Development finance explained – what is it & how does it work?

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    Chris Godfrey

    Page written by Chris Godfrey. Last reviewed on July 15, 2024. Next review due 2025.

    Developing property for resale or to retain as an investment or for your own residential needs can be a great way to generate income or move up the property ladder. However, South African real estate development can be costly, and many potential developers lack sufficient funds to pay in cash. Fortunately, there’s a way to solve this problem – development finance provides special loans to purchase land and pay Bill the builder and Scott the sparky. Don’t let the lack of cash limit your ambitions. Check out a tailor-made development loan and get busy building.

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      What is development finance?

      Development finance is a term for loans used to support the costs associated with a residential or commercial development project. Unlike long-term property mortgages, development financing is typically short-term, with lifecycles in the range of 6-24 months. Loans can be used to buy land and pay for construction costs, and they are suitable for ground-up new builds, conversions or refurbishments of existing properties.

      Andrea Reynolds, Swoop’s CEO & Co-Founder
      Andrea Reynolds
      Swoop’s CEO & Co-Founder

      A word from Andrea

      "Due to the costs associated with real estate development and many property developers requiring cash to complete their projects, development finance is becoming an increasingly popular option to fill this gap. Development finance provides special loans to purchase land and pay your contractors."

      How does development finance work?

      Property development finance assists with funding a residential or commercial development. Unlike regular home or commercial mortgages, where a loan is taken out to buy an existing property, development finance is used to build a new property or to renovate or convert an existing property. Because the development property does not yet exist (new-build), or it is going to be significantly changed from its current condition (refurbs and conversions), development loans are granted on the cost of the development as well as the projected future value of the property when it has been completed. In all cases, LTC (loan to cost – the size of the loan against the total deal costs) and LTGDV (loan to gross development value – the size of the loan against the end value of the property once constructed), the borrower’s previous track record in the sector and their ability to repay the borrowing are all considered during the assessment of loan applications.

      With development loans, interest is usually rolled-up or capitalised. This means that the interest charged by the lender is added to the loan balance rather than paid as a monthly instalment. This means there is no drain on cashflow during the construction period and the total interest charged is paid when the properties are sold or refinanced to repay the debt.

      Types of development finance

      Development finance facilities are all unique, there is no one size fits all facility. They are tailor-made products specifically designed for different types of development and created bespoke for each scheme a developer undertakes. Development finance loans can be used for the following purposes:

      • Residential property development
      • Commercial/semi-commercial property development
      • Renovations/conversions/refurbishment
      • New builds
      • Single-unit developments scaling up to large multi-unit schemes
      • Development exit funding (sometimes called sales period funding) – similar to a bridging loan and typically used to finance a recently completed development until the units are sold or refinanced on a longer term loan facility.
      • Mezzanine development finance – a secondary line of borrowing for the same development. Usually used to reduce the need for a large cash deposit. Sometimes called a ‘junior loan’ or a ‘junior mortgage’.

      Some development projects may require a mix of different loan products, (for example, new-build mixed with conversion of an existing structure), or the developer (borrower) may be unsure as to which kind of financing to apply for. Professional opinion is advised in such circumstances. 

      The process explained

      There are multiple steps in any development finance deal. A typical transaction looks like this:

      • Initial enquiry – free advice – formal application submitted to lenders when the time is right
      • Lender provides an agreement in principle – indication of terms and conditions
      • Lender conducts due diligence, which may include a site visit and/or valuations
      • Projected future value of development delivered
      • Lender makes formal loan offer – accepted by borrower
      • Lawyers create documentation – signature by all parties – exchange of contracts
      • Completion – first drawdown of funds to buy land or start construction
      • Additional drawdowns to fund build costs
      • Repayment of loan – usually when the development is sold or refinanced

      Most lenders will require a substantial file of documents from the borrower at the time of application, however we work with our clients to make this process as painless as possible. Having all your ducks in a row will enhance the potential for successful project funding. Every lender will have their own proprietary criteria for documentation, but key paperwork includes:

      • Details of planning permission and any drawings
      • Details of any planning restrictions or levies that may impact project profitability
      • Complete breakdown of all project costs
      • Details of borrower’s development experience and examples of previous projects
      • Schedule of works (operational calendar) broken down by phases
      • Details of architects, contractors etc.
      • List of borrower’s current assets and liabilities, plus projected expenditures during the life of the project
      • Proposed exit strategy
      • Projected gross development value – what will it all be worth when completed?

      Whilst experience is preferred for most lenders, if you’re a first time developer there are options available to you too. 

      How much can I borrow?

      Development loans start from as little as R200,000. Different lenders have various upper limits. Our team of experts can provide you with options up to R50 million.

      What are the interest rates?

