Part 4 of an eight-part series written by Ian and Ritchie for Property Investor News, featuring some of the key aspects of small-scale property development covered by propertyCEO’s ‘8-Pillars’ system. This article appeared in the November 2021 edition of the magazine.
In part 4, Ritchie looks at how to go about getting the finance you will need to pay for your property development deals.
I recall way back in the mid-90s, one of Tom Cruise’s better (and possibly more underrated) films, Jerry Maguire, gave us the memorable tagline: “Show me the money!”. A quarter-century on, finding the money is still one of the top questions and concerns of those considering taking on a development project for the first time. After all, your development won’t get out of the blocks without funding. And if you’ve no track record as a developer, who in their right mind would lend you hundreds of thousands of pounds, if not millions, to do your first property deal? Surely it would require a massive leap of faith on the lender’s part, or perhaps just pure recklessness? You won’t be surprised to learn that neither are hallmarks of your average commercial lender, and yet the reality is that all the money you could want is out there. You just need to know how to go about approaching things the right way. Let me shed some light.
Finance for developments can come from several potential sources but let me start with what is route one for many developers, namely commercial funding. There are a significant number of banks and lending organisations out there that specialise in lending to developers. Most, but not all, prefer to do business via commercial brokers, and this is generally good news for you because it means the broker will do the shopping around for you. You should approach several brokers to ensure you’ve got access to a good range of lenders, and each broker will find the most suitable options based on the project and your own situation.
There are two parts to the lending. The first loan is used to purchase the asset, i.e., the plot of land or building to be developed, and the second funds the development work itself. Your lender will advance you up to 70% of the asset finance, leaving you to find the remainder from either your own cash or from private investors (more on this later). The bank will then take a first charge on the asset. The good news is that they will then lend you 100% of the development finance, which they will release to you in tranches during the project’s development phase. At each stage, they’ll send a surveyor round to make sure that the previous advance has been spent appropriately and that the development has moved forward before they release the next tranche.
There are two parts to the lending. The first loan is used to purchase the asset, i.e., the plot of land or building to be developed, and the second funds the development work itself. Your lender will advance you up to 70% of the asset finance, leaving you to find the remainder from either your own cash or from private investors (more on this later). The bank will then take a first charge on the asset. The good news is that they will then lend you 100% of the development finance, which they will release to you in tranches during the project’s development phase. At each stage, they’ll send a surveyor round to make sure that the previous advance has been spent appropriately and that the development has moved forward before they release the next tranche.
When you apply for a mortgage on your home, the lender is interested in two key things; is the property worth what you’re paying for it, and can you afford the repayments. With development finance, you’ll be pleased to know that as an individual, you are far less important a consideration. The lender is going to be assessing three key things. Firstly, that the project can return a 20%+ profit on GDV. Secondly, that the professional team is suitably experienced and financially robust enough to undertake the work. Only last (and least) will they want to make sure there are no concerns with you, the developer.
Aha, you cry; this is where they kick out your application when they discover that you’ve never developed property before. Well, if that were the case, lenders would run out of customers once all the existing developers had retired, and this hasn’t happened. Yes, some lenders want experience, but it’s your broker’s job to find a lender that WILL lend. What about those pesky CCJs against you and the absence of a glowing credit rating? These won’t be as critical as you might think because you’re not the most crucial piece of the jigsaw puzzle, as far as the lender is concerned. Plus they’re lending to your SPV (the new limited company you’ll set up to run the project) and not to you personally. But you must make sure you disclose EVERYTHING to your broker. Your cupboard should be completely skeleton-free, and you’ll look like a time-wasting idiot if you fail to disclose something material that later gets discovered (and it will).
Lenders have a lot of flexibility regarding the structure of your deal, particularly if they feel there are any additional elements of risk. They can increase the interest rate they charge you, reduce the amount they’ll lend you (the loan-to-value), or increase their fees. This flexibility allows them to get comfortable with many additional risk factors such as your lack of experience or any other issues they feel are important. While this may increase the cost, it won’t automatically mean your deal won’t stack, just that the finance costs will be higher. And guess what – once you’ve repaid the loan on your first development, you’ll have a proven track record and will now have access to more lenders and better rates.
You won’t be surprised to learn that the banks don’t simply look at your calculations and assume you’ve correctly projected a healthy profit. Instead, they employ dedicated teams whose job is to rip deals like yours apart and stress-test every aspect. They’ll look not only at your assumptions, but also at what-if scenarios like your contractor going bust and house prices dipping. Only once they’re completely satisfied that the deal returns the required profit margin will they lend you the money. This should give you a considerable level of reassurance; if the experts think your deal stacks, then there’s a lot less reliance on your own calculations.
Our old friend, branding (see part 1 of this series), takes centre stage again when you engage with both brokers and lenders, and it’s a massive own goal if you’ve not got this sorted before you start looking for finance. Website, business card, smart attire, firm handshake; everything will be judged, and it’s possible to look totally professional even without having any personal development experience. Remember that you’re an entrepreneur bringing a team of professionals together to take advantage of a development opportunity; the lenders won’t expect you to lay any of the bricks personally. Look and act professionally, and you’ll stand out from the crowd.
This professionalism applies equally to the way you present your business and your project. How thorough and accurate are your calculations? How deep is your due diligence? What work have you done to show that your selling prices aren’t overly optimistic? And how have you presented your business and the professional team that will make the project happen? You won’t be surprised to learn that as a training company, we spend a lot of time making sure that our students get this part right – it can be critical to securing the finance you need.
