Since the 2008 US sub-prime mortgage market crash there is no doubt funding criteria have tightened for property investors and developers. While there is still scope for innovative funding strategies, the new regulations introduced by governments and central banks around the world have certainly reduced speculative investment.
We therefore thought it would be useful to take a look at modern funding opportunities for both buy-to-let and development investment. There are many options available and while we will cover these in as much detail as possible, you should take financial advice from a qualified professional before undertaking any funding arrangements.
The UK has traditionally leaned more towards homeownership than rental with the market given a significant boost by the Thatcher government’s right to buy legislation introduced in the 1980s. Since then we have seen a massive increase in house prices, more focus on rental accommodation with a significant increase in buy-to-let investment. As a consequence, buy-to-let investment is now an integral part of the mortgage funding sector.
In a scenario which occurs time and time again, commonly referred to as boom and bust, appetite for risk tends to increase in the boom times and disappear in the difficult times. In order to both protect the integrity of the UK financial sector and to a certain extent reduce the peaks and troughs of boom and bust, the Prudential Regulation Authority was introduced in 2013. The aim was to “prevent loosening in current industrial standards for buy-to-let underwriting, curtail inappropriate lending and reduce the potential for excessive credit losses”.
Historically, funding for buy-to-let investments was effectively “self-funding” due to rent income and fairly easy to secure. The situation has changed over the last few years. As well as taking into account the financials of individual buy-to-let deals the personal finances of the borrower are now central. The idea is that in the event of reduced rent flow from a buy-to-let investment the borrower would have sufficient income to make up any shortfall. Some may call this ultra-cautious, some may call this sensible.
Buy-to-let deal structure
Over the years we have seen a significant increase in the number of private landlords in the buy-to-let sector. For some time the buy-to-let market was relatively unregulated but as returns continued to grow this attracted a rogue element. In many ways the government was forced to tighten regulations and create a more “professional environment” in which buy-to-let investors could operate. Many have a sneaking suspicion the authorities would prefer a relatively small number of large corporations to dominate the private rental market and effectively freeze-out private landlords.
Whether or not this is true is debatable but what we do know is that legislation first brought in by the former Chancellor George Osborne has significantly reduced the tax benefits for private landlords. We have seen a gradual reduction in the element of mortgage interest which is tax deductible against gross rental income. By the 2020/21 tax year just 20% of mortgage interest will be tax deductible against a private landlord’s gross rental income. This will significantly reduce the benefits of buy-to-let investment for higher rate taxpayers.
Interestingly, all mortgage interest is tax deductible for investments held within a company or other corporate entity. This has seen a growing number of buy-to-let investors using limited companies and Special Purpose Vehicles (SPVs) in which to hold their buy-to-let assets. As interest is a legitimate cost within a company it is highly unlikely that the government will tinker with this in the same manner as for private landlords.
Typical loan to value ratios for SPV buy-to-let mortgages tend to be around 75% to 80% and often attract higher rates of interest than traditional mortgages. That said, experts predict a significant increase in competition in this sector which will ultimately place downward pressure on interest rates and could lead to more favourable loan to value ratios. Time will tell.
The use of limited companies/SPV buy-to-let investment vehicles would seem to be the more sensible long-term route for many investors. However, there are a number of factors to consider during the mortgage application process:
- Take advice from your accountant, tax advisor and financial planner prior to any application
- Compare and contrast the costs/benefits of going down the limited company route, take into account future expectations for your own financial situation
- Speak to specialists in the field of limited company lending as this is not as straightforward as private mortgage arrangements
- If you plan to refinance at a later date, bear in mind the six-month rule and loan to value ratios likely to be available
- The setting up and application process for a buy-to-let mortgage through an SPV will take longer than normal
- Remember that companies operate under the corporation tax system and shareholder dividends/employee salaries under the personal tax structure
- Attractive headline interest rates often come with additional costs such as arrangement fees which should all be taken into consideration
- SPVs are the perfect way to separate individual investments and revenue streams although it is possible to use limited companies for multiple investments. Ensure you fully understand not only the tax implications but also the potential need for personal guarantees, collateral and possible funding limitations
- Factor in the time taken to arrange deposit funding options and any potential delay on your mortgage application
- Some lenders may request business plans, cash flow forecasts, asset/liability profiles and up to 2 years of accounts if you are already a director of an active buy-to-let SPV
- Personal and business credit ratings will be taken into account
- Before applying for additional buy-to-let funding ensure that your current buy-to-let assets are in order and not in need of additional finance
- Use the appropriate SIC codes when setting up your limited company to indicate property letting/ investment
- Make yourself fully aware of the additional actions required with a limited company and additional expenses such as preparing report and accounts
- Proof of income will be required taking in your tax situation, bank statements and any payslips
- You will need to be fully aware of your obligations and responsibilities if asked to provide personal guarantees, fixed/floating debentures and deed of priority contracts
- to save time, ensure your deposit funding is available before you make an SPV mortgage application
There is no one size fits all for SPV buy-to-let mortgage applications therefore you should expect interest rates and restrictions to vary depending upon the assets in question. In general, mortgage rates tend to be slightly higher than normal for holiday lets and HMOs as opposed to more traditional buy-to-let investments.
