If you're a property developer who is looking for funding to help get your next project off the ground, it's important to know what lenders are looking for before they decide to invest.
In this blog post, we will outline 12 things that property development lenders typically look for before funding a property development project. Keep these in mind as you move forward with your own development plans!
Almost every experienced property development lender has heard of the five Cs of credit, that are character, capacity, cash flow, capital, and collateral.
These are reminders to ensure that all requirements for underwriting a loan request are met. When a lender concentrates solely on the deal's structure—cash flow, capital, and collateral—rather than the borrower's capacity and character, he makes an incredibly common (and often fatal) mistake.
Capacity and character are especially vital in any commercial and residential property development, where the borrower's and his team's performance is critical. However, lenders always prefer determining who the borrower is.
What is the borrower's legal entity?
You've been introduced to the various types of legal ownership if you've attended an introductory law course, a property development course, or a broker course. A limited partnership (LP) and a limited liability company (LLC) are the most common ownership structures in commercial real estate.
The restricted liability these two types afford investors is one of the main reasons for their use.
In an LLC, each member is alone responsible for their investment. The same is true with a limited partnership, except for the general partner, usually the developer.
Another significant benefit is that investors avoid paying double distributions (dividends) tax. Profits (and losses) from partnerships and LLCs are "passed through" to individual investors. They aren't taxed twice: once at the corporate/partnership level and again at the individual level. Profits and losses from LPs and LLCs may move through numerous legal entities before being recognised by each partner or member.
Single purpose entity in real estate
The legal entity that owns the property is always a single-purpose business to avoid commingling funds to other projects, identify diverse capital compositions among investors, eliminate tax concerns from other initiatives, and aid in organising and bookkeeping.
That is, it will be made specifically for your borrowing purpose. It's critical to understand the primary players behind the ownership entity and, more importantly, who will be in charge of it during the loan period.
Who is in charge?
The developer prepares the property development loan proposal. He is the primary player in analysis because he is anticipated to be in charge of the project.
The developer has ultimate power and responsibility for the borrowing entity's whole operation. He will carry out all the duties necessary to complete the project, pay off the loan, and allow the investors to profit.
What is owned by whom?
An LLC's operating agreement is an excellent place to figure out who the members of an owning entity are and what rights they have (or a partnership agreement or a similar document). This document will spell out the parties' legal ownership interests, as well as their responsibilities and rights.
The fewer persons involved in any organisation that may be relied upon to reach an agreement, the better. It would be best if the lender inquired about the members of the team and what the developer expects of them throughout the project's lifespan. It is crucial for the PD lenders to find out who owns the legal entities that are members of the ownership entity and how they will be participating. Then they figure out how each member's risk-reward connection works.
Risk and rewards in real estate
Owners' risk-reward connections frequently do not reflect their monetary inputs.
The "money member," for example, might provide 90% of the minimum stock in exchange for a deferred simple 10% interest rate and a 50% share of the expected profits. For the remaining 50% of profits, the developer may contribute 10% of the stock (it is unusual but not extraordinary for a developer to contribute no cash equity at all).
In this case, the money member is putting his money on the line. However, his risk is lessened by the fact that he will get 10% simple interest (referred to as a "pref") before his equity is returned. The equity might be returned to him first or split proportionally (sometimes referred to as a pari passu basis).
In this case, he would receive 90 cents for every dollar of stock returned on a pari passu basis. If the project does not make a profit as predicted, he may still be able to recoup his entire investment plus a ten per cent annual return in the form of deferred interest. The developer will receive his 10% share back either on a pari passu basis or when the money member receives his entire equity back.
The developer does not receive any rewards for his work until all equity has been repaid to investors or lenders. However, because the developer may be paid a developer fee, a general contractor fee, a profit fee, an overhead fee, or a construction manager fee directly or indirectly through affiliates or relationships, he may be able to make a good profit and recoup his equity investment regardless of whether the planned project makes or even loses money. In this case, the developer may not be interested in seeing the project through to completion because he has already received his 10% ownership plus some additional income from fees. On the other hand, the partner may suffer a significant loss.
