The visible appeal of property development

Of the various asset classes and sub classes in each category, property development stands out. It represents a very different and visible option. Some investors like to be able to “kick the tyres” and seeing a project develop from an architect’s proposed plan to a completed development is extremely satisfying.

In principle, there is little difference between developing a property and investing in the markets or anywhere else. As with any investment, it is about the risk taken against the potential rewards gained. Some would also say that within the associated costs there is also a certain parity.

If one compares percentage fees with purchasing and developing a property to annual management fees and other costs of running a robust portfolio, then in some cases they are not dissimilar. The one fundamental difference of investing in property development is the option of gearing. Borrowing to invest allows exposure to larger returns from a relatively small upfront contribution.

From refurbishing and selling a property to purchasing land and submitting a planning application, there are many options from a financing perspective. The types of loans that are available include refurbishment loans, both light and heavy, dependent on the work volume and the use of planning or not. There are also full development loans, which are backed by planning applications and detailed analysis to illustrate that the numbers reflect correct cost and market conditions.

These types of funding options are aimed at those wanting to venture into property investment, from first-timers refurbishing a buy-to-let property to large corporate developers. The funding is normally underwritten on the strength of the numbers provided within the required schedule of cost and schedule of works, which are provided by the applicant or their contractors. These documents help the lender understand how the timeframe and cost will be met and managed.

As with any numbers, they do not lie, and ambitious projects can easily be picked up on by the lenders and rejected at this stage. The other important key is the experience of the applicant. A first-time investor with no experience of property development means the underwriting will be heavily concentrated on the contractors behind the project.

This is to ensure there is relevant understanding of the works expected. In this situation normally cost is increased to reflect the risk from the lender's side. Experience is key.

Key points

• Property development is an increasingly popular form of investment
• There are funding options available aimed at investors interested in property development
• One way lenders look to finance development are loan-to-cost ratios (LTC)

Development finance is made up of a senior debt or first charge lending position. This comes in the form of a land loan, which usually consists of 65 per cent to 70 per cent of current market value. This would be classed as the acquisition loan, followed by potentially fully funding the cost of works within a set parameter based on the end value or gross development value (GDV).

The funding of the works would be paid to the investor in tranches, based on the schedule of costs submitted on an application. Funds would be repaid to the investor once the project develops, which is monitored by a quantity surveyor who inspects the project to ensure the funds have been spent as expected on behalf of the lender. The quantity surveyor also monitors the value during the project.

By using a loan-to-end-value limit, lenders protect themselves from any potential market twists or unexpected turns. An alternative way lenders look to finance development is with loan-to-cost ratios (LTC). This involves totalling the overall cost of the project and allowing a loan directly against this figure, which can vary from 55 per cent to 85 per cent, again all within an end value (GDV) parameter to ensure the project is not overfunded or the developer's numbers over ambitious. 

The cost of development finance senior debt can also vary widely. Lower gearing requirements against the end values can allow an experienced developer to achieve 3 per cent to 5 per cent on funds, with total annual cost, inclusive of fees, about the 7 per cent mark. If developers lack experience and want higher leverage or to maximise their borrowing, then cost of funds can increase to 10 per cent to 13 per cent all-in.

Although this might look expensive, by using the leverage on offer the risk taken by the investor is minimised. However, the rewards are as attractive as ever, allowing any shrewd investor to overlook the price of funds and take their seat at the table on the end values.

There are further borrowing options in this sector made up of mezzanine finance and equity positions, which allow leveraging up to 90 per cent to 95 per cent of total cost for the right project. They all come at a price, of course.

When the cost is blended it represents an attractive possibility given the minimal exposure expected from the investor. A 5 per cent or 10 per cent stake for a potential return of 25 per cent to 35 per cent of end value is always going to attract attention. However, in using these funding options there are many mouths to feed via 2nd and 3rd charge positions and are normally only considered for larger scale projects.

With any investment, there is always a possibility that things might not work out as expected. Property refurbishment and development are no different. Exposure to the property market is an obvious risk, given the effect of any political change of direction, as well as the potential for domestic and worldwide events that can affect overall confidence.

There are also more doorstep risks. Cost of materials can increase unexpectedly during the process; values and demand might drop and overruns are certain to affect the margin with most developments. On a smaller scale, the contractors might not deliver what is expected and the designated timescale might have been too presumptive. All of these things will eat into the initial profit margin. Many pitfalls are present with property investment, but risk is measured with the potential rewards. 

Ultimately, as in every business, cash flow is key. By holding a strong cash position and using the option of a loan investors can retain flexibility while still being exposed to the potential upside.

The attraction of lucrative returns over a 12-24 month period, given the buoyancy of the property market, is difficult to ignore. Over the past 10 years, the cost of borrowing has decreased and this is reflected in the development finance and heavy refurbishment sector.

Minimising the upfront skin in the game from the investor makes developments an attractive option to most with the correct risk appetite. But investors need to remember that the weather can change quickly in any asset class. The only way to know when it will, is by being aware and watching the sky.

Matthew Yassin is a partner, specialist finance, for Coreco