While many people prefer to avoid bridging loans, often seen as an expense form of short-term finance, it can have a role to play in many scenarios. The more common projects associated with bridging loans are:
- Auction purchases
- Additional property purchase while awaiting settlement of an agreed sale
- Redevelopment of existing properties.
The idea is simple, the potential profit on a transaction, or the uplift in value after redevelopment, is greater than the cost of the bridging finance. Where the investment is being held in the longer term the uplift in value can create attractive refinancing opportunities. Bridging loan lenders tend to focus more on the details of a project as opposed to the investors personal finances.
Factors to consider when applying for bridging loans include:
- Independent valuations will be undertaken by Royal Institute of Chartered Surveyors (RICS) approved parties
- A “bricks and mortar” and forecast redevelopment valuation would be required to show the potential profit
- Lenders would require a clearly defined degree of headroom between finance costs and sale profit/revaluation uplift factoring in associated risks
- The rate of interest charged will depend upon the specifics of each project
- Funding for larger redevelopment projects would require evidence of a good track record and experience in this area
- You may be required to give personal guarantees and/or a charge over the property
- Any additional assets you own could be used as collateral for bridging finance
- Larger redevelopment projects would likely operate on a staged payment schedule with inbuilt targets
- Projects where there is already significant capital investment by the borrower may well attract low interest rates due to the perceived lower risk factor
- There must be a clear exit strategy in place prior to any application for finance
- Larger projects will require a business plan and information regarding contractors
There is no hard and fast rule regarding the loan/value ratio with some bridging loan lenders using the criteria of 75% up to 100% of a RICs valuation. While others lenders will base the ratio on the expected end value of the property. Whatever the situation, the lender will always require a “comfort zone” between the amount borrowed and the value of the development going forward.
Bridging finance will also attract a variety of different fees such as entry/exit fees together with broker fees and the lenders own legal fees. At the outset the lender will factor in a degree of profit although early repayment may well lead to additional charges. The structure of individual bridging finance agreements can vary with options to repay interest on a monthly or quarterly basis or at the end of the term. You should also make yourself aware of the small print as some lenders will add their fees to the loan amount on which interest would be charged - others will charge separately.
Bridge to Let
Bridge-to-let mortgages are a natural hybrid of buy-to-let mortgages and bridging finance to provide short-term financing for buy-to-let investors. They may be used to acquire a property or perhaps an acquisition and redevelopment ahead of refinancing. The structure of such arrangements means that the same lender will be involved with the bridging finance and a preapproved buy-to-let mortgage arrangement.
The Prudential Regulatory Authority stress test/affordability conditions must be met on both the bridging finance and the eventual buy-to-let mortgage. In situations where there is redevelopment to be done the lender will require a pre and post-development valuation from a RICs approved third party. If the redevelopment is substantial the lender might introduce a staged payment schedule, with targets, only after receiving evidence of the borrowers experience with such projects.
As with all financing options, the interest rate charged, duration and payment terms, together with the wider structure, will depend upon the individual project. In theory, the exit route from the bridging loan phase should already be in place with a preapproved buy-to-let mortgage. However, changes in the cost of the project, or the market value of property in the region, could impact the overall cost of refinancing.
In effect these are two different forms of finance and prior to signing up you should be fully aware of any charges incurred. There may also be collateral/personal guarantees required. This will be made clear prior to approval and sign up.
In the aftermath of the 2008 worldwide economic downturn there was a significant increase in property sales via auctions. With financial institutions looking to jettison unwanted repossessions there were a number of opportunities, and still are, to acquire undervalued assets. As a consequence, auction finance (akin to bridging loan finance) is a very useful and popular tool amongst those attending property auctions.