Alternatively, a developer may choose to remain participating in a project to continue receiving fees, mainly if they are significant compared to his net worth.
When reviewing the partnership agreement or the operating agreement, pay attention to the capital call provision, which specifies who pays if more money is needed.
Even if the project's prognosis indicates a positive return, there may be a funding shortage along the route to completion. Additional equity capital is frequently available if profits are expected. However, regardless of how solid the estimates are, the property development lender may face a problem loan if the investors cannot come up with extra funds.
When a property development lender can acquire a sense of what is at stake for each member and partner, it can help reduce an undesirable circumstance created by a developer's lack of finances. Money is more likely to be found when and if needed when there is a lot on the line. Subjectivity and intuition can significantly affect how the property development loan is structured and how much it costs.
Actual working relationship vs. Legal relationship
Even if the property developer has a formal definition of responsibilities, there are situations when he may not have as much control as he appears to have. When a well-known, experienced, or powerful money partner is involved in the agreement, this is more likely to be the case.
Because he relies on the more vital partner, the developer, the weaker financial partner, may be severely limited.
He may even be so reliant that he cannot make a living or continue his growth activities without a more vital partner. If there are issues with the project during construction, completion, lease-up, marketing, or sale, the developer may seek financial, construction, technical, or other assistance from a stronger partner.
Whether the problems are caused by the developer or by exogenous factors, the stronger partner will typically take a more active role in the project's day-to-day operations to compensate for his greater financial risk.
Getting along with people who have diverse interests
The owners may have interdependent but different interests in many real estate transactions. It's relatively uncommon, for example, to come across a joint venture (JV) in which one partner serves as the developer and the other as the general contractor (GC).
It appears to be an excellent synergistic relationship on the surface. However, it might become a serious issue if they have a falling out.
They both want to finish the project in the end, but their immediate concerns prohibit them from doing so. It will be difficult, if not impossible, for the developer to fire the GC if he does not perform as intended.
Suppose the JV includes a partner who is a potential or existing tenant. In that case, you should be transparent about the relationship, including what work is going into the tenant's space and who is paying for it.
What is a tenant's recourse if he or she is dissatisfied with the developer's rate of development or quality of work, and who will suffer the financial penalties? Who will have the upper hand if the JV partners are at odds? Who will be able to seize the initiative?
Of course, you're attempting to determine the following: Is it good or bad for the project and the lender, given the members and the membership structure? Does it enhance or lessen the lending facility's risk?
Key member's and Partner's Roles
The project may confront an undesirable situation in which the developer's control is endangered, depending on the structure of the borrowing organisation. As a result, you should be aware of the big investors' competence, as well as their abilities, strengths, and shortcomings.
This is usually not a difficult assignment because, on most projects, the developer will be the dominant character and the only one you can trust. Limited partners and cash-contributing members, on the other hand, frequently lack the knowledge, expertise, or inclination to take control of a project unless it has reached a critical stage.
On the other hand, when dealing with larger and more complex negotiations, including multiple layers of the organisation or an active JV partner, it may be critical to investigate each member's function and capacity.
A key member doesn't need to have substantial development experience. Even if a large investment bank providing mezzanine financing subordinate to your property development loan does not have direct construction experience, it will have significant financial resources to employ the necessary talents to execute the task.
It should also have sufficient resources and the unquestionable ability to carry your loan in the short term and eventually pay it off with its funds if no refinancing or sale occurs.
The conditions under which other members might vote to remove the developer as managing member and replace him with another member are an essential part of the operating agreement. Unless your attorney specifies otherwise in the loan document, the developer can be replaced without any approval.
12 Things property development lenders will consider before funding a property development loan
Lenders may concentrate on the capacity of the borrowing entity (the participants) once they know its composition. Ability and capacity are said to be equivalent.
