How does property development finance work? Why is it so complicated?

There are various elements to property development finance, which are known as “ranches


Property development finance relates to any money or capital required to fund the development of a property or site of properties. It tends to run as its own industry within finance ranging from the smallest refurbishments to large scale multi-house sites.

The industry is considered “non-regulated” meaning that it does not have to adhere to the stricter lending criteria of, say, mortgages because property developers are considered professionals (whereas mortgages are used by homeowners - not business-related) - and development finances always requires lending to a corporate body - a company, as opposed to an individual.

There are various elements to property development finance, which are known as “tranches” (the French word for “slices”). These slices are defined by their risk and return - where a higher risk will generate a higher return and a lower risk will generate a lower return but have more security (probability of being paid back). These tranches are known as senior debt, mezzanine / junior debt and equity - each of these can also be subdivided to give specific types (such as “stretched” senior debt).

The correct use of each type of tranche can be used to generate the preferred outcome of the funding - from cheapest funding to highest potential profit. The property development industry - being driven by security and returns on lending, can and has traditionally been very difficult to infiltrate and rarely consistent to borrowers due to it’s levels of complexity and lack of ways to learn.

What is Senior debt?

Senior debt forms the largest part of development finance as it is the biggest tranche, usually lent by banks and specific lending institutions - most similar to mortgages. Banks that hold significant client money (from saving accounts etc.) look to then deploy that money it holds, in order to make a return on it. These deployments of funds will range from very low risk (but high security, such as bonds) to higher risk lending such as development finance.

Senior debt is generally defined as “last money in, first money out” and makes up the largest part of the costs of a project, typically 60% to 90%. The balance of the costs (the “shortfall”) will have to be made up by the developer, known as the equity.

The senior debt lender will have professionals produce reports on the value of the land/development, the costs of the proposed works and any legal matters around a sire or borrower. Once content with these, they will lend the money on a fixed interest rate (known as a “coupon”) which is usually between 4% and 12% - according to the perceived risk. This interest is usually rolled-up, so the borrower does not have to pay monthly (or “service”) interest like a mortgage but allows the developer to pay back the loan (“principle”) and rolled interest at the end of the project, out of the profits.

The senior debt lender will employ a Project Monitoring Surveyor (PMS) to give monthly reports on progress and sign off payments to contractors and professionals, as progress is made - ensuring the lender never pays out more than the developer has spent (to protect their security).

A total debt facility on a project will be split into sections:

  • The land loan - the amount of money that goes towards the purchase of the site.
  • The development loan - the sum of money to pay for all of the development of the site.
  • The interest facility (“retained interest”) - the amount of interest that the lender will roll-up (not need to be serviced monthly) to be paid at the end.
  • The fees - arrangement and exit fees.

If a loan is made at, say, 65% Loan To Value - and the Value (gross development value when the site is finished) is say £2,000,000, the gross loan will be £1,300,000 (65% of £2,000,000). From this;

  • The retained interest will be deducted.
  • The arrangement fee will be deducted.
  • Any professional fees for the bank’s monitoring will be deducted.
  • The development facility (cost of the build) will be deducted, and;
  • The remaining amount will make up the land loan. The difference between the land price and the land loan is the equity shortfall (cash needed to make up the difference).

Senior debt can come in other forms, dictated by the Loan To Value (LTV) - how much a bank will lend relative to the value of the finished project (the Gross Development Value / GDV). This is known as the amount of “leverage” as with a wrench, a longer lever allows more pull - in this case less equity. These forms are typically;

  • Senior debt - up to 55% Loan To (Gross Development) Value. This will have the lowest interest rate.
  • Stretched senior debt - up to 65% LTV, and;
  • Super-stretched senior debt - up to 75% LTV - carrying the highest interest rate.

Senior debt lenders will charge fees, known as “in” and “out” or “arrangement” and “exit” in order to increase the return on their lend and cover overheads. Therefore, an interest rate (coupon) is not the only cost of a senior debt loan. The lender is usually looking to achieve a gross return on their money, relative to the time it is lent for - so the interest coupon and fees, relative to the total lending time, make up the Internal Rate of Return (IRR) for the lender - usually their key metric.

Loans by senior debt lenders are always made on a fixed period, allowing for a build period and a sales period. If the loan is not paid back on this agreed timescale, the lender reserves the right to call in the loan (have it paid back) when they wish. This can be very bad for the borrower if they have not finished selling the site, and are in default (have not met the agreements of the loan).

Most lenders will allow reasonable extensions of time to avoid this if progress can be seen. As a further protection, lenders will take the “first charge” on the site (meaning they have the right to take ownership), a debenture on the company that owns the site (allowing them to take control of the company) and a Personal Guarantee (PG) from the individual in charge (typically 20% of their loan) to incentivise the borrower to finish on time - though it could be considered that this is a dis-incentive, as the downside for the borrower is very serious.

What is Equity?

Equity means share ownership - which in the instance of funding means cold, hard cash. The equity requirement (commonly known as the “shortfall”) is the rest of the money needed to make up the costs after the senior debt. The equity in any project will always go “in first” and “come out last” - as it is the highest risk and potentially, the highest reward.

Equity is traditionally the hardest to raise (if the developer does not have it) - as few institutions, like banks, like to lend equity due to the perceived higher risk of it. Therefore, property developers needing to raise equity will traditionally have to approach High-Net-Worth Individuals or specific equity lenders - who are quite rare and have the pick of all deals that come to them.

The simplest way to calculate the equity shortfall on a project is by adding the total costs to buy and build out the scheme (land, acquisition costs, build, professional fees and debt costs), less the gross debt facility (as above) and the remaining amount is the equity shortfall.

