Finding Development Finance
If I were to give you a pound for every new developer who’s told me they’re worried about money, you wouldn’t have to worry about money. Perhaps unsurprisingly, the financial aspects of development projects are where many people have their biggest concerns. After all, developing property doesn’t come cheap, and if you haven’t got a healthy bankroll behind you, where exactly is all this cash going to be coming from?
Well, I’m glad you asked since quite a few misconceptions are flying around about development finance, and it will be good to set the record straight.
I’ll start by looking at how ‘traditional’ development finance works before focusing on a few dos and don’ts of private investment. But I’ll make two critical points at the outset to whet your appetite; firstly, you’ll almost certainly need less of your own money than you’d think you would. And secondly, having people lend you money is often a lot easier than you think it would be. So, with those two shameless teasers in mind, let’s dive in.
In development, you have two elements that require financing. Firstly, there’s the asset you’re going to buy (the land you’re going to build on or the property you’re going to convert), and then there’s the cost of developing it (the cost of design, construction, finance, and the fees of all of your professionals, etc.). There are (usually) two sources of finance; commercial finance and private money. Commercial finance typically comes from specialist banks, peer-to-peer lenders, and family funds, while private money arrives either through loans from private investors or your own cash. Nothing prevents you from using private money to fund the entire project, but most development deals are funded by a mixture of commercial finance and private cash combined.
Commercial lenders typically lend up to 70% of the asset purchase cost and will require private finance to pick up the remaining 30% (effectively the deposit). For the landlords among you, this isn’t a million miles away from buy-to-let finance, where a deposit of 25% is often required. But there’s a fundamental difference, and it’s quite a biggie; with a buy-to-let mortgage, your 25% deposit money is likely to be your own cash rather than a private investor’s. After all, that money will be locked away in your bricks and mortar for quite a long time.
But with the asset purchase finance on a development, the money is typically only needed for 18-24 months, plus you’ll be able to use other people’s money to fund your 30% deposit. Now, before you all ask where do I sign, I need to add an important caveat. While it’s technically possible to use none of your own money in a development project, most commercial lenders prefer the developer to have some ‘skin in the game’. This ‘developer contribution’ requirement varies, but it is often expressed as a percentage of the overall project cost or a percentage of the deposit. For example, let’s assume we’re going to convert an old bakery into flats. If we bought the bakery for £400k, and assuming the commercial lender was happy to lend 70% but needed you to put in 10% of the deposit yourself, you would have to stump up just £12k.
So far, so good – we’ve now bagged ourselves an ex-bakery, and we’ve only invested £12k of our own cash, compared to an equivalent £400k buy-to-let where we would presumably have had to put in £100k (and invested it for a lot longer too). But now we need to spend some more money to convert our bakery into apartments. Let’s assume we need another £400k to fund all the development costs. This will be considerably more than you’d spend getting your equivalent £400k buy-to-let ready for the market. Still, I’ve got some more good news for you: the same commercial lender that lent you the 70% asset finance will also lend you 100% of the development costs. And they won’t need you to put in any more of your own money or anybody else’s.
This often comes as a shock to many people (I hope you were sitting down). Why would the same lender give you another £400k without needing more security from you? The answer is that they already have a 30% deposit and a first charge on the property or land, plus every brick that gets laid as part of the development phase adds to its value. As a result, the value of the asset increases as the development progresses, plus they don’t advance you all the development finance in one go – you’ll get it in tranches.
There’s another factor that needs to be considered here, which is profit. We’re not converting the old bakery for our health – we want to make a decent return. Which coincidently is precisely what our commercial lender wants us to do. They will insist that we target a minimum return of 20% of the gross development value (GDV). So, the high-level numbers for our bakery conversion are £400k to buy it, £400k to develop it, and if we assume a £1m GDV, we’ll be targeting a £200k profit for ourselves.
This is where those sitting down after the previous shock now have to turn the lights off and lie quietly on the floor. Did I really just suggest that by investing just £12k of your own cash, you can borrow a further £788k and turn your modest stake into £200k within 18-24 months?
I’m pleased to say that the answer to that question is yes. Is it easy? No. But then, if it were easy, everyone would become a property developer, wouldn’t they? But it IS possible if you know what to do, and it’s why so many landlords are now turning to small-scale development as a property strategy, either as an additional or an alternative investment strategy. I can’t think of any other investment strategy that can consistently deliver that level of return over such short timescales.
So, where exactly will you be able to find the sources of this finance? And why on earth would anyone lend it to little old you? Let’s start with the commercial lenders. Most traditional lenders operate through a broker network. This is excellent news for you because it means you can find a broker or two who will go and hunt down finance for you rather than you having to trawl cap-in-hand around the market yourself. The commercial lender won’t be poring over your business plan; instead, they’ll be working up their own numbers. This is something that they do day in, day out, and, dare I say it, they will be much better at it than you will. This is excellent news because if they offer to lend you the money, your numbers must have been correct!
