SME Lending – Development Finance
Development Finance, which is also called Construction Finance or Property Development Finance, is a form of borrowing that assists in the building of multiple residential or commercial buildings. It is available through banks, finance companies and private lenders.
As a Business Finance Professional, you will need to understand the various options available and what lenders look for when providing this type of finance, which is quite different from the way they assess residential mortgages.
Key Terms
Development Finance comes with some unique terms. Here are the main ones you will come across when working in this space.
Gross Realised Value (GRV)
The gross realised value (GRV) is the estimated value of a property development project when it is completed. Some lenders use this figure to determine the amount they are prepared to borrow. When funding against GRV, GST is excluded.
Total Development Costs (TDC)
Total Development Costs (TDC) represents all the costs involved with completing a project. It includes the purchase cost of the development site; development approval fees, construction outlays, construction contingency amount as well as all marketing, sales, interest and holding costs. Many lenders prefer to use this method for determining the loan amount.
Pre-Sales
Pre-sales are arm’s length and unconditional property sales entered into before construction is completed. For such a sale to be considered as a conforming pre-sale, it is usual that a 10% non-refundable deposit be held in a solicitor’s trust account, or directly in the lender's account.
The reasons lenders require pre-sales are: -
To establish a market exists and that individuals and investors are willing to buy what is being constructed
To provide additional security, giving the lenders access to the pre-sale deposit should something go wrong
To ensure there aren’t undisclosed incentives offered as part of sales (e.g. cash rebates) which inflate the GRV or TDC they have used to determine funding levels.
Different Lenders
In gaining an understanding of Development Finance it is useful to consider things from the perspective of the different types of lender.
Bank Finance
Traditionally, the banks have been the “go-to” lenders for development finance. As a guide the terms of development finance offered as senior debt by banks would be: -
Lend between 60 % to 75% of TDC (varying based on commercial property development or multi-residential development); or
Lend between 55% to 65% of GRV (varying based on commercial property development or multi-residential development)
Lend up to $100 million
Maximum Term of 36 months
Indicative Interest Rate – 5.5% to 7.5%
Indicative Establishment Fee – 0.3% to 0.5%
Pre-Sales – 50 to 100% debt cover (case by case basis)
For security, the banks will use a combination of arrangements, including: -
First mortgage over the real estate being constructed
A General Security Agreement (GSA) over the SME/Developer rights in the security property, and all related presale deposits held
Full recourse directors and shareholders guarantees
A tripartite agreement between the SME/Developer, the bank and the builder.
In today’s environment, banks are increasingly risk-averse and conservative in assessing development finance applications. They take a two-pronged approach by a) determining the SME’s/Developer’s ability to repay the debt and b) determining the viability of the development project and the attractiveness of saleable final asset.
To put it another way, the banks look into the track record of the individuals involved in the project as well as the security of the development itself. As such, professionalism in the application process can be very influential, and demonstrating project development experience may be the difference between securing funding or not.
Non-Bank Lenders
Specialist development finance companies, tend to take a more asset-based approach when assessing the loan with not as much emphasis about the experience and backing of the actual SME/Developer. As a comparison, the following is a guide to non-bank development finance options: -
Lend up to 85% of TDC (on multi-residential development only); or
Lend up to 70% of GRV (on multi-residential development only)
Lend up to $15 million
Maximum Term of 18 months
Indicative Interest Rate – 10.0% to 12.0%
Indicative Establishment Fee – 1.5% to 2.5%
Pre-Sales – nil under $8million loan (then case by case basis)
The arrangements used for security include: -
First mortgage over the real estate being constructed
Limited recourse directors guarantee
Negotiable limited General Security Agreement (GSA) over the SME/Developer rights to the security property, and all related presale deposits held.
Full rights and designs to all intellectual property held on the site
A tripartite agreement between the developer, the bank and the builder.
The attraction of non-bank lenders is that they offer flexibility in their lending assessment, rather than the formulaic approach of the banks. Depending on their degree of specialisation in development finance, they are less concerned with the SME/Developer and more interested in the project itself.
Some specialist lending companies have gained expertise in assessing each project on its own merits by identifying the qualities of the property, its location and post-project sale scenarios ranging from best to worst case. For SMEs/Developers, this can mean they are not at the mercy of having to provide their financials which, because of the nature of their business, can look great one moment and not so good the next.
In addition, pre-sales are not as much of a criterion for the non-bank lenders. Some quality projects do not naturally lend themselves to pre-sales. An example would be the building of 14 owner-occupied apartments in a sought after, up-market suburb. A specialist non-bank lender would recognise this is a different case to the construction of 36 investment-grade units in a lower socio-economic area and that pre-sales would be much more difficult to secure for the first project. As such, certain non-bank lenders would be able to take this into account and waive the need for high levels (or any) pre-sales. Meaning the SME/Developer can get funding for their project, get it underway sooner and save on marketing costs associated with having to attract pre-sales.
Another point of difference for non-bank lenders is the higher loan to value (LVR) they use for borrowing. Whether it be against GRV or TDC, the amount of funding a SME/Developer can secure is generally greater.
Of course, the downside in going the non-bank route is the higher interest charges and associated fees they levy for the perceived additional risks of development finance.
Private Lenders
A third, not so common option for development finance is using a private lender. The comparative guidelines for borrowing in this space are as follows: -
Lend up to 90% of TDC (on multi-residential development only); or
Lend up to 80% of GRV (on multi-residential development only)
Lending Limit – case by case basis
Maximum Term of 24 months
Indicative Interest Rate – 16.0% to 20.0%
Indicative Establishment Fee – 2.0% to 5.0%
Pre-Sales – generally nil
The reason that private lending is not so common is the cost. And the cost is a reflection of the fact that these loans sit behind senior/bank debt or specialised/non-bank debt as a second mortgage. Private lenders are taking more risk than first mortgagees and therefore charge more.
Alternatively, to abrogate risk they may use Mezzanine facilities which means the SME/Developer is potentially giving away future equity in the project.
The benefits are that less equity needs to be found to commence a project (larger LVRs) and pre-sales are rarely part of the equation. It is also possible, in private equity arrangements, that the SME/Developer can withdraw their equity before a project is finished.
Capitalising Interest
Development finance differs from traditional residential mortgages in that the borrower can usually capitalise interest as part of the finance arrangement. This means the SME/Developer does not pay interest during the construction phase of the project.
Interest is added to the amount owed at the end of each month and the borrower starts paying interest on interest. However, the agreed total loan amount cannot be exceeded by this capitalising of interest. If the loan is for 65% of TDC, once this amount is reached, no more funds will be available. Lenders take this into account in assessing whether the SME/Developer will be able to service their debts.
In development finance, the repayment of debt commences once the project is finished and the marketing and on-selling phases start.
GRV or TDC
As a general rule, banks are more likely to lend based on TDC and non-banks on GRV.
For SMEs/Developers, GRV can be a better option. Even though the costs are greater, because you can borrow more with less equity, the Return on Investment is higher. And, there is less of the requirement for pre-sales.
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