E.g Total costs = £1,000,000, less Gross Debt facility (£650,000) = £450,000 shortfall.

Equity can come in different forms - each of which may be more or less desirable to the borrower:

Side-by-side equity

Side-by-side equity is where an investor puts in a sum of the required equity (shortfall) in return for a profit share at the end. They may also take an interest rate (hurdle) on the amount of money they have invested and for the period invested. This means the investor is being paid profit at the same time as the developer - sharing the risk.

Preferred Equity

Preferred equity is where an investor invests a sum of the required equity for a fixed-sum return. This would likely be a lower amount than side-by-side share, but the investor will be paid after the debt is paid back, and before the developer. This is less risky but allows the developer either more of the upside profit, or less if the scheme is not as profitable as predicted.

Equity on Coupon Equity on coupon is where an investor invests a sum of the required equity in exchange for a fixed interest rate, to be paid out after the debt is paid back, again, before the developer.

What is Mezzanine? Mezzanine (“mezz”), sometimes referred to as Junior Debt (because it is subservient to senior debt - i.e. comes after in importance), is another slice of funding that sits between senior debt and equity. Mezzanine is lent to a higher Loan To Value of the total debt borrowed; for example, senior debt might be provided to 60% of the Gross Development Value, and mezzanine debt might come in to increase the debt to 70% LTV. It’s a bit more money to borrow meaning less equity is needed to be put in by the developer.

Because it is subordinate to senior debt (it is paid back later, and has a higher risk of being paid back), it is more expensive than senior debt, typically between 12% and 20% per annum.

As “mezz” is also a form of debt, it requires security from the borrower - which will come from a personal guarantee and / or a “second charge” on the property (the first charge has the right to take over the property from the borrower, the second charge gets what is left over in a sale).

What is commonly overlooked when raising finance, is that , while mezzanine debt might be more expensive, by adding a slice to senior debt - the cost of debt will be “blended” as per the following example, to reduce the amount of equity required:

Gross Development value of site = £2,000,000, with costs of £1,600,000.

Senior debt at 55% LTV = £1,100,000.

Cost 7% = £77,000 per year.

Equity required = £500,000 (£1.6m less £1.1m).

Add in a mezz slice to 65% LTV = £1,300,000 borrowing.

Extra cost of mezz (£200,000), at 15% = £30,000.

Equity required = £300,000 (£1.6m less £1.3m).

Blended cost of debt and mezz: £77,000 + £30,000 = £107,000.

As a percentage, the total borrowing is 8.2% (£107k / £1.3m)

Summarily, £200,000 less equity needed for only £30,000 cost. This is said to increase the Return On Equity (ROE) as less is needed to achieve a higher percentage return.

Requirements for lenders

All lenders, be them debt or equity - have certain requirements from a borrower - which mostly revolve around security, experience and return on investment.

Security means that a lender wants a level of control with the loan - in case problems occur and to ensure the commitment of the borrower. Security comes in the following forms;

A charge - this is a land-registry document allowing the holder to take control of the property, should the lender need to step in. A senior debt lender will always take a first charge meaning that the property cannot be sold or transferred without being paid back what is owed to them. Mezz and equity lenders will commonly take a second charge on the property, which ranks behind the first charge holder but allows them to be paid back what is owed to them next.

A company debenture - the first charge lender will commonly also take a debenture on the company (that owns the property) which allows them first refusal to take over the company in case of distress. It is worth noting that property developments always must be owned by a company as opposed to an individual because property development finance is unregulated meaning funds can only be lent to businesses and not individuals. This company is known as an SPV (Special Purpose Vehicle) - set up purely to own this one property.

A Personal Guarantee (PG) - this is a sum of money that the borrower (individual, not company) pledges, typically to cover build and interest overruns. This gives the lender comfort that the borrower is focused and has the funds available to pay further funds required, over and above the loan. PGs are typically 20% of the gross loan facility on senior debt but can be 100% on mezz and equity loans.

A Deed of Priority (DoP) / Intercreditor Agreement - this document states the order payments to charge holders in case of default by the borrower.

Common myths

Some themes commonly arise around property development finance that are not commonly and openly answered. These can include some of the following:
Rolling credit lines. Lenders do not queue up with funds reserved for property developers on a rolling basis. Quite the opposite is true - lenders need significant comfort that every deal presented to them is thoroughly scrutinised and will not chase a borrower with wheelbarrows of funding.
Borrowing without PGs. It is very rare for a lender to not take a PG, as, given the sums of money involved, lenders will want to know they have at least some recourse ona borrower and know they have significant funds available if needed. Because of this, lenders are very insistent on certified Asset and Liability statements of the borrower, proving their actual net-worth.
Penalties (the lack of) - senior debt lenders will almost always enforce penalties on borrowers who breach the terms of their loan. Exceeding the agreed timescale for the loan is a breach, upon which lenders will usually extend their facility but start to charge a lot of money which can wipe out profits very quickly.
The scheme is profitable. Probably the most common myth - many property developments are presented to lenders with a breadth of optimism. This can be in the form of ambitious sales expectations, low build costs or short time periods. Lenders see a lot of schemes and become very adept at seeing over-optimism quickly, leading to distrust of a property developer’s capabilities.
Price increases are natural. Even in what would be considered a rising market, lenders will not allow any expectation of price rises, even over a development period of 2 years. Lenders will always look to rely on today’s prices for a scheme.
Hurt money (lack of). All loans associated with property development finance will want to see some commitment from the borrower as they believe it keeps the borrower focused. The only exceptions on this would be private borrowing from an individual (which is not actually property development finance) or some companies that offer full funding on a scheme without PGs - in this instance the developer is actually just a manager and his no ownership of the scheme but the possibility of profit share.

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