Key considerations: Investment loans vs. Development loans

Income

One of the key differences between investment loans and development loans concerns the time frame within which the property is, or becomes, income-producing. An investment property is likely to generate income from the outset – providing comfort to lenders that the repayment of the loan is less risky and that the borrower will have access to a steady flow of income with which to service the interest costs and, in some circumstances, repay the capital. In development loans, the properties being built will not generate a source of income practical completion has occurred and tenants/purchasers for the properties have been found. For this reason, lenders are likely to require further security in development loans to mitigate the risk that the development will not complete as planned and interest and fees are often capitalised so that they are paid together with principal amounts at a time when the borrower has access to income from the developed property.

Security

In an investment loan, lenders are concerned with the borrower’s ability to repay the loan on time – and the security package they require therefore usually focuses on the borrower’s assets, which lenders will be able to sell if the borrower defaults. By contrast, in development loans, the borrower’s ability to service its debt also depends on a number of third parties including contractors, consultants, architects, engineers and surveyors. As such, lenders are likely to require additional security in the form of collateral warranties and assignments of the benefit of development contracts, as the intention is, rather than selling the unfinished property, for lenders to have the ability to essentially step into the borrower’s shoes and direct the contractors to finish the development. Furthermore, a cost overrun guarantee may also be needed to satisfy the lenders that any unforeseen increase in development costs will be dealt with either by the borrower or another group company.

Monitoring

It is in lenders’ interests to closely monitor development loans as they inherently carry more risk than investment loans. This monitoring is achieved through various methods – borrowers may, for example, have to obtain their lenders’ approval of the form of lease which is to be used once properties are ready to be let. The financial covenants to be adhered to throughout the duration of the loan are likely to include Loan to Gross Development Value (rather than merely Loan to Value) and Loan to Cost ratios to allow for the fact that the property’s value should significantly increase upon completion of the development but that, in the meantime, additional costs will have to be borne by the borrower in relation to the development. Sales milestones and requests for the provision of a units disposal schedule are often found in development loans, whereby lenders seek comfort that individual units will be sold within a specified time frame. Regular site inspections by the lenders’ agents, the appointment of a quantity surveyor and a requirement for any utilisation requests to be signed off by the project monitor confirming that the expenses being financed by each specific draw down do not exceed the budgeted costs of the development, are also common in addition to the usual property undertakings. This is not to say, however, that investment loans do not have monitoring requirements too. For example, lenders often require very regular valuations of the property throughout the life of the loan to ensure that the value of the property does not decrease and, in the case of loans with a long term, this can prove costly for the borrower.

Conditions Precedent

As can be expected, lenders in a development loan will want to be satisfied that the relevant contractors have been appointed and will want to have sight of the relevant executed contracts prior to any utilisation being made. In addition, evidence that all such contractors have suitable professional indemnity insurance in place and are covered by adequate contractor’s all risk insurance will be needed. Lenders will want to know that all necessary consents and authorisations in relation to the development have been obtained by the borrower, and may also request a report on the development prepared by their chosen project monitor. These requirements are in addition to the usual conditions precedent found in investment loans (such as the need for a report on title in relation to the property) and this means that it is likely for the satisfaction of conditions precedent to take longer than it might in the context of an investment loan and, as a result, borrowers considering a development loan would do well to get organised as early as possible in order not to unduly delay entry into the loan agreement.

Events of Default

The successful completion of a development depends not only on the borrower but also on a number of third parties duly performing their obligations. As such is not within the control of the borrower, events of default such as failure to achieve practical completion within the required time period or the insolvency of certain contractors could jeopardise the development and cause the acceleration of a development loan even if the borrower is not at fault. Whilst these events of default are necessary for lenders and are therefore unlikely to be completely done away with, a compromise is often found in the insertion of cure periods which allow borrowers to remedy issues before any drastic action is taken by lenders.

The above is a non-exhaustive list of key negotiation points which both lenders and borrowers ought to keep in mind when considering whether to enter into development loans. At Memery Crystal, our Banking and Finance team has a wealth of experience in advising lenders and borrowers on a range of real estate investment and development loans and would be delighted to assist with your next project.