The challenges of development lending

Financing development projects requires a unique underwriting process and far more ongoing scrutiny than in an investment deal, writes Lauren Parr.

Development finance is risky business compared to investment lending, not least because of the lack of standing assets to collateralise loans. In addition, there are many costs and potential snags to navigate prior to a project reaching completion.

“You’re looking at construction risk, making sure the asset gets built, as well as the capacity and experience of the borrower to deliver the project,” explains Randeesh Sandhu, chief executive of UK-based residential development lender Urban Exposure. “You need to make sure the main contractor is reputable, and you have the relevant security in the form of performance bonds or insurance in place to protect you.”

Development lending is also labour-intensive. “You could spend months working on a deal and not end up doing it,” adds Sandhu. “Depending on the scheme, size and complexity it can take a long time to do the necessary due diligence before you even lend, which means you need a skilled team in place.”

The objective is to structure a facility that strikes the right balance between the bank’s risk and the developer’s economic needs, providing the sponsor with the flexibility needed to deliver a construction project.

Pricing is calculated in relation to how de-risked a scheme is, Sandhu explains: “How many pre-sales are there? How advanced is it on designs?”

For traditional banks, that means careful due diligence to ensure a loan fits with the organisation’s lending criteria. “Like many banks, Deutsche Hypo has a rating system for calculating risk margins, for instance, factoring in how much of a building has been let, what a building’s technical standards are in terms of IT supply etc, and how this is reflected in construction costs,” says Sabine Barthauer, a member of the board of managing directors at German bank Deutsche Hypo.

“Like other banks, we plan very extensively year by year, what we want to earn in the coming years. This is the basis for the pricing of each individual financing,” she adds.

Leverage is determined through a combination of working out costs, the rental risks, “and in the end a material discussion about what kind of structure it is and what’s a competitive margin”, she says. “We think about who the customer is, what the quality of a project and location is, and what’s the market for this kind of finance, before making our bid.”

Due in large part to regulatory pressures, banks take a more conservative stance on development lending than alternative lenders. For example, a UK high street bank lending at 60 percent loan-to-cost equates to around 50-55 percent of the end value on residential. A bank might charge a 3-4 percent coupon on development compared with 2-3 percent on an investment basis, as well as non-utilisation fee of up to half the margin on undrawn funding.

Debt funds, meanwhile, lending at up to 90 percent LTC, or up to 75 percent of the GDV, are likely to charge a coupon of as much as 10 percent, with no non-utilisation fee, a market source says.

Covenants are structured differently than for investment loans. As the projected cash flow is not secured to 100 percent cashflow during the development financing period, banks concentrate on LTC and interest coverage ratio at the point of completion.

“Sometimes there is a pre-let phase but we look to the point of completion and say, ‘What could the potential rental income be,’ and then we try to find an ICR which might fit this project at the point of completion,” says Barthauer.

Once a building is out of the ground a development loan can be converted into an investment facility for a fee, normally after completion or stabilisation of cashflow to cover the interest. “Our customers are typically developers and they sometimes want to sell projects as a full package with an investment loan in place. We look into the income an asset is producing and try to secure a good senior lending option for the long term,” Barthauer adds.

The €53.7 million, three-year development loan La Caixa and Natixis provided to fund the construction of an outlet mall near Barcelona by a joint venture between TIAA and NEINVER flips into a four-year investment facility upon completion.

“The facility was structured to comply with a 60 percent LTC ongoing covenant, with the final instalment of debt available once a certain level of pre-let is met,” says Farrah Brown, head of treasury at TH Real Estate.

In some circumstances, it is possible to decrease equity and increase LTC during the life of a loan, where deals are progressing according to plan.

More work for lenders

For lenders, development ties up substantial resources and is time consuming business, as loans and construction projects must be monitored on an ongoing basis. “There’s more work involved for the lender in a development loan. You don’t lend all the money on day one; there are incremental draw downs on a monthly basis through the life of loan,” says Richard Fine, co-founder of debt advisory Brotherton Real Estate.

A lender will appoint a monitoring surveyor who receives a monthly schedule of costs incurred from the developer’s contractor, which the lender ultimately signs off before releasing funds. “It’s important to check the work you’re paying for is being done to the right specification. Lower quality could result in lower GDV,” says Urban Exposure’s Sandhu.

It’s an ongoing process of communication between the lender and construction company, with ideally no more than four weeks passing without an exchange. “If there are changes during construction phase, you need to know what will be changed and what the associated costs will be,” Sandhu adds.

Projects rarely unfold as expected and it’s not uncommon for issues to arise during the development phase, typically relating to time and budget. Over-spending on the construction process can cause significant problems and can result in delayed build periods, Sandhu continues. Sales and lettings also need to be monitored. “You have to make sure sales and marketing is happening according to plan, or that off-plan sales milestones are being met,” says Sandhu.

A lender will commission an independent valuation to make sure assets are sellable at the right price, and are also mindful of what other supply will come onto the market in two or three years’ time. “Is pound per square foot right and capital value right? Is it mortgageable?” asks Sandhu. “A lot of PRS units out there if sold individually are not mortgageable. You have to buy the whole block or nothing at all. If you’re selling off-plan you need to check the contract to see whether deposits are going to be used for construction or held.”

There are many considerations for lenders to manage throughout the development process, combining to create higher risk, but also putting higher potential returns on offer.

In order for a development loan to run smoothly, Sandhu believes lenders “must be really on top of costs and the build programme in terms of time; have contingencies in place, and make sure they are using the right professional team”.

“You need to make sure you’re happy with the contractor and the form of the contract, and make sure you have a decent performance bond in case the contractor goes bust,” he says.

Fine adds: “So long as the developer is able to prove a track record in keeping costs under control and managing the risks associated with a development, lenders should be able to make good risk adjusted returns.”