The other reason they will be keen to lend you money is because you play a far less important role in the process than you might think. When you get a mortgage, the lender’s key concern is your ability to make the mortgage repayments. But with a commercial development loan, the primary concern is whether the deal makes a profit. The secondary concern is whether the team delivering the project is solvent and up to the task (I’m talking about the architect, contractor, project manager, and so on). Only after these two boxes have been ticked will the lender be interested in what the developer is all about. Yes, they’ll want you to be credible and professional, but you’re not the most important piece of the puzzle for them.
There’s also the fact that first-time developers often go on to become second-time developers, so every lender has an eye on their future client base. Most commercial lenders will insist that developers sign a personal guarantee that further protects their investment, while others may, in addition, insist that there is someone with experience on the team who can provide support when needed. The key objective for you as a developer is to ensure that your project still makes a profit, even if there are a few bumps along the way. That’s why commercial lenders insist that developers target a minimum 20% margin since this gives them a significant cushion against unknown cost factors.
Peer-to-peer lending, a.k.a. crowdfunding, is another excellent source of commercial finance. Here, an organisation with development expertise (the crowd funder) pairs investors with developers. Crowd funders are usually more developer-centric, with shorter turnaround times on decisions and often greater flexibility. However, the degree of due diligence they will do on your project is like that of any commercial lender. The investors (typically not experienced in development) have the advantage that each investment opportunity has been vetted by the crowd funder beforehand, which significantly de-risks things for them.
So, at a high level, that’s the commercial finance sorted. Let’s now turn our attention to private finance, the other side of the funding coin. In our bakery example, we needed to raise a £120,000 deposit and were putting in £12,000 of our own cash. And you’ve probably already spotted the large elephant in the room asking you who on earth is going to lend you the remaining £108,000.
Now, most people hate asking for money, which, as it turns out, is quite lucky because asking for money is just about the worst way of getting any. The problem is that no matter how you dress it up, a request for money has all sorts of implications. The first obvious implication is that you haven’t been able to raise the money you need from other people. And this prompts questions such as ‘have lots of other people already turned you down, ‘don’t you have any money of your own and, if you do, why are you asking to borrow mine’ and ‘perhaps it can’t be such a great deal if people haven’t rushed to invest with you’. You come across as a bit needy, and it’s not a great look.
But let’s consider the hard facts. The going rate for private investment in property development is between 8% and 10% per annum. So if someone lent you £10,000 for two years, they could expect to receive up to £2,000 in interest from you. Despite the recent efforts of the Bank of England, this is still a highly attractive rate of return compared to what investors could expect to receive by leaving it in their savings account. So the question is not whether people want an 8% to 10% return; of course, they do. The more important question is why they should lend money to you. Or, put another way, how do they know they’ll get their money back? This is where credibility plays a key role. One of the key aspects of the training we deliver to our students is branding, ensuring that they look like credible and investable developers before they do their first deal.
It sounds tricky, but it’s perfectly possible when you know how. And, of course, it helps when you know exactly which boxes you need to tick to push private investors’ buttons. But if you don’t ask for money, how on earth do you get it? The trick is to reverse the buying and selling roles. Instead of asking for investment, you want people to ask you for investment opportunities. And the best way of doing this is to create some scarcity. Let’s be clear; you’re not trying to polish a turd here – you are genuinely offering a fantastic opportunity. After all, how many investment deals have you been presented with recently that produce a 10% return? Hopefully, you can see that if you have both credibility and a great offer, it will be a highly attractive proposition. But it becomes even more attractive when you make it clear that the opportunity to invest is limited. After all, you’re only doing one development at a time, and you already have a group of private investors lined up. If they’re serious about it, perhaps you could let them know when the next investment opportunity comes up. After all, it acts as social proof if people know that others are already signed up.
Another key feature of private investors is that they don’t wear a name badge. You can’t just google them like you can when you’re looking for an architect or a solicitor, so they’re entirely invisible to you most of the time. However, this rather challenging situation is more than offset by the fact that anyone could be a private investor. It could be your mum, your best friend, a colleague, or an acquaintance. Or it could be the chap you bumped into at the dentist or the woman you met at a networking meeting – literally anyone. And, of course, you won’t know they have any money to invest until you start talking about what you do, which is where you can let slip what a great deal your current private investors are getting.
An interesting aspect of private finance is how close to home many new developers find funding. It’s easy to assume you don’t know anyone with money to lend you. But people don’t generally talk about their savings or finances, so you’re not likely to know. It’s only when you start mentioning what you do and the investment opportunity that exists that potential investors from among your friends and family make their interest known. Plus, they already know you, so they will be far less worried about you heading for the hills with their cash. This is ideal – after all, why shouldn’t you put a great opportunity their way?
Hopefully, that’s given you an understanding of how development finance works and how you could approach the issue of obtaining private investment. And for those who haven’t considered small-scale property development before, including those who are perhaps rethinking their buy-to-let strategy, I hope it’s given a perspective on how highly leveraged smaller development projects can be. There’s certainly a lot of opportunity out there at the moment, and existing property people are very well-placed to take advantage.