They can occasionally reject a property development loan proposal based on the borrower's capabilities after a brief inspection. Capacity might be a crucial deciding factor.
1. Knowledge about the proposed property type
The developer and development team should have demonstrable experience with the proposed project type. For example, suppose a developer has a construction company that has successfully created freestanding suburban single-family houses. In that case, he and his company's experience in developing an urban high-rise office building will be of minimal benefit.
Generally, property lenders never give a developer an "opportunity or a break" to work on a project that isn't in his area of competence. If he already has a relationship with you or your institution, try not to be swayed by it or threats that he will take his business elsewhere. You and the institution will probably be better off if the borrower switches lenders.
There are situations, though, when lenders have no choice but to offer a loan to a developer who is not an expert in his field. When the customer is large enough, the lack of experience in one product category is outweighed by considerable experience in another (for example, a prominent office developer erecting a midsize apartment project).
It can also happen in smaller institutions where political issues trump business. The lenders' task is to balance the developer's expertise and experience against the specific project he's proposing and to change the loan terms to account for any additional risks.
Requesting the developer to expand his team, funding the project in stages if possible, cross-collateralising the loan, obtaining personal guarantees, boosting contingency reserves, and requiring more up-front equity are examples of strategies to accomplish this.
2. Developer's history of successful and failed projects
If a property development lender realise a developer has failed, he will seek out third parties or ask the developer for an explanation. A developer may be submitting his first proposal to his institution because he has harmed his connection with another lending institution that views the developer as responsible for poor performance.
Perhaps the borrower did not perform as planned, and the loan's performance became a significant issue due to the developer. There's no guarantee that his next deal, which could involve a new investor, will go better.
3. The developer is known as a paper tiger
Some people are better at promoting deals than working them after they close in any business involving salesmanship, marketing, and promotion.
These are frequently, but not always, "big picture" types who produce lovely loan proposals that are more fantasy than reality.
If you get the idea that the developer is exaggerating, too polished, or that the forecasts make the transaction look too good, the lender will verify his résumé of claimed accomplishments carefully, giving special attention to his role, contribution, and engagement in previous projects.
He may have been a part of significant achievements, but only in a small way.
4. Jurisdiction in politics
Even small-scale initiatives' success can be heavily influenced by the political jurisdiction in which they are located. The size, breadth, and character of development can be changed or even killed in urban settings due to a maze of regulations, limits, and politics.
These considerations may be much more critical in suburban and rural locations, where initiatives are more visible and may impact the local population.
A developer working outside his jurisdiction should expect competent, experienced assistance in handling the jurisdiction's zoning, building, environmental, and other restrictions. That person can be a local architect in bare instances. Even simple problems can necessitate the involvement of multiple pricey professionals.
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5. Projects numbers
Most middle-market and higher sphere property development firms are dominated by one or a few individuals who play a very active and dictatorial role in their companies.
If the person is working on multiple projects simultaneously, the question is - how many he can work on at once without risking the success of the one being lent against.
If the loan is for a project substantially smaller than the borrower's other ongoing initiatives, he will most likely devote more time to them.
Because project complexity is not proportional to its size, a new project is more likely to receive insufficient attention. On the other hand, if your loan is for a large-scale project, the developer's smaller-scale initiatives may divert his focus, affecting the larger project's success.
If he takes on too many initiatives at once, not only will his control be diluted, but his time and attention will be diverted as well. Many seasoned loan officers feel that the money they advance flows straight into the project for which they have lent. In most cases, this is correct.
However, suppose there are cost overruns or delays in a loan advance from another property development lender for a different task. In that case, the borrower may use your provided money to assist his other project. Essentially, he lends money from a job that is doing well to one that is causing him stress.
Later, if the other project's finances continue to suffer, he may not be able to continue with the new project. As a result, the number of concurrent projects and their financial health is critical. It isn't easy to judge a developer's capacity to work on multiple projects simultaneously.
