How to finance for your property development projects
By Ritchie Clapson CEng MIStructE, propertyCEO
For small-scale developers, money is simply a tool you hire for doing the job. Here is how it works.
Let’s say you have your eye on an old commercial building that you want to transform into four swanky new apartments. It will cost £200,000 to buy the building and a further £300,000 to develop the four flats: total required is £500,000.
A commercial lender will typically lend up to 70% of the £200,000 asset purchase price, which leaves you to find the remaining £60,000 as your deposit. This is the same process as a buy-to-let mortgage, where a 25% deposit is usually the norm.
The big difference with development is that the cost of creating the end product involves much more than simply sprucing up a rental property with a lick of paint and a quick trip to IKEA. In our example, you need £300,000. The good news is that the same lender who financed the £200,000 asset purchase will also lend you the development finance (providing you have planning permission or permitted development rights in place). And they won’t just give you 70% of it, they will fund the entire £300,000.
This development finance covers all costs associated with the project. It includes the fees for your team of professionals, the finance costs (interest will be rolled up and paid at the end of the project), and of course, all the materials that will be delivered to the site. There’s a standing joke in finance circles that the only thing that turns up on-site if a lender advances all of the money in one go is the developer’s Porsche. So, you won’t be getting your hands on the £300,000 in one lump sum. Instead, you will draw it down throughout the project. The lender’s surveyor will pop round regularly to make sure that each tranche of cash has been spent appropriately and is all accounted for before they’ll authorise the next payment.
But let’s rewind for a second because I glossed over the bit where I said you needed to find a £60,000 deposit. Not everyone will have that sort of money to invest. So, can you only take on a project if you’ve got a serious amount of cash in the bank already? Do you need to bankroll all of your 30% deposit personally?
The good news is that you don’t. This is where private investors come into play. Private investors are individuals who have savings or capital to invest and who are looking for a reasonable return. Now, unlike your architect or your contractor, you can’t look private investors up in the phone book and ring a few of them up. You’ll first need to find them yourself and then convince them to invest with you. If that sounds challenging, there’s more good news. While there’s no ‘Private Investors r Us’ to turn to, the reality is that almost anyone could be a potential private investor. Friends, relatives, and colleagues can often be a rich seam to tap into because they already know you and (presumably) trust you.
You may think that none of your friends or family has that sort of money. But you’re likely mistaken. They won’t advertise the fact, because usually people are pretty private when it comes to their finances. Yet people have savings, and people have pension lump sums. But in this day and age, the one thing they don’t usually have is an excellent rate of return for their money. The same goes for people you network with or encounter in everyday life. There are potential private investors at every turn.
So, what can you offer them? Most private investors can expect to receive an 8% to 10% annual return in property development. It’s not bad, is it? Particularly when the same money will earn them less than 1% in the bank. And while their loans won’t be secured on the property you’re developing (the commercial lender will take a first charge), the fact that the underlying asset is bricks and mortar rather than stocks and shares is a big plus, security-wise. And, of course, you don’t need to try to find just the one investor; you could instead find six investors who are willing to lend you smaller amounts individually.
Does this then mean that you won’t need to put in any of your own money?
While it’s possible to use other people’s money exclusively, it’s certainly not the easiest route. These days most commercial lenders will want you to have some skin in the game as the developer. Sure, the lion’s share of the deposit can come from private investors, but you should still be prepared to stump up some of the cash yourself, and each lender will have different requirements in that respect.
Ok, so that’s given you an overview. Here are five things that will make finding the money for your next property development project a lot easier.
1. Use a commercial broker
Commercial lenders are specialists, so your typical high street bank won’t usually be on your shopping list for development funding. Some lenders have a direct-to-developer model, but many rely on a network of commercial finance brokers to bring them business. And here lies yet more good news – these commercial brokers are on your side. Their job is to find a lender who can fund your project. Transparency is critical, and your broker will need to know all about the deal and your professional team, as well as you and your development business. If you have a few financial skeletons in your cupboard, tell your broker. It invariably comes out in the wash anyway, and you risk alienating everyone involved if you ‘forget’ to mention your unmentionables. Armed with the truth, your broker can then go out hunting on your behalf to find you the funding. How many brokers do you need? There’s no harm in having two or three on speed dial, as they won’t all be tapping into the same sources. But they can be a great ally as you move forward to secure that first deal.
2. Build a brand
Property development is a business where there’s invariably more than a few bob at stake for everyone involved. For both commercial lenders and private investors, you’ll need to inspire confidence. How serious are you? And how knowledgeable? Do you have a business plan and a team that ticks all the right boxes? Do you understand your deal inside and out? The word that crops up in each case is ‘you.’ But it shouldn’t just be all about you. You need to have a brand behind you. A name, a logo, a website, and a business card. People need to feel that they’re doing business with a brand and not just an individual, no matter how firm your handshake or how convincing your smile. So make sure you set these things up right at the start so that they can silently go to work for you in the background. The number of private investors who didn’t try to check out the developer’s website before they agreed to lend them money is probably as near to zero as makes no difference.
3. Learn how to analyse your deals robustly
When you put your deal forward for consideration by a commercial lender, it’s fair to say they’ll kick it pretty hard to see what falls off. Do your costs look reasonable? Does the professional team have enough experience? Are your anticipated profit numbers prudent or pure pie in the sky? And what happens if the market changes or the contractor goes bust; do you have a second exit strategy? This is, of course, excellent news; it means that if they agree to lend you the money, then you can be reasonably sure it’s a solid deal.
4. Cast your net far and wide
Commercial lenders are traditionally Route One when it comes to finding finance, but they’re not the only game in town. One of the more recent kids-on-the-block is peer-to-peer lending, aka ‘crowdfunding.’ The premise is simple. The peer-to-peer lender secures funds from lots of different private investors on the one hand, and then they arrange for the money to be lent to developers on the other, taking a fee in the process. Like the commercial lenders, they’re adept at critiquing deals, which means their lenders can have confidence that only good developers with decent deals will be put forward. But they can also offer advantages to developers over and above the traditional lending route, so it’s well worth doing your research. You’ll also find many investment clubs and groups out there as well as a range of high-net-worth ‘angel investors.’
5. The deal is king
In short, there is a lot more money out there that needs investing than there are property deals that return 8-10%. So don’t forget that it’s the developer that has the whip hand when it comes to finding investors, and not the other way around.
One word of caution; don’t forget that money lending is a heavily regulated business, and there are some key ‘dos and don’ts’ when looking for and approaching private investors. Be sure to check out the FCA’s rules on the subject.
ABOUT THE AUTHOR
Ritchie Clapson CEng MIStructE is a veteran property developer of almost 40 years and co-founder of propertyCEO, a nationwide property development and training company that helps people create a successful property development business in their spare time. It makes use of students’ existing life skills while teaching them the property, business, and mindset knowledge they need to undertake small scale developments successfully, with the emphasis on utilising existing permitted development rights to minimize risk and maximize returns.