Importance of an Exit Strategy and Property Development Finance

There are several ways to arrange property development finance and several types of lenders in the market. What is common to them all is their need to understand and to have confidence in the way that they are going to be paid back. So, lenders will ask a number of questions at application stage about how this is going to be achieved and they will form an opinion on the credibility of the borrower’s strategy. That opinion is no less important than all the other aspects of the loan application and if the lender does not believe in the strategy, then the loan will not be forthcoming.

By definition, if you are engaging in a property development, it is only going to last as long as the building takes, which tends not to be very long, usually about 12 months. If you require finance, including to buy, then it will reflect the same time period. At the point that the money is lent, the lender does not have a finished house to lend against. This will only be the case when the project is finished. If anything were to go wrong during the building phase and the lender wants to repossess, it will be the lender who has to sort out the problems and organise the completion on the building. This is neither something that they want to do, nor have in house expertise to do. Their business is lending money and not building houses. (The circumstances under which a development lender would repossess a project is covered in other articles). This risk that the lender takes is reflected in the interest rates paid for this type of finance. Lenders in this market do not want to be involved in long term loans; their business strategy is short-term lending, their knowledge base is geared for this and so are their systems.

So, it is both the lender and the borrower that want to see the development loan repaid. The borrower wants to repay because he is being charged a higher interest rate than on normal loans and the lender because he is a short-term lender and wants his money back.

What, then, are the options to achieve this? Well, quite simply, it is either to sell or to keep.

KEEP THE DEVELOPMENT
There are many reasons why a borrower may want to keep. It could be that it is not the right time to sell because the market has dropped, or more likely, that it was never the intention to sell. Usually the intention to keep is based on a plan to let the property, either to long term tenants, or, frequently nowadays, for letting to holiday makers or on AirBnB. Sometimes, in the case of self-build, the borrower will want to move into it. Keeping a new property empty is not a wise move because such properties are frequently targeted by thieves and vandals and moreover insurance cover will have extra conditions applied.

If it was always the intention to keep, then it is very important that the borrower knows at outset that they are going to qualify for the long term loan and to the extent that if they do not qualify for that loan, that they either modify the project or even do not start it. It is a very bad strategy for the borrower to find once the build phase is over that he has no alternative other than to sell.

What is frequently forgotten is that the lender’s interests and the borrower’s interests run in parallel and are virtually the same. The borrower does not want his project to fail and neither does the lender because it puts the loan at risk. So, whereas the borrower may think that the lender is asking difficult questions about the project, it is only because they are prudent questions usually borne out of the greater experience of projects that the lender will have. That actually helps the borrower evaluate and organise his project better. Thus, although it is not always mandatory, it will certainly help the lender when considering the loan application to see some confirmation that the borrower has qualified for a long-term loan. Such an acceptance is called a “Decision in Principle” (DIP) or an “Agreement in Principle” (AIP) and will require the borrower to make a formal application to a normal mortgage lender. The development lenders know perfectly well, that if a borrower has been accepted for a long term loan, that such an acceptance probably only lasts for six months; but it gives the lender an indication that the borrower will qualify at some stage in the future and also that at least the borrower has been organised and forward thinking enough to make an application.

When the building is finished then the borrower can invoke his DIP, or re-apply if it has run-out, follow the process through to completion and the long-term loan will be used to pay-off the development loan.

It is fair to say that if a borrower does not have a full understanding of the implications and procedures required “to keep”, then they should seek the advice of a broker that does know and that has experience not just of residential mortgages but also of Buy-to-Let mortgages and Holiday Let mortgages. In the case of Holiday Let mortgages there are not many brokers familiar with this style of loan and of the market, so seeking some expertise is particularly important.

SELL THE DEVELOPMENT
The fundamental rationale for the borrower for doing the project is to make profit and fundamental to that is the final value or sale value of what has been built. This is known as the Gross Developed Value or GDV. When making the loan application, the lender will look closely at this figure and determine how realistic the borrower’s estimate is for this. If they agree, then all is fine; if they disagree, the loan size may be pared down or the loan may not be offered at all.

As the build phase progresses, and sometimes even before it has started, experienced developers will put the property up for sale, using plans and illustrations of the finished product for prospective buyers to look at. This is called “Selling Off-Plan”. If a buyer is found, the buyer’s surveyor too will look at the plans and advise the buyer on his view of the finished value. If everything ties up and even if some negotiation is done, then the experienced developer will pressure the buyer to exchange contracts. This should be reported to the development lender, who will be absolutely delighted because it has de-risked his loan to know that a sale is agreed.

Obviously if all goes smoothly, then the sale will pay-off the development loan. On occasions, if multiple properties are being built, then the development lender may ask for 100% of the sale proceeds of the first sale and continue to ask for the maximum amounts until his loan is paid off. This leaves the developer to make all his profit out of the last few sales of the project. Although this may not suit the developer, it is a frequently occurring situation, but not one that always exists. It is important that a developer checks this when applying for the finance. It could be that a different lender will only want a proportion out of each sale leaving some profit for the developer; and if this lender has a slightly higher interest rate, it may still be something that a developer chooses to do

By on April 23, 2020   /   Blog