‘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 pride of place in the newest shopping destination.
That’s the theory anyway.
But to build it you’ve got to fund it. As a developer there are a number of ways you can approach this. Broadly speaking 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 the purposes of 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 whilst the interest payments nibble away at the profit margin.
As with all commercial deals, the balance for the developer to strike is one between risk and reward.
About the author
James works alongside clients to help find practical solutions to problems so that they can achieve their goals and realise the value of their assets in a timely and cost efficient manner.
