There are many options when looking to fund your next property development project. The way in which you structure any borrowings will have a significant impact upon your long-term returns. We have covered some of the more common project development finance routes below with comments and observations.
After the 2007/8 sub-prime mortgage collapse in the US, which spread throughout the world, it can be difficult to obtain affordable bank funding for property projects. Traditionally banks tend to work on a 70% loan to cost (LTC) ratio and may exceed this at a cost. Performance for larger loans is a real issue however. For some developers this can leave a significant shortfall which may need to be filled with relatively expensive additional forms of finance.
While interest rates on property development funding will vary from project to project, if the LTC ratio is less than 70% interest charged is usually sub 5%, 7% – 8% on loans from 70% to 80% LTC and between 10% and 12% on loans where a higher than 80% LTC has been secured.
As we touched on above, other forms of property development finance may need to be used in conjunction with traditional bank funding to fill any shortfall. One popular option is mezzanine finance which is traditionally in the region of between 10% and 15% of LTC. Mezzanine finance is less expensive than equity finance as it is normally a fixed rate and is ahead of equity in case of losses and allows the developer to retain their equity share.
The obvious problem with mezzanine finance will occur if a project incurs delays or is unfinished. Whatever the situation, the developer will still need to pay back the mezzanine finance and in situations of default this can be converted into an equity stake in the development. On the surface mezzanine finance is more affordable than equity-based finance but default terms can be prohibitive.
There are pros and cons to equity funding with investors sharing both the risks and the rewards. Where little or no funding is required the equity returns can be relatively high for the developer. However, where an additional equity investment is required the profits may be split on a 50/50 or pro rata basis, depending upon the details of the agreement. This can have a significant impact upon the returns for a developer although, as we mentioned above, both parties will also share the risk.
In theory equity funding is one of the more expensive options but done correctly it can allow a developer to significantly leverage and increase the size and quality of schemes they undertake. Over the last few years we have seen crowdfunding become more popular and there are also various networks of high net worth individuals willing to invest in property developments. As ever, it is a case of balancing the risk/reward ratio against the profits which you are “giving away” to other equity investors.
Source: Property Forum