100% development finance - a dead end?

Until mid 2007, 100% development finance wasn’t a dead end and was widely available from a number of financial institutions, attracting interest from small to large developers across the world. Attractive terms could be achieved with a percentage of profits given away to the financing party of anywhere between 35-50% of profit. Tim Mycock, Senior broker at Red Chilli Structured Finance examines the current market to see how highly leveraged funding for developments has been effected.

Developers and Mid 2007

“Mid 2007 was a heady time for developers looking at prospective schemes; should they look at traditional but capital hungry senior debt funding or should they look at 100% gearing but give away a proportion of the profits? The availability of finance then meant margins from development lenders were being squeezed and traditional lending prudence increasingly overlooked as lenders came under pressure to be more and more competitive in order to win business from their rivals. At this time, developers had the luxury of being able to shop around and look for the deal that suited them and their business needs the best, whilst also considering their return on capital. Naturally, not only does a highly leveraged deal generate a higher return on capital than that of a straight forward senior facility, but it also allows a developer to take on much larger projects than would otherwise be possible.

Deals were put together in mid 2007 in accordance with market conditions, property values were soaring, comparables for other schemes aplenty and valuers able to be bullish. This gave high leverage lenders the comfort they needed in order to lend at a high percentage of GDV. In most instances Personal Guarantees were required at a capped level; however this was not always the case. Lenders would often take a priority profit share on a development ranking ahead of the developer’s profit. From the lenders’ point of view, as the developers’ profits came out last, they would remain focused until practical completion and subsequent sales of the units.

Equity Recycle

More often than not highly leveraged schemes were put together for flatted developments (both speculative and pre-sold) as well as high end single units and small volume houses. This enabled developers to recycle equity and allowed businesses to grow.

Therefore, having to give away a percentage of the profit to a third party did not matter to a lot of developers as they did not need to have cash in the deal and it allowed them to continuously expand their businesses and increase their return on capital. There was, and still is, a huge demand for these facilities in the market place.

Development Finance and the Credit Crunch

Since the ‘credit crunch’ started, recognised by many as having started in autumn 2007, the availability of 100% finance for developers has significantly diminished, although highly leveraged loans can still be structured through a number of different methods.

The days of a UK lender offering a 100% facility over £10m have, for the time being at least, ended. As an influx of overseas money has come into the UK from various sources around the world more and more institutions are offering 100% development finance; however these remain largely untested and strict criteria have to be met. Predominantly all these schemes need to be pre-sold/ let, at least to a certain level, whilst pricing has increased dramatically with some instances charging a 25% IRR plus over 50% of the gross profits. However, in a market where beggars cannot afford to be choosers, these deal are attractive.
There are other ways to achieve 100% finance though these are using multiple lenders and across the capital structure. Senior debt terms at 60% of GDV (72% of cost on a 20% Return on cost basis.) Mezzanine up to 75% LTV and equity up to 83.3% LTV, thereby achieving 100% LTC. Whereas in mid 2007, guarantees may not have been required, they most certainly are now and of a meaningful nature. Lenders will look to take floating debentures over an SPV, as well as cost overrun guarantees and, in some cases, performance guarantees. With the market in its current unstable position lenders are looking to a greater extent for assurance that a developer will not simply walk away from a development part way through if things get tough, values slide, or there is an unexpected increase in build costs.

The difficulty remains with the asset type for the development - 100% funding is achievable with pre-lets/ sales; however the strength of the forward purchaser or covenant will be scrutinised and at least a 10% deposit will be required on pre-sales. This is due to the fact that many investors walked away from pre-sales, preferring to lose their small deposits (e.g. 5%) rather than complete on a property whose value has dropped or against which a mortgage cannot be raised. Flatted developments have over the last 6 months become increasingly more difficult to fund especially in overdeveloped areas such as the North West (e.g. Leeds, Liverpool, Manchester etc.) In some instances it is impossible to raise a pound let alone 100% development costs on a site in these regions. Small housing schemes in good locations, as well as high end units, are still able to attract leveraged funding. On a commercial scheme, again it will be location and covenant led with banks taking a view as to the strength of the covenant. Speculative 100% commercial funding is becoming increasingly much harder to achieve.

In the wake of the recent credit crunch and predicted recession many analysts, market commentators and journalists have discussed the issue surrounding the availability (or lack of) of finance. Whilst many lenders have currently closed for business, and especially before Christmas, there is still finance available from certain sources. However a general sense of doom and gloom is now pervasive and has unquestionably affected sentiment. But this is a good time for the developers who can, with the right scheme and able to procure finance, embark in new projects encouraged by the fact that there will be a shortage of available units in 18 months to 2 years time as a result of the current development glut.

Conclusion

In conclusion, the sudden deterioration in market conditions over the last 12 to 18 months has engendered an unprecedented seismic shift in the funding markets in general and in development finance in particular. Back in the ‘good old times’ when highly geared finance was readily available and relatively cheap, competition between developers for sites was rife. In today’s market as finance is more difficult to come by, ever more complex structures are needed in order to achieve 100% development finance. Highly leveraged loans enable developers to grow their business whilst recycling their equity, but it needs to be understood that a larger percentage of the profits than ever before will need to be given away, as pricing has dramatically changed over the past year”.

Red Chilli Structured Finance is an independent property finance advisory firm specialising in arranging funding for property projects in the UK and all over Europe.

Call us on 0845 210 5000 to discuss your funding requirements.

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