An early sense of how busy the developer and his primary staff are and the number of projects he can accomplish will help you decide whether you should be concerned. Whether he is, he will try to figure out if any of the developer's projects are having difficulties, which could necessitate more money or attention than usual.
Then the lender must make a judgement call and determine whether the developer and his firm now have the resources to handle the proposed project. If he doesn't believe they do, ask him to explain how he plans to handle the project, given your worries.
6. The developer's organisation
The structure a developer has developed around his company is related but not directly related to the number of projects he works on at any given time. Lenders look for a strong team of at least one other strong partner who can step in and take his place.
He should also delegate authority (and accountability), especially in areas where subordinates are more knowledgeable. He should have a representative on the job daily in construction, barring unforeseen circumstances.
7. The property development team
The capacity of in-house staff is crucial, as is the capacity of outside professionals. Although outside professionals are typically less crucial than the developer because they can usually be replaced, doing so is always expensive and can compromise the project in many circumstances.
When one crucial professional is replaced with another, the project will suffer material harm, sometimes physical but always financial.
It can be challenging to evaluate the developer's team, especially on smaller projects where experts are paid less, have less expertise, and have less comprehensive track records. At the very least, the lender obtains résumés from the architect and the general contractor or construction manager, along with references.
He requests the names and résumés of the principal subcontractors on more critical deals. Major subcontractors nearly always include those who perform electrical, plumbing, masonry, superstructure, and carpentry work, depending on the job.
Architects always have résumés, references, and a track record that is immediately traceable.
Don't try to fool a lender by a flashy brochure, which has become the norm in architecture.
For example, a developer might be impressed by a school building, an inventive gymnasium, a courtroom, or a retail centre designed by an architect. However, he may be unaware of the design and construction of a hotel or office building and the services available.
In many sorts of constructions, size might be a problem. The type of project is a more crucial consideration when evaluating an architect's relevant experience. The developer must have some prior experience in the location where he'll be building. For the architect, it is much more crucial.
Most building standards and requirements may be quickly looked up and integrated into development plans and specifications, but some aspects are virtually usually overlooked. An architect who has made past mistakes and omissions on similar tasks is likely to know how to avoid making them on yours.
It is usually not a problem for larger architectural firms because they have the experience and resources to engage local professionals to supplement their in-house capabilities.
Smaller organisations, on the other hand, may never be completely aware of local standards, may be too thin on multiple projects, or may be searching for their subsequent work as soon as the one with the developer is through.
Because the architect may have to interact with local municipal personnel regularly if there are zoning, regulatory, construction, or legal issues, personal familiarity with local officials and employees can be a huge help in obtaining development approvals in the shortest time and for the least amount of money.
8. Construction manager or General contractor
Not only does the lender familiarise himself with the types, magnitude, and locations of projects performed by the general contractor or construction manager, but he should also make sure that at least one reference comes from the owner of a previous project. It is nearly impossible to show that a contractor worked on a given task and, if he did, the extent of his involvement without consulting references. Lender also contacted the inspecting engineer at his institution to check if he has any insights or knowledge about the prominent members of the building team.
Inspection engineers are an excellent source of team reviews because they review projects for a living. Keep in mind that, while a lender is conducting your due diligence on the project's team members, a skilled developer has likely done a better job because the team he assembles will work for him and report directly to him. There's a lot on the line for him.
The developer has frequently worked with the general contractor or construction manager on previous projects and is familiar with most of the major subcontractors. As a result, he understands what to expect in terms of performance. Lender is doing his due diligence after the developer is finished with his. It should provide the lender with some peace of mind, especially if he is looking at the credentials of a seasoned builder.
However, there are thousands of stories of incompetence in the construction sector, so doing some due research is always a good idea. Due diligence is critical when working with an inexperienced or smaller builder to safeguard your institution and career.
9. Financial resources
Even for a publicly traded corporation, determining financial capability is difficult. It was especially evident in the early twenty-first century when officers of several publicly traded corporations were fined and sentenced to prison for misrepresenting their employers' financial status.
