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Development finance: debt vs forward funding

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Posted by James Polo-Richards on 29 April 2016

James Polo-Richards Commercial Development and Investment Partner

‘If you build it, they will come’ or (for the real film buffs amongst you) – ‘if you build it, he will come’.

Whatever the line, the sentiment remains the same. Property development is intended to attract and draw people in. This applies whether you are a large international logistics company looking for a new distribution facility, a company looking for a new office or a high profile retailer wanting the pride of place in the latest shopping destination.

That’s the theory anyway.

But to build it you’ve got to fund it. As a developer, there are several ways you can approach this. You could split the options into four:

  • Equity;
  • Debt; 
  • Forward funding; and
  • Forward sales.

Forward sales are probably less common than they were in the past, and equity is great but is only viable if your shareholders have deep pockets, so for this note, we are going to focus on the differences between debt and forward funding.

Debt

Debt comes in many shapes and sizes – junior debt, senior debt, mezzanine debt, bridging finance and so on, but what we are really dealing with in all cases is a bank or other financier lending money which is then secured by a charge against the property.

Forward funding

This normally involves a pension fund or other institutional investor seeking a better investment compared to what it can find on the standing market. The investor will agree to buy a development that hasn’t yet been built (but which may be pre-let) with the benefit being that the fund or investor will acquire an investment with a better yield than if the development had been built already.

The key pros and cons of both methods are as follows:

Return

From a developer’s perspective, debt finance is likely to lead to a greater return from the development provided; it can find a willing buyer. By using the debt to complete and finalise the development, the developer can bring the completed development to the open market and sell it by way of auction to the highest bidder.

On a forward funding deal, the yield is usually agreed at the outset, and the total return for the developer will often be lower, to reflect the risk element that the funder has taken on by having to fund the development itself.

Certainty

Forward funding wins out here. By tying up a funder at the outset, the developer has certainty that the construction phase is paid for. Depending on the deal structure and timing, a forward funding deal may also allow the developer to claim sub-sale relief on SDLT; on some larger properties, this can represent a significant saving and a nice addition in the profit column for a developer.

Under a debt deal, the developer is reliant on finding a willing buyer when the completed development goes onto the market. Until the development has been sold the developer is left on the hook paying interest to the debt financier and could be faced with the choice of having to reduce the asking price and lowering its return or waiting longer and seeing if anyone will come forward with an offer while the interest payments nibble away at the profit margin.

As with all commercial property deals, the balance for the developer to strike is one between risk and reward.

Tags: Real estate

About the author

James Polo-Richards

Commercial Development and Investment Partner

James leads on the firm’s work in commercial development and investment projects.

James Polo-Richards

James leads on the firm’s work in commercial development and investment projects.

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