      Interest rates vary from 7% to 15% APR, however, as development loans are short-term, the amount of interest charged is of lower importance to the borrower than the total deal costs (fees, etc) and the loan covenants (terms and conditions), that a lender will insist upon. This is where our team of commercial finance managers will guide you through the various options available to you. The cheapest rate isn’t always the most competitive overall deal.

      What fees & other costs are involved?

      Fees vary according to each loan and the specific set of circumstances surrounding the deal. Typical fees included in development financing are:

      • Lender arrangement fee – a charge from the lender for providing the finance.
      • Broker arrangement fee – a charge from the broker who functioned as intermediary between borrower and lender, as well as any other professionals involved in the deal.
      • Monitoring surveyor fees, (sometimes called Quantity Surveyor Fees, or QS) – costs to maintain professional surveyor oversight of the development to ensure it complies with building regulations and deal covenants during the term of the loan.
      • Exit fees – a charge applied when the loan is paid off.
      • Legal fees – lawyer costs and fees.
      • Non-utilisation fees – interest is usually charged only on the sum of money drawn from the loan pool. Some lenders may additionally charge a non-utilisation fee to compensate them for funds they have made available to the lender, but which are left unused and not earning interest.
      • Management/admin fees – office costs and fees to manage the loan.

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      An example

      Unlike regular home or business mortgages, development loans are paid out in stages from an agreed loan pool. Lenders will typically limit the funds they are willing to provide to no more than 70% of land purchase costs, and up to 90% of the construction costs.

      Here’s an example of new-build development finance:

      1. A plot of land has been sourced that has planning permission to build ten, three bedroom detached houses. The land can be purchased for R600,000 and the cost to build all ten houses will be R2,000,000. Total deal costs are R2,600,000, (ex. fees and interest).
      • The estimated value of each house after construction (including their freehold), is R350,000 meaning a gross development value (GDV) of (10 x R350,000) R3,500,000.
      • Development finance can be used to raise up to 70% of the land cost = R420,000 and 90% of the build cost = R1,800,000.
      • A loan facility is set up for R2,220,000. (The pool). Funds are released in stages, with an initial release of R420,000 to help buy the land. The developer will provide cash in the sum of R180,000 to complete the land purchase.
      • The remaining R1,800,000 will be released in stages as the new-build progresses. The borrower will use their cash first, with the lender then following with further drawdowns.
      • The borrowed sum of R2,220,000 plus interest is repaid when the houses are sold on completion. As this deal is not a joint venture, the developer retains all the profits.

      With most development loans, interest is only charged on funds that have been drawn from the loan pool.

      100% development finance

      Most South African property development finance options cap out at a maximum of 60-80% of the total deal value. However, 100% development finance may be achieved if: 1). The borrower enters a joint venture with a financier who is willing to provide lending to the total deal value in exchange for interest and a share of the profits. 2). The borrower offers additional collateral as make-weight security in lieu of a cash contribution.

      To find out if 100% financing is an option for you, please contact us today.

      Does planning permission need to be in place?

      Yes. Most lenders would expect to see full planning permission in place before issuing a formal offer of finance and instructing solicitors to commence legal due diligence. However, some niche lenders may proceed to legal due diligence if outline planning permission has been obtained, but they will only draw down the loan facility once full planning consent has been achieved.

      Can I get funding as a first-time developer?

      Yes. Although a lack of previous developer experience may make it more difficult for first-timers to borrow the funds they need, financing may be possible from niche funders, or from mainstream lenders if the first-timer teams with an experienced developer to co-manage the project.

      Can I get funding with bad credit?

      Probably. There are development loans available for borrowers with bad credit, or even no credit. Even if you’ve been turned down elsewhere, we may still be able to secure the funding you need. Contact us now for a confidential discussion about your project and how we can help.

      Bridging finance for property development

      Bridging finance is a short-term loan used in real estate development to cover the timing difference (or gap) between one property related transaction and another. 

      Commercial vs. residential development finance

      Development loans may be classified as ‘commercial’ or ‘residential’. How do they compare?

      Loan featureCommercial loanResidential loan
      Purpose of loan          Development of property for business or large-scale residential use. (May be mixed – use with business units mixed in with dwellings)Development of property for residential use. Usually a single residence or a small number of units
      Maximum loan value    Up to 70% of land and 70% of build costsUp to 70% of land and 90% of build costs
      Term of loan      Until development is complete, typically 6 to 24 monthsUntil development is complete, typically 6 to 24 months
      Interest rate  4% to 15% APR4% to 15% APR
      Regulated or unregulated            UnregulatedMay be regulated
      Exit strategy    Sale of property upon completion repays debt, or the property is retained and leased out, which will require the borrower to refinance with a long-term mortgageSale of property upon completion repays debt, or the property is retained and leased out, which will require the borrower to refinance with a long-term mortgage

      Exit strategy is an important element of any property development financing. Because most commercial developers intend to sell the completed property to repay the loan, lenders will typically expect to receive a strong sales and marketing plan as part of the application process. In contrast, residential development projects seek to build a home for the developer, or a small number of units for sale. This difference reduces the marketing need and can make it easier to obtain a residential development loan than a loan for purely commercial purposes.

