James Bloom, managing director of development finance at Masthaven, outlines five steps to confirm if development finance is the right lending solution.
We all know that when it comes to business, time is money. So if you have a client seeking finance for a property investment, the chances are they want a firm lending decision as swiftly as possible. Development finance is one possible approach, but how do you decide whether it offers the best solution for a particular scenario quickly and effectively?
To help you identify when development finance should be suggested over other short-term lending options, we recommend following a relatively straightforward process based on five simple questions.
1. What is the loan for?
The first thing to think about is of course, what exactly is the loan for? Not only does this identify whether or not development finance is likely to be the right lending solution, but it can also tell you if the associated costs are realistic. Consider the following key points:
- As we all know, location plays a huge part in property prices; a property in central London is far easier to sell than one in the Highlands of Scotland.
- Size is also important; large properties are harder to sell but may offer a greater return on investment.
- Is the project a single or multiple property development? Lenders tend to put limits on project size – at Masthaven we don’t normally fund more than 12 properties per product but will go beyond this if the risk profile is right.
- What type of property is being built? Non-standard construction types can be hard or even impossible to mortgage, which hugely impacts on resale value.
2. Who needs the loan?
A little background information on the borrower can be an invaluable indicator of whether development finance is a suitable product in both financial and practical terms. Having a good, clean credit history and reasonable net assets is a great start, but these aren’t the only criteria:
- Borrowers should be able to cash flow the project, and have ample liquidity with the ability to quickly raise funds in case of any unforeseen costs or delays.l Having relevant property development experience will make borrowers more likely to receive a decision in their favour.
- It’s important borrowers don’t step too far out of their comfort zone, although readiness to take the next step in a development career is to be supported: someone who has managed a large
property extension should be ready to oversee the build of a single property, for example.
3. How much is needed and why?
The next step is to gain a clearer understanding of the reasons for requesting a loan for the particular amount. The history of the development could prove telling; if there has been previous lending, and particularly if the loan is intended to repay another lender, we’ll need to assess whether or not development finance is the most suitable product:
- How much of the borrower’s own funds will be put in to the development? Ideally up to 25% of the total project costs should come from the borrower’s own capital, as it adds weight to the proposition.
- If a borrower has dealt previously with another lender it’s important to understand the situation; it doesn’t usually make sense for a borrower to leave another lender but there are exceptions.
- Has the proposed development previously fallen through? Under the right circumstances this isn’t necessarily a barrier to a favourable decision.
4. Do the numbers add up?
If the loan request makes sense in terms of the circumstances and amount requested, you should next go into the figures in more detail:
- l Borrowers shouldn’t be looking to spend more than 35% of gross development value (GDV) on the site purchase, unless the location is unusually strong.
- Check the projected build costs per square foot (psf) against both the average build costs in your area and the expected sale value. Alarm bells should start ringing if the projected costs are significantly lower than the likely cost.
- Is the loan to value (LTV) realistic and appropriate? If a loan is approved then 100% of build costs will usually be covered, but unless the borrower is very experienced and the proposition is strong it’s unlikely the maximum figure of 50% of site purchase price will be offered.
- The profit margin should be around 25-30% of the total project costs. A project where the expected return is lower than this can easily run into problems.
5. Will the project be completed?
Obviously, it is in everyone’s interest that a project, once started, comes to fruition. A few further checks will help ensure this proves to be the case:
- Development finance isn’t intended as a long-term solution, so borrowers should have clear and achievable timescales in place for the completion of their proposed development.
- Evidence of careful planning provides reassurance that a project is likely to be delivered; however, developments very rarely go completely to plan, so a degree of contingency is essential.
- Money is lent on the build in arrears at defined stages to ensure value has been added, with a surveyor inspecting the site at each stage before funds are released; this needs to be accounted for in budgeting.
Ultimately, each borrower and each project is unique and deserves case-by-case consideration. This is something only a specialist, client-focused lender will be able to provide. Asking the right questions upfront will help ensure an application has the best possible chance of success.