How do property developers finance property and make their profits?

Why developers need to sell off-plan property

As a property investor, one of the main attractions is the enormous profits that are possible by using leveraging to grow a property portfolio. Property developers understand this investment strategy, and they also use leveraging to maximise their profits. In other words, rather than using their money to see a property through from planning to completion, they’ll use other people’s money. However, whereas you or I might finance a property investment with the aid of a buy-to-let mortgage, developers need to use some financing strategies to fund building.

In this article, you’ll find out how developers finance their new build projects and why off-plan sales are so important to them.

Lenders don’t want to lend

Okay, so this is a concept that most people find really difficult to get their heads around. Lenders, like banks, who make their profits by lending, don’t want to lend! The reality is that they are not in the risk business that you and I are in when we invest. They don’t take the risks that property developers do when they buy land and build property. Lenders want to sit back, take no risk, and reap the rewards of having the cash to lend.

When making a loan to a developer, the lender will treat them like it treats you or me when we ask for a loan. It will assess the strength of the borrower and the viability of the project. Where we need to provide a property valuation, developers have to give the lender a feasibility study. The types of loan that a developer might require to finance the project include:

  • An acquisition loan to fund land purchase, permissions, and other pre-development costs
  • A construction loan to cover the costs of building

What other criteria do lenders want from a developer?

Apart from a good track record and a detailed feasibility study, a lender will also expect the property developer to foot some of the costs of buying the land and building the residential development. For example, let’s say that a developer has identified a project and cost it out to £10 million. This cost includes the land purchase and building costs. The developer might finance, say, 50% of the land costs and 70% of the build costs. If the land costs £2 million and the build £8 million, then the developer needs to come up with £3.4 million instead of the whole £10 million.

How development loans are repaid

Commonly, developers are expected to repay the development loan in stages. These coincide with project milestones, and would typically include the base stage, fixing stage, and completion. It gives you an idea why property developers release their properties in stages: doing so allows them to repay their loan commitments. The lender will have to place penalties or higher interest charges for late payment – so it’s in the developer’s interest to complete each stage by the time it says it will.

An interesting fact about development loan interest

The interest on a development loan is usually capitalised when the loan is made. It simply means that the developer doesn’t pay the interest as you and I would on a residential mortgage, but instead it is added to the amount borrowed. Every month the interest is added to the amount outstanding, and so interest is charged on the interest added.

Again, you can see that it’s in the developer’s best interests to sell property early and repay the loan. If the developer doesn’t do this, the interest owed can mount up quickly.

Other types of financing

Banks and lenders are not the only route to financing a new build development. A development company could set up a joint venture, for example. In this case, the developer provides the expertise, and its joint venture partner provides the cash. The developer’s partner would not charge interest on the funds provided, but instead take an equity stake and a percentage of the profits (like the investments made on Dragons’ Den). Even in this case, the joint venture partner will probably want to see that there is some financial commitment from the developer.

A developer may also be able to access what is known as ‘equity and loan funding’ – this simply means that cash is provided, but the lender reserves the right to convert the loan into equity. In such an arrangement, the lender would convert the interest (plus capital repayment) it would receive a share of the profits.

Why do you need to know about developer financing?

It’s always good to know that a developer is committing at least some of its capital to a development project. For the lender, it gives a cushion of comfort (the same reason that, as an investor, you can only borrow to a maximum of 70% of a property’s value). As an investor, seeing that the developer is willing to risk its cash gives me a sense of security – if the developer is willing to take that risk, then so am I.

However, understanding how a developer funds a project also helps you to understand how its pricing policy on property sales evolves during the lifetime of the project:

  • At the early stage – sometimes before the ground is even broken on the build – the developer will want to make sales to get cash in quickly. It provides financial momentum for the development, is cheaper than borrowing from a bank, and also provides a record of pre-sales that will help the developer to access future project loans at better rates.
  • Those early sales are the ones where the investor is in the strongest position. The properties have not yet been built, and the developer is cash hungry. At this stage, you can negotiate some very sexy discounts to market value.
  • As the project matures, the developer becomes less needful for cash. It can afford to negotiate on price much harder, and its profit margins increase.

The earlier you invest in a development, the better your profit is likely to be – not simply because of market movements, but because of development financing dynamics. Developers make their profits on sales made towards the end of the development timeline. Investors make the best profits when they invest early.

The problem for individual investors is getting access to early-stage off-plan property investment opportunities. To find out how you can do this, contact one of our team today on      +44 (0)207 923 6100.

Live with passion

Brett Alegre-Wood

Brett Alegre-Wood
January 24, 2017

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