      For commercial property developments, if the property is being constructed for self-occupation lenders would expect the exit of the development loan to be in the form of a refinance on to a commercial mortgage. Our team of commercial finance managers will be able to arrange this for you. If the commercial development is to be occupied by a 3rd party tenant, then the lender would expect to see a pre-let agreement during the underwriting process to provide confidence that a long marketing period will not be required to attract a new tenant to the completed building.

      Joint venture development finance

      Joint venture (JV) property development finance describes a partnership between a developer and a financier who is willing to fund up to 100% of the total deal value in exchange for a share of profits when the property is sold, plus interest on funds loaned. Most JV deals work using a special legal tool called a special purpose vehicle – or SPV. (Sometimes call a special purpose entity or SPE). This is a temporary holding company that acts as legal entity and funds-holder during the life of the project. Borrowed funds are repaid when the property is sold, with surplus funds (the profits) being shared between developer and financier. Typically, the profit share in a joint venture is 60% to developer and 40% to financier but can be negotiated.

      Development exit finance explained

      A form of bridging loan, development exit finance is granted to a developer after the project is complete, but not yet sold or refinanced with a long-term mortgage. Lenders expect development loans to be repaid in full when a project is completed, yet it may take time for the developer to sell the property or to obtain a mortgage. To bridge this gap, lenders may provide development exit finance which repays the more costly development loan and remains in place until income from unit sales or a long-term mortgage are available to repay the exit loan in full. Exit loans can sometimes attract a lower interest rate when compared to development finance, so it sometimes makes sense to refinance immediately on completion on to a more cost-effective solution. 

      Who offers property development finance?

      Development finance can be obtained from a range of lenders – major banks, investment companies, independent financiers, specialist property lenders, etc. Every funder will have their own lending criteria. Some may want a fully-fleshed out plan and a mountain of documents, others may simply want a valuation and look at your credit score. Finding the best loan for your development is a crucial as finding the best builders and carpenters, so it pays to shop around when looking for a loan. 

      How do I repay the loan?

      Standard options to repay a development loan are:

      • Use the sale proceeds from the finished development to repay in full.
      • Refinance the loan with a new, long-term loan. This option is suitable for borrowers who wish to keep the completed development for themselves or to rent out.
      • Refinance the loan using a development exit bridging loan. (Exit loans are usually granted at a lower interest rate). This tactic retains as much profit as possible, as it avoids having to wait for the sale of the property to repay the development loan in full.

      Tips for applying

      Even seasoned property developers can get caught in loss-making projects, so the first-timer or minimally experienced developer should consider any project with great care before applying for funding.

      The first thing to consider is the development itself:

      • Has the property been on the market for a long time, or is it being remarketed? If so, why? What are the problems with the property or the seller?
      • What can I afford to pay for the property or land? Keep to a budget.
      • What will the building work cost? Does it fit within the budget? Have you researched any hidden issues that could significantly raise costs?
      • How reliable are my architects and contractors? Always get references and seek help from well established, trustworthy suppliers.
      • Have I built in a contingency to manage emergencies or cost over-runs?
      • What is the projected value of the finished project? How does it compare to similar sites in the area?
      • Is there enough demand for this type of development?
      • Who is my target buyer, and will they come to the development?
      • Is there local competition from similar developments? Am I competing in a flooded market?
      • What is my projected profit and when will the project complete?

      If you can positively answer all the above, you are ready to approach lenders for funding. But first:

      • How strong is my credit? Check your score and report before applying. Contact credit reporting agencies to correct any errors.
      • Have I provided all the requested paperwork? Missing documents could delay your funding and cause you to lose the land/property you intend to develop.
      • Do I have sufficient funds to pay a cash deposit, or do I have collateral (such as real estate) that I can offer as make-weight security?

      How do I apply?

      Loan and application documentation can vary significantly. Getting the right loan with the right paperwork at the right price and at the right time is critical to a developer’s success. Contact Swoop to arrange a confidential discussion about your financing needs. Begin with the best deal to give your project the best start possible. Get started today.

      Written by

      Chris Godfrey

      Chris is a freelance copywriter and content creator. He has been active in the marketing, advertising, and publishing industries for more than twenty-five years. Writing for Barclays Bank, Metro Bank, Wells Fargo, ABN Amro, Quidco, Legal and General, Inshur Zego, AIG, Met Life, State Farm, Direct Line, insurers and pension funds, his words have appeared online and in print to inform, entertain and explain the complex world of consumer and business finance and insurance.

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