Imagine how many smaller businesses are getting away with lying now if they could get away with it for so long. The biggest impediments to determining financial strength are inherent in the techniques employed. Balance sheets or personal financial statements, for example, are snapshots of a corporation at a specific time.
Although income statements can demonstrate results yearly, cash flow, particularly in the real estate market, can vary greatly. The day after a loan closes, bank deposits can vanish. In real estate, you nearly always have to rely on unaudited financial documents, which might be more fiction than fact, even when prepared by an accountant.
When banks or PD lenders assess a property developer's financial capacity, they consider the following:
- Cash flow projections
- Refinancing timing and impact
- Lease expirations and timing
If you are a property development lender, you should be alert for the following:
- High net worth but low cash and working capital
- Cash Flow timing and quality
- Overstated property valuations
- Unlisted liabilities
- High leverage
Although evaluating the borrower's total financial health is vital, you'll be focusing more on his performance against the collateralised property; thus, you should adequately scale his financial strength. Due to unreliable financial projections, you shouldn't rely on the developer's net worth and cash flow as much as his equity.
Capital call provisions are essential in partnership and operating agreements. Lenders want to know that at least one partner will invest if needed. Property developers should be the main contributors because passive investors are hard to find. Inactive partners are usually requested for money late.
They need time to process the unpleasant news and gather the necessary funds. This delay can harm a financially troubled property development project.
If the lender thinks the developer may have trouble supplying additional unplanned equity, he can demand more significant equity while keeping the loan amount the same. The additional equity can be invested into the project immediately, and he can assign more to the loan's contingency budget to cover overruns.
This early control helps prevent building delays. Contingency funding must not run out before the project is finished.
Land as equity
Investors watch out for property developers who use land value as their sole or significant equity contribution. Borrowers often paid less for land and saw it appreciate over time. Possession of land, even above the standard loan-to-value ratio, won't guarantee the borrower has the cash to finish the project.
It won't ensure his commitment in tough times. Many borrowers are less enthusiastic about investments made with land than with cash.
It would be best if you also were wary of partners who don't invest cash or whose money goes elsewhere. Deferred broker fees for property equity are typical. The broker, now a partner, doesn't invest any cash. He probably won't invest real money if there's a capital call.
Another red flag is a developer working with the same equity partner on multiple ventures. The equity partner may make further equity investments if needed. In this circumstance, the developer cannot repay the equity partner. Instead, he provides the partner with a stake in the project. You may receive this equity partner's impressive business financial statements during due diligence.The partner, who wasn't paid on his previous agreement, won't invest in this one with the developer. If anything, he wants to recoup his last deal's cash with the loan before making a profit. Despite his net fortune and liquidity, he may delay or refuse to fund the initiative. You should know what exactly is equity finance and how does it work.
Developer's personal capacity
Knowing the developer's personality can prevent complications.
Suppose the borrower has all of the right qualities, such as experience, money, and a good reputation, but has trouble getting around, talks in long rants about the past, does not appear to be fully present when spoken to, takes time to orient himself to questions, etc.
In that case, it may be possible that his health may have deteriorated to the point where he no longer can work on a project that will take two or more years to complete before repayment, and so on. It isn't common, but it's not unheard of either.
There is a propensity to fail to notice or overlook impairments, especially in the real estate market, where a significant majority of property developers are one-or two-person firms or are employed chiefly by family members.
Several well-known and accomplished developers have worked much past the point at which others might consider it appropriate to retire.
If the borrower's health is questionable, it's irresponsible to lend money without vetting his succession. Does he have a successor? Even if he appears in good health, it's nice to know that a team can carry on if needed, at least until the matter can be reviewed and treated.
Lenders may not deny a loan request solely for health reasons. He is not a doctor; thus, his institution could be accused of prejudice. If the borrower's health represents a substantial concern in the loan analysis, he should consider utilising other factors to refuse the loan.
