Banks are still the primary source of funding for developers. However, due to the credit crunch, banks’ lending criteria have tightened, even for experienced developers. There are alternatives, including private sources of funding: however, these should be approached with great caution.
“[The alternatives] are much, much more expensive, and my suggestion for beginning developers is if a bank is not going to lend you the money, you should also be concerned about your money and your equity,” says Michael Yardney, director of Metropole Property Investment Strategists and an experienced developer. “I’ve found that most of those who have gone to private lenders such as solicitors’ funds or mezzanine funds have gotten themselves into trouble.”
A solicitor’s loan is an example of short-term ‘asset-based’ lending. In these cases, the lender (usually a law firm) does not check your ability to repay the loan. It merely lends you money based on the value of your property. The fact that you may not have any other assets or significant income will be no impediment to you obtaining a loan. At the end of the project, you have to repay the loan in full, usually by selling all of the units. There is no option to hold on to the properties and refinance for the long term.
One of the first requirements of a mainstream bank is that you have significant equity in your project. There is no such thing as 100% or even 90% financing in property development. “For smaller developments you may need 20% equity. For larger ones you’d probably need closer to 30–40% equity,” says Yardney. “As opposed to your own home, or sometimes for investment properties, the banks want you to have some ‘hurt money’ – you’ve got to have some equity in there.”
For developers who don’t have sufficient equity, one option is turning to a ‘mezzanine’ lender.
“Mezzanine finance is a form of debt usually taken out for short periods of time and used to give you sufficient funds to attract funding from a traditional source, like a bank,” explains Yardney. “Banks will lend you, say, 70–80%. The mezzanine lender sits above that as a sort of second mortgage. Because they would sit behind the main lender if the project is liquidated, they charge a higher rate of interest to take on that extra risk.”
Developers who are comfortable with elevated levels of risk and are looking for a highly geared project might turn to mezzanine lenders. For everyone else, Yardney suggests staying away. If you don’t have sufficient equity, then wait until you do, or start on a smaller project and work your way up. “At this stage of the cycle – where things are more risky, where we’re not in a high capital growth environment – don’t take the risk of undercapitalising your project right from the beginning,” he says.
Another option is getting into a joint venture with an individual or group of individuals.
“If you can bring a level of expertise, you may find other people who say, ‘I’ve got money and I don’t have this expertise,’ ” Yardney says. In these cases, you could form a strategic partnership where each party brings its strengths, whether financial or in management skills, to the table. Be certain, however, that you have a solicitor draw up a water-tight contract so that everyone knows what their rights and responsibilities are."