John Hartigan, Senior Investment Manager, Blackfinch Property
Recycling funds from the sale of completed houses to part-finance the rest of the development can often prove a challenge for development lenders, largely due to the additional risks involved. For example, in traditional property lending, the property is usually the key asset secured by the lender. Therefore, when the property is sold, the lender expects 100% of the sale proceeds (after sales costs) to reduce its debt.
However, in circumstances where borrowers are involved in developing sites with multiple units, they often complete several units and sell them while still building out the rest of the site. If the borrower doesn’t have large amounts of cash equity, it can be difficult to fund the whole development – the lender expects 100% of the sale proceeds irrespective of whether the rest of the site remains part-complete.
One solution to this potential problem is to ‘recycle’ part of the sales proceeds, so the lender agrees to receive less than 100% of the sales proceeds, with the balance being ‘recycled’ to fund the other units in the development. The risk for the lender is that they have released 100% of the security in a unit but not received 100% of the cash. So, in a typical Loan to Value (LTV) ratio, the loan may reduce less than the value – meaning the LTV stays higher for longer.
In one recent example, we had worked successfully on several projects with a respected regional developer in the Midlands. But in their latest West Midlands project, there was limited equity available for them to build a further 53 houses without adopting a recycled sales approach.
This required some highly detailed analysis and a comprehensive assessment of the risks should problems arise during the recycled sales phase of the build. Practical control mechanisms were agreed with the borrower and their Project Manager. Bespoke facility documentation, an LTV covenant, a net sale proceeds covenant, and a recycled sales limit were all required to ensure that the loan risk remained acceptable with each recycled sales drawdown.
A key element of the process involved matching the net sale proceeds to the original independent valuation. This ensures the LTV could be compared at each drawdown to the value of the units/land that were still to be sold.
Despite the disruption of lockdown, the project progressed exceptionally well – with the units completed on budget. Sales completed ahead of schedule ensured the smooth recycling of sales proceeds and debt reduction. Once this loan was repaid, the same approach was applied to the final phase of the project, which has also progressed very well, with the first units sold last week.
At first glance, drawing up agreements to recycle funds may seem onerous for lenders, given the additional risk assessments and bespoke documentation required. But provided these additional risks can be assessed and managed, borrowers definitely appreciate working with lenders who are willing to demonstrate a degree of flexibility and help them bring projects through to completion.