If he feels the borrower's health may be a concern but is rushed to close the deal, he should look for other ways to improve the credit. It may require a project manager, another team member, or more equity to reduce the loan-to-value ratio to offset the higher risk.
The developer's performance is key to loan payback if the borrower isn't healthy enough to finish the project and isn't backed by others who can take over, don't make the loan.
It's tough to assess a person's positive and negative traits objectively. Character judgement is subjective. Lender or someone from his institution will have first-hand experience with the borrower if he already has a relationship with them.
Some general inquiries can be instructive.:
- Was the borrower pleasant to work with?
- Was he as good as he said he'd be?
- Was he responsive to information requests?
- Is he a problem-solver?
- Did he lead his group?
Because it is a human inclination to take positive features for granted while accentuating bad ones, if he is a new potential borrower, lenders are unlikely to notice favourable traits as much as potentially hazardous negative ones.
Character qualities are rarely used to deny a loan. Economic conditions can lead to a lender's market or a mismatched borrower and lender.
In a strong market, the lender and his department may be at or near workload capacity; therefore, taking on demanding or tough borrowers may be counterproductive. Depending on the lender's management and reward programmes, you may have met or exceeded your financial goals (a period is almost always one year).
Booking more business, especially with a borrower he knows has a character problem, might cost him when a new period arrives and new financial targets are given.
Future ambitions are usually higher than earlier ones. To achieve goals in the following period, he may need to exceed them in the present.
When a borrower matches his loan request with the wrong type or size of the lending institution, but mitigating factors make the loan desirable, the character is often the decisive factor.
Note for lender:
If his loan is too big or too small for your institution's "sweet spot," you should undoubtedly turn him down if he has a character problem. Why fight for him if he's beyond your institution's mission? Save the fight for a good borrower.
Character labelling can prepare the lender for a rocky lender-borrower relationship. Personalise his response to the developer. Some borrower features to watch for:
- Unable to expedite things
People are dynamic and developing, with complex personalities. Personal labels can assist build a framework for a conversation, but they can be harmful if misused or if they hinder flexible contact. Be wary of labels and open to adjusting your mind as a relationship develops.
Most loan officers enjoy a deal. They see a completed project outline, the figures make sense, a property tour goes well, they like the borrower, and they're impressed by his presentation.
So, what do property development lenders look for before funding a PD project? The list above provides a snapshot of the key items that are considered.
If you're thinking about embarking on a PD project, it's important to be aware of these factors and have your team in place early on so that you can present a strong case to potential financiers.Successfully develop your first property, enrol now for Mastermind property development course.
How do you ask for project funding?
The best way to ask for project funding is to be clear about what you need and how the money will be used. It's also helpful to have a well-developed business plan and a track record of past successes. When asking for project funding, it's important to remember that you're asking for someone else to invest in your idea. This means that you need to make a strong case for why your project is worth funding and how it will benefit the person or company who provides the money. Being concise, clear, and professional are all key when asking for project funding. And remember, always be prepared to answer any questions the person or bank may have about your proposal.
Can I get a mortgage for property development?
Yes, you can definitely get a mortgage for property development! However, the type of mortgage you'll need will vary depending on what stage of construction your project is in. If you're still in the early stages of construction, you'll likely need to take out a short-term loan or bridge financing. This type of loan covers the costs of getting your project off the ground until it's ready for long-term financing. Once construction is complete, you can then apply for a traditional long-term mortgage. Mezzanine finance is another option if you're looking to finance a property development project. This type of financing typically comes in the form of subordinated debt or equity.
What do funders look for in a loan proposal?
When it comes to lending money, there are a few things that all funders look for in a loan proposal. The first and most important thing is that the person requesting the loan has a good credit score. This indicates that they are likely to be able to repay the loan on time. Funders also look at the proposed interest rate and how long the loan will be for. They want to make sure that they are getting a good return on their investment, and that the loan is not too risky. Lastly, funders look at what collateral is being offered in case of default. This could be anything from property to stocks and bonds.