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Development Finance Essentials

Expert Lawyers Highlight Key Considerations


Karen Roberts, Press Officer | 0207 400 8714

This article sets out some considerations which are relevant in the context of a senior development loan facility.

Development Security Structure 

A typical real estate development finance structure assumes that the borrower will be a SPV property owning vehicle. The lender will expect to take a fixed and floating charge over all of the assets and undertakings of the borrower including but not limited to:

  • a legal mortgage over the property
  • a charge over any buildings insurance and during the development phase, where the borrower insures, a charge over any insurance policies in relation to the development
  • a charge or assignment over any development documentation (see below)
  • a charge or assignment over the construction documentation (see below)

The lender will also typically take a charge over the entire issued share capital of the borrower.

In finalising the security structure for a development the lender will want to understand:

  • the construction procurement strategy (see below) as this will determine which documents need to be covered by the security
  • who the contractor, key professionals and key subcontractors are as the rights of the borrower in respect of these parties should be caught by the security.  The lender should also have separate stand-alone collateral warranties and/or third party rights from these entities
  • what parent guarantees or performance bonds the borrower will have the benefit of in relation to the contractor to ensure that these documents are captured in the security package
  • how the development is insured and any security that is capable of being granted in respect of that insurance. In addition, the lender will expect to be co-insured and first loss payee on the insurances. Where the contractor insures, this point will need to be picked up as early as possible as the contractor may need to obtain specific endorsements to a group policy or similar

Income and Repayment

Unlike an investment financing, in a development financing where the whole (or substantially all) of the property is being developed or redeveloped, there will be no income generated during the development phase. Interest and fees will usually, therefore, be rolled up and added to the principal of the loan. In other cases interest may be funded through subordinated loans from a shareholder or from a reserve account which is credited with shareholder funds at the outset of the transaction. The approach will differ depending on the transaction.

The repayment requirements of a development facility will depend on the exit strategy of the borrower. Below is a summary of some of the typical structures one might see:

  • If the borrower strategy is to sell or let the entire building following practical completion, there will typically be a short tail in the facility following practical completion to allow the borrower to complete on the letting or sale. Where there is a requirement for a pre-let or pre-sale of the asset, repayment will be tied to completion of the sale or lease and the lender will want to see that there is a requirement in the underlying documentation to complete the sale or lease at or shortly after practical completion. Repayment of the loan and rolled up interest would be made in one bullet repayment at completion of the sale or lease
  • If the borrower strategy is to sell or let multiple units within the building following practical completion, there will typically be a longer tail in the facility following practical completion during which the borrower is required to complete on the sales or letting of the units. There may also be milestones for pre-lets or pre-sales to be met during the development phase. Depending on the length of the tail and the sales strategy, interest may become payable in this period together with scheduled amortisation in order to ensure that the sales strategy is being executed in accordance with the agreed plan at the outset. Where the units are sold (or lettings made at a premium) the borrower may be required to apply the net disposal proceeds in prepayment of the loan with a bullet repayment on the termination date of the facility.

It should be noted that where borrower strategy is to hold and let the entire building, rather than requiring repayment, the lender may agree that the facility can flip into an investment style facility following completion of the relevant lease(s). In this scenario rent will be applied to pay interest and any scheduled amortisation of the loan in the usual way with a bullet repayment to be made on a refinance or sale at a termination date in the future.

In the current market it is unusual for a senior commercial real estate development financing deal to be carried out on a speculative basis. The lender will want to be satisfied that the asset will be income producing once the development has reached practical completion and so, for example, is likely to require an agreement for lease to be in place as a condition precedent to completion.

Speculative development in the residential sector is, at the time of writing, still seen more frequently.  However, the lender will want to be comfortable that there is a market for the units which are being constructed and to understand the market value and rental income which might be expected to be achieved once the development is complete.

Development Documentation

The lender will expect to be provided with full details of any development agreements, including any agreements for lease, in place.  The lender will wish to ensure in so far as possible (without incurring any significant risk premiums) the borrower is not assuming risks which it cannot pass on to its supply chain, to an insurance policy or which are not ‘usual’ developer risks.

Furthermore, a lender will, ideally, be seeking to ensure that any agreements with third parties are not terminable by the third party without reference to the lender.  A lender will, where appropriate, want to agree a right to “step-in” to the developer’s shoes in the event of a material breach of the loan documentation and/or a breach of the development documentation.

If development finance is anticipated at any point during the development process, it is advisable to inform legal advisors at the outset of the process so that they can consider issues such as this prior to agreeing the form of any development agreements with third parties.

Construction Documentation

The lender will want to approve the borrower’s procurement strategy, the key team members such as the professional designers, certifier, quantity surveyor and contractor(s), the form of professional appointments and building contracts, insurance arrangements and any performance security with a view to establishing that these are in an institutionally acceptable format.

As we note above, the lender will be looking for security over the construction documentation.  This security will ordinarily be from the key members referred to above, including all parties with design responsibility.

One of the key points to consider is whether the lender will have the benefit of collateral warranties or third party rights.

Whilst third party rights were introduced through the Contracts (Rights of Third Parties) Act 1999 and so are not new, the market has been relatively slow to adopt them but that is now changing.  As regards lenders, there has been a reluctance to accept third party rights on the basis that they do not enable the lender to take over the obligations in the construction documentation.  In an enforcement scenario (e.g. borrower insolvency), lenders may want to have the option of using the existing supply chain to complete the project and realise the investment value in the development as that will usually be the most cost-efficient solution.  Using the same team will avoid any arguments as to whether any warranties given by the supply chain have been prejudiced.

Appropriate drafting of the third party rights should be able to overcome this perceived issue and, in any event, the supply chain are more likely than not going to be incentivised to co-operate with the lender as the lender holds the purse strings and will assume responsibility for the borrower’s historic debts and the payment of future fees.  Frequently, the construction documentation enables collateral warranties to be called for in the alternative (but not both) in case the lender has a specific preference.

The direct rights (whether by collateral warranty or third party right) include warranties which are co-extensive with the warranties given by the supply chain to the borrower coupled with the right (but not the obligation) on the lender to assume the obligations of the borrower by way of a step-in right.  It usually gives the lender a notice period within which it can decide to step-in and assume the obligations before the relevant member(s) of the supply chain can terminate their contracts.

Claire Illingworth is a Partner in the Real Estate team and Rohan Campbell is a Partner in the Banking & Finance team at Irwin Mitchell.

This article first appeared in the Estates Gazette on 18 November 2017