Before I move on to private investors, I need to mention crowdfunding, aka peer-to-peer lending. This is a more recent yet highly credible alternative to the banks, although the lending arrangements are broadly similar. Crowd funders attract investors on the one hand and property development investment opportunities on the other. Their internal experts kick the tyres of each developer’s deal just as a bank would, before offering it to their lenders to invest in. The business takes a commission off the top, and the lenders get a healthy rate of return, confident that both the developer and their project pass muster. Crowd funders try to differentiate themselves from the banks and promise a more developer-centric model, plus they can often give rapid decisions in principle. You should certainly have them on your shopping list.
No article on development finance would be complete without the mention of personal guarantees (PG), and these bad boys can sound a bit, well, scary. What is a personal guarantee? It’s a commitment you give to a lender that you’ll repay the money from your personal assets if there are insufficient profits from your development to repay their loan. Can they repossess your home? No, but they could theoretically get a court order to make you sell your assets. If you have a JV partner you will be jointly and severally liable, and you will even be required to have your PG explained to you by a solicitor so that you understand what you’re taking on. So, in short, they’re pretty serious things.
But here’s the thing. The reason you’ll be asked to give a personal guarantee is NOT because your bank can’t wait to get its hands on your assets. That’s actually their second worst outcome. Banks are rubbish at property development, and their worst-case scenario is you suddenly deciding you find development too difficult, chucking in the towel and throwing them the keys. So, the way they can prevent you from simply walking away is to have a nuclear deterrent like a PG to hand. Banks are no strangers to development. They expect projects to have bumps in the road, and all they ask is that a) you tell them about them and b) you come up with a plan to solve them. Bury your head in the sand at your peril. But if you’re open and honest, your lender has a vested interest in working with you to see the project through to completion. Your commercial lender will insist you give a PG, and your private investors may ask for one. In short, they come with the territory, and if you’re not comfortable with that, then you won’t get any funding.
I mentioned earlier that you’d have to find at least 30% of the asset price as a deposit, either yourself or through private investors, so let’s now take a look at this side of things. The first point to note is that most commercial lenders will want the developer to have at least some skin in the game, so they may not want you borrowing all of the private money from third parties. That said, it shouldn’t break the bank. I looked at a lender recently who wanted the developer to put in just 10% of the deposit. So, on an asset purchase of £200,000 with a 30% deposit, the developer would have to lend £6,000 personally and could find the remaining £54,000 from other private lenders. This highlights one of the big attractions of small-scale development; if you were buying a £200,000 buy-to-let, the bank would want you to stump up £50,000 of your own cash as a deposit. But a £200,000 development project requires (in my example) just a £6,000 investment.
Ok, let’s talk about these private investors. Where do you find them, and why would they lend you any money? Let’s answer the second question first as it’s more straightforward. You’re likely to be able to offer private investors an interest rate of between 8% and 12%. Where else can they get a return that good where the underlying asset is property? The strong returns available from property development compared to other asset classes means there’s an insatiable demand for good deals. There’s loads of money out there looking for 8-12% returns, but not so many development deals around that can provide it. It underpins one of the common mindset problems that new developers have. They’re desperate to find funding, so they give too much negotiating power to would-be investors. The reality is that there will be lots of investors desperate for those sorts of returns, and the developer holds the trump card.
It’s worth noting that private investors will not have a first charge on the asset, as your commercial lender will have this. The exception will be if you’re funding the deal exclusively with private money. Will they be concerned? Some might, but they’re getting 8-12% because there’s limited security, plus you can offer them a PG.
Private investors can be difficult to spot because they’re not listed in the phone book. On the plus side, almost anyone can be a potential investor, and you need to bear this in mind when you meet people. The trick is to tell everyone what you do. Many of our students find investment close to home. Friends, family, and colleagues often have savings or pensions to invest, and they have the added advantage of knowing you and (hopefully) trusting that you won’t run off with their cash. Bizarrely, the key to finding private investors is not to ask for money. The problem with advertising the fact that you want money is that it makes you look needy. We teach our students how to secure all the private investment they need by getting private investors to ask THEM if they can lend them money! Sounds crazy, but then who else is offering 8-12% returns?
No article on development finance would be complete without the mention of personal guarantees (PG), and these bad boys can sound a bit, well, scary. What is a personal guarantee? It’s a commitment you give to a lender that you’ll repay the money from your personal assets if there are insufficient profits from your development to repay their loan. Can they repossess your home? No, but they could theoretically get a court order to make you sell your assets. If you have a JV partner you will be jointly and severally liable, and you will even be required to have your PG explained to you by a solicitor so that you understand what you’re taking on. So, in short, they’re pretty serious things.
Here are my top tips for dealing with private investors:
- Always let them see a draft loan agreement, and have your agreement signed off by a solicitor and not borrowed from someone else or downloaded as a template. You want some comeback if there’s a problem
- Always be upfront with your investors about both the lending process and also what could potentially impact the return of their money, for example, if the project is delayed
- Have a handful of large investors rather than a boatload of small ones; otherwise, you’ll spend too much time managing them all
- Get more loans in principle than you need. It’s easy for a private investor to say yes, but when it comes to handing over the cash, some will get cold feet, or perhaps their funds are not currently available.
- Stick to straightforward loans rather than joint venturing with investors. It’s usually cheaper, plus you’re not giving any control away
- Make sure you understand the current FCA rules that govern loans, and in particular, the distinction between sophisticated and non-sophisticated investors
- Don’t oversell your investor pitch; think ‘we work with a select panel of private investors’ rather than ‘get your totally AMAZING investment returns HERE!’
- Make sure you have your branding sorted before you court investors, as it’s a major tick in the credibility box
Development finance is a big subject, and I’ve not been able to cover it all in this article. Still, I hope this has given you a fair overview and a few tips. Next month I’ll be looking at the best places to find property development deals and revealing some of the mistakes that lead many developers to miss out on some great opportunities.