Assessing the Cost of Capital On Property Development Projects

There is no single way to raise the capital necessary to fund a property development project.

Depending on the size and scope of the venture, a developer might opt for some kind of term loan, a development finance package, bridging loan or a joint equity venture in which the profits are split between one or more other parties.

But if there isn’t a single way, there is arguably a right way. Or to put it in different terms, each venture is different but the best possible outcome for a developer is to secure a finance solution that delivers the maximum profit when the project is concluded. A major factor will be the cost of capital.

The Bigger Picture  

Stepping back from the specifics of development projects, there is a wider point to be made here. A huge amount has been written about the ever-broadening range of finance options available to entrepreneurs, in terms of their characteristics and suitability. There will be, for example, times when the best way to raise money to support business growth is to sell equity – either via a crowdfunding platform or direct to an angel syndicate or VC fund. The advantage of equity finance is that it doesn’t involve loan repayments and the business also stands to benefit from the involvement of investors who have an interest in promoting its growth. The possible disadvantage is that the cost of capital can be high. An entrepreneur has to take a view on whether it is better to have a smaller stake in a larger company or to retain total ownership while perhaps struggling to achieve growth.

In the case of debt finance, the cost of capital is usually lower, but ultimately any loans must be repaid. Beneath the broad umbrella, overdrafts, term loans and invoice finance, all serve different purposes and each comes with its own timelines and cost profile. So a business owner has to think about not only the nature of the loan – is it right for the purpose – but also the associated costs, mapped onto a timeline that may well stretch over a number of years.

And of course, over the lifetime of a business, the cost of particular solutions might not be the crucial factor – flexibility and availability could be equally important. However, cost should always be taken into consideration.

Development Projects

That’s perhaps even more true of a particular kind of entrepreneurial venture – namely the development project. Unlike a business, which might – for example – trade for ten, fifteen or twenty years, accessing multiple sources of finance along the way, development projects have a clearly defined timespan between the beginning and conclusion. For instance, the project might be to refurbish and sell a block of flats. A more complex venture might involve buying land, knocking down existing structures and then building anew – with a view to selling immediately when the work is complete.  

There is, therefore a direct relationship between the total cost of financing the project and the profit banked at the end. Thus finding a finance option that is both fit for purpose and cost-effective is crucial to success.  

Breaking Down the Numbers

But what does this mean in practice?

Well, an analysis carried out by The Route – Finance illustrates how the choice of a particular finance package can influence the outcome in a very significant way.  

The Route analysed one of the development projects its Private Debt Platform, funded to the tune of £12,650,000 and compared two possible options that were open to the client. The first involved a structured loan package combining £12,115,000 in senior debt and an additional £535,000 of mezzanine funding. Payable over 15 months, the senior debt was priced at 1.25% interest per month and the mezzanine at 2.0%.  

The second option was a joint venture equity deal. Again playing out over a 15 month timeframe, this agreement involved the partner taking 50% of the developer’s profit on conclusion.  

Serving up a gross development value of £20,829,000 and a gross profit of £20,204,130, this is a lucrative venture. However, The Route’s model shows that while the Joint Venture Equity structure delivered a net/developer profit of £3,777,065, the senior debt/mezzanine solution offered a better return to the tune of £5,174,596. That’s a 37% increase in net profit.

That is of course just one example. The “right” solution will always be dictated by circumstances, the availability of finance and the terms set by the financiers. However, it does illustrate the importance of looking carefully at the pros and cons of any offer. Equally, it demonstrates how structured solutions involving two or more finance products – such as senior debt and mezzanine – can deliver good outcomes.

This is an area where The Route – Finance is developing its offer. In addition to straightforward term loans, the Private Debt Platform is also offering structured packages tailored to the needs of individual businesses.

To find out more about The Route – Finance call: 020 3141 9040

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