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At Zeifmans, we’ve supported countless clients throughout every phase of the land development process. Over the years, we’ve honed our knowledge of best practices for financing these large and often complex projects. After all, no matter what structure you create for a development, the type of financing chosen will always be key to the project’s success.
Generally, there are two ways to finance a project: equity or debt. Equity financing uses your own capital, whereas a lender provides the funds in a debt financing. Some equity is needed for every project since most lenders will not lend 100% of the project.
It’s wise to form relationships with a variety of lenders so that you have multiple options in choosing the right structure for your development. Keep in mind that your lenders are your partner in the project. Like any relationship, a partnership will only be successful if managed well. Establish trust and communication early so that both sides can benefit. Since interest rates are unpredictable, it’s critical to safeguard your project from an economic downturn by nurturing your relationship with lenders and by implementing a strong project strategy.
Determine direction
Prior to obtaining financing, you should determine the strategy of the project. This discussion should be held by all the investors and should include market analysis and risk assessment.
Some risks that you should consider include:
Entitlement risk
Can you obtain proper zoning and permits?
Construction risk
What happens if estimated costs change or you encounter delivery delays? Do you have a financing strategy in place to bear unexpected costs?
Capital market risk
A change in interest rates could affect construction costs, as well as hinder the purchasing power of your potential buyers.
Pricing risk
Unanticipated competition may enter the market prior to completion, resulting in oversupply of product.
Political risk
A change in government or local/foreign political factors could influence a range of issues.
Your project strategy should be established early on, as it will influence the financing approach. Some developers choose to maximize their Loan-to-Value ratio (LTV) and stretch their equity as far as possible, even though they may bear substantial financial cost. For example, this strategy may require a second mortgage on the property at high interest rates. While this might reduce the profit of the project, the actual returns may be greater as the money used to build the property didn’t belong to the developers.
More risk-averse developers – prefer to avoid debt and put more equity to work while maximizing profit. Borrowers with lower LTVs will qualify for more favourable financing rates than those with higher LTVs as lenders consider the LTV ratio to be indicative of a lower risk. In general, the less debt and the more equity in your financials, the more likely you will be to secure financing from a lender.
Types of debt
Throughout different phases, different types of loans may be needed. For example, during the servicing and development stages, construction loans are often the best option. During the stabilization process, a more permanent loan may make more sense.
Guarantees and non-recourse debt
If the developer doesn’t have a financial track record, the lender may require the principals or owners of the entity to guarantee the debt. This provides the lender with a group of individuals from whom the loan can be recovered in the event of default. If a guarantee is not required by the lender and the property is the only means of recovery, the loan is called a non-recourse loan.
Construction loan
A construction loan is typically a short-term loan (usually less than 3 years) that is intended to finance the construction of residential or commercial developments. Construction loans tend to have higher interest rates and are secured by the property they are meant to finance. Money borrowed through a construction loan is divided into advances, and distributed according to a schedule of milestones. The cash flow generated by the completion of the project is then used as permanent financing to pay off the construction loan.
Bridge financing and second mortgages
If the construction loan can’t finance the entire deal, developers may secure interim or bridge funding, or take out a second mortgage. Unlike a first mortgage, where the lender is the highest priority on title and gets its money back first in the event of default, second mortgages do not prioritize the lender’s default protection. Thus, these loans come with a higher interest rate to cover the added risk to the lender. That being said, they are a valuable option for developers in need of cash to bridge the gap between a first mortgage and the equity owed to an owner or developer.
A word of warning
It’s not uncommon for circumstances to change during a loan period, causing a developer to want to exit a loan. In Canada, there are several types of prepayment penalties that should be taken into consideration. Prepayment terms are identified in the loan documents and can be negotiated along with other terms.
Basic prepayment penalty
This penalty multiplies the current outstanding balance by a specified prepayment penalty.
Interest guarantee
On prepayment, the lender calculates the net present value of the interest it would have received if the loan was held to maturity, maintaining its yield/profit from the loan.
Declining penalty
Also known as “Step-down”, the lender agrees to a simple schedule of prepayment penalties, often stated year by year.
Lockout
Under these terms, it’s impossible to prepay. This would more commonly cover a specific period of the loan, usually early in the term.
Your trusted team
When financing a land development project, it’s helpful to have a team of experts to guide you through the decision-making process. The team at Zeifmans can help you navigate throughout the project life cycle, ensuring that you choose a structure that will result in achieving your goal objectives. Reach out to our team today to get started.
Suggested supplemental insights:
Is land banking an effective investment strategy? Part 1 in a 3-part land development series
Land planning and profitability | Part 2 in a 3-part land development series
Land development and sale | The final installment in a 3-part land development series
Developing a property? Here’s what you need to know at every stage.
Hitting it out of the (Development) park – Issues for emerging real estate players
