out there looking for a good home than there are opportunities that return 8-10%. Plus there’s a way of appealing to investors that we teach which means people will actually ask YOU if they can invest!
I hope that’s helped you get your head around the finance side of development. Next month I’ll be looking at how to go about finding your first development project – I’ll see you then.
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