It’s no secret that entering the field of property investment or development costs a huge amount of money. Some people are lucky enough not to need to borrow to purchase their first project, but the vast majority do.
Whether or not you receive funding will probably be the biggest factor in determining the success of your project and/or venture. If you don’t have the available capital to begin, and no one will lend to you, you are unlikely to get very far.
Therefore, finance is very important to the novice and experienced developer alike.
© Copyright Betty Longbottom and licensed for reuse under this Creative Commons Licence
I’ve written on the subject of Property Development Risk before, and to present the subject of obtaining finance it’s necessary to bring it up again. However it’s probably not in the way you expect.
Managing risk is very important in any business venture. If a company exposes themselves to too much risk on a regular basis, sooner or later something will go wrong and the consequences could be substantial. Likewise if risk is avoided at all costs, the venture is unlikely to grow. Risk is to be embraced but in a controlled way. Profit or losses are the wages of risk. There are ways for a property developer to manage risk; however it should be done with a view to your partner.
When I mention a partner, I mean the bank. If you obtain funding, you will literally be going into partnership with the bank. It’s most definitely not like an unsecured loan or even an owner/occupier mortgage. If you are using a substantial chunk of the bank’s money, they will want to know absolutely everything about your venture. This is when it’s important to consider the flip-side of risk management. Your bank is also extremely interested in risk management; therefore everything you do to limit risk, might have the effect of moving the risk in their direction. The bank is in the driving seat, there is a good chance they have put more money into the venture than you have, so they will be working hard to limit their own level of risk. In this situation, if you really need to borrow to realise your plans, you must take on a significant amount of risk.
Visualise the banks as being like a wild animal, they need gentle and convincing coaxing to entertain your plans. If you offer them a deal where they end up shouldering too high a proportion of the risk, they’ll be off before you know it.
So what should you be doing to get the banks to take you seriously?
Don’t use a Limited Company. The whole purpose of a limited company is to control and limit liability on the owner/s. Therefore if you set up your development/investment business as a Ltd company, the bank faces substantial risk because they will be severely hampered in recouping any potential losses if the venture goes wrong. The bank will be much more comfortable if they are lending to an individual rather than a company.
The CV of the Borrower. The person borrowing the money should really have a good idea of what they’re doing. And if it’s your first property development venture and you are considered a novice, it’s an excellent idea to work with someone else who does know what they’re doing. Obviously this is a bit ‘catch-22’, you can’t borrow the cash until you’re experienced, and you can’t gain experience because you can’t get the cash. No one said it was easy; do your homework, plan the project (especially the finances) well, take advice from a building contractor/Building Surveyor/Architect so that it’s less likely you will go far wrong. This is what the banks are looking for.
Don’t take on too big a project before you’ve gained experience. Most successful property developers start their new careers by carrying out very light renovations to properties that just require a bit of updating and tidying. This way the developer gains experience, and begins to accumulate more capital (hopefully). It’s important to learn what works well, and what doesn’t. It makes a big difference to your decisions when it’s your money going into a project.
Don’t expect to borrow heavily against your first project. This point is probably quite an obvious one in the current financial climate; however it’s an important point. There are financial advantages to borrowing against a property development, but fine-tuning the gearing is something to concentrate on when you are experienced and running a larger project/portfolio. Banks are beginning to be slightly more flexible in their lending criteria, however you really should be able to invest at least 25% into a project and also have enough in reserve to cover a part of the early construction phase and contingencies.
It’s important to see the banks point of view when approaching them for finance. They are in a powerful position, and it is vital that the developer/investor convinces the bank they represent a low risk.
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Why the banks can’t win
This post is a bit of a rant I’m afraid. It’s in response to the constant contradictions in house prices and sales reports, and whoever is (apparently or supposed to be) to blame for them.
For the last year (at least) there has not been a single week when all sources of information have actually been in agreement on whether houses prices are rising or falling. As has been quoted many times – “the problem with predicting the future is that’s impossible”. The fact is that residential property values are fluctuating at the moment. This means (as far as I can see) that they ‘want’ to slowly begin to increase (their natural state) but certain factors are holding them back or restricting a rapid increase in some way. What could that be? Well, considering the vast majority of prospective property owners need to borrow to fund their purchase, it would make sense to conclude that the banks are now limiting their lending. If you regularly read reports in the papers (especially from the US) you would be forgiven for believing that the banks do not want to lend at all, and they are turning away a good 90% of applicants.
We all now know what caused the recession. It was the freely available level of credit that was underpinned by property values. As residential (and commercial) property values appeared to be increasing for so long, many people (and businesses) borrowed continually on cards and loans; comfortable in the knowledge that it could all be paid off, simply remortgage their property (what’s the harm?) and carry on. All it took was a realisation by the banks that this level of credit was going a bit too far, and a subsequent ‘tightening’ of lending criteria and it all ground to a standstill. The widespread belief that mortgages were almost unobtainable by anyone, lead to condemnation of the banks; they had gracefully accepted a huge amount of the public’s money (generously offered by Mr Brown and Mr Darling) and now they wouldn’t give any of it back to us. Bankers were conveniently demonised by most of society (initiated by Mr Brown, I seem to remember) as being responsible for the whole thing.
However, I simply do not believe this to be the case. Admittedly this is due to personal experience and subsequently, I am open to comments to the contrary. I have several friends and associates who have had no problems whatsoever in obtaining a mortgage within the last couple of months. When the banks changed their criteria for providing mortgages, the vast majority of people affected were remortgaging their property. In most cases to pay off high levels of personal debt accumulated on credit cards and through unsecured loans. Only a very small proportion of the applicants turned-down were actually purchasing a property. This would suggest (to me) that the new criteria for lending had generally been introduced to be of benefit and that only those applicants deemed uncreditworthy were refused. Obviously many readers are likely to have anecdotal evidence to the contrary, but this I strongly believe is the case.
Surely, if the banks are to blame to ‘getting us into this’, by being too generous with their lending, they should be thanked for taking steps to becoming more choosy with their credit recipients.
I believe that a general ‘baseline’ for property values is the total build cost. Obviously this is linked to land value which is in turn linked to completed property values…such is the intricate nature of property economics. Land values and build costs do tend to be less sensitive than the completed property values. However we are now getting down to levels that are more in line with these costs, and so my opinion (for what it’s worth) is that property values haven’t really got much space to fall further (I hasten to draw the reader’s attention to the site disclaimer by the way).
As for these reports in response to property values and markets, the ‘natural’ state of the property market is a gradual increase; attributed to the desirability of property ownership and it’s relatively short supply. I believe all the reports should be viewed with a degree of scepticism and an educated opinion should be formed over the long term. This approach will enable you to make the decision to buy or sell with confidence.