The traditional process regarding a successful auction transaction is as follows:
- 10% deposit paid on the day
- Signing of a Memorandum of Sale
- Completion of transaction within 28 days
There will obviously be auction fees associated with the sale but if you are unable to complete within the 28 day period there will be financial penalties. The accumulated cost of listing fees, marketing costs and penalties, as well as the risk to your deposit, can be significant. As a consequence, relatively flexible short-term finance arrangements, with the intention of moving to a long-term buy-to-let mortgage, can be extremely useful.
Traditional mortgage brokers are often wary of refinancing assets within the first six months of ownership. Therefore it is useful to build up a relationship with a mortgage expert able to secure refinancing options within this initial six-month period. As this type of financing arrangement is not necessarily commonplace you may incur a number of additional charges and potential delays. It is therefore essential to start this process as soon as you have acquired your auction property.
Leveraging your finances and assets can be extremely appealing if structured correctly and within comfortable limits. Therefore, if you are looking to expand your buy-to-let property portfolio you may well be able to use equity from other properties to part finance additional purchases. This may take the form of a traditional refinancing mortgage or a bridging loan using existing property equity as collateral. You will need to go through the standard affordability checks but the greater the collateral available the more chance of a successful outcome.
Some buy-to-let investors will re-mortgage existing properties to release equity and then take out additional bridging loans to cover the full purchase/redevelopment costs. The idea behind this is simple; the rental income streams will cover all financial liabilities paying down the mortgage and increasing the investor’s equity.
Unfortunately, we have seen instances where investors have overstretched or given themselves insufficient headroom between liabilities, assets and income. While a useful means to quickly expand your property portfolio it is essential that you do not overstretch your finances.
Property Development Finance
Property development finance is an extremely competitive area of the market and one which offers both traditional and innovative funding options. This type of finance tends to be used for:
- Purchase and redevelopments
- Ground up developments
- Part build projects
- Utilising property with or without prior planning permission
The end goal is simple; the uplift in valuation should be greater than the cost of purchase/redevelopment finance. There are obviously a number of restrictions and conditions attached to such finance which tends to be of a short-term nature - with the idea of refinancing at a reduced rate.
The interest rate and the structure of property development finance will depend upon the finer detail of each project. As a rule of thumb, any funding release will be based upon the Gross Development Value (GDV) with a traditional range of between 60% and 65%, with a maximum of 75% of total cost. As a means of protecting the lender and the borrower’s exposure, with larger projects the capital tends to be drawn down on a stage by stage basis. Interest can be rolled up or paid on a regular basis but this will be agreed prior to approval of the loan.
As a means of tying in the investor (or group of investors) it is common to see debt finance released in tandem with additional equity sources. This could be the investor on a stand-alone basis or with various third-party investors. There is nothing better to focus the mind of an investor than the risk of losing their own capital and/or assets which they have used as collateral.
On occasion it may become apparent further down the line that planning permission can be enhanced. In this situation it may be possible to extend the finance available but this will ultimately be down to the lender.
Mezzanine finance may also be available for property development where there is a relatively small funding gap. The scope of finance would be unlikely to exceed 20% of the GDV and there may be additional charges, higher interest rates and even a profit share when the project is finished.
Delays, increased costs and unforeseen issues can have a major impact upon financial requirements for individual projects. As a consequence, detailed risk assessments would be carried out at the outset and, where stage payments are released, when certain targets have been hit. Due to the complex nature of property development finance and the risk/reward ratio, before approving applications lenders will require an array of information such as:
- Full disclosure of equity sources
- Full and frank disclosure of planning/permitted development consents together with details of any conditions laid down by the Local Planning Authority or other legal precedent
- Details of any restrictive covenants, unexpired licences, legal obligations or local precedent would also need to be discharged
- Information concerning additional restrictions which may impact the project in a negative manner
- A copy of the building regulations approval (different from the planning application approval) issued by the Local Authority Building Control Service
- Proof of a Building Standards Indemnity Scheme from an approved warranty provider
- Confirmation of no impending rulings which may impact the project such as access, circulation, easements, layout, parking, appearance and scale
- Evidence of a full Environmental Impact Assessment (EIA);
- A full Health & Safety Risk assessment
- Confirmation that no extraordinary utility-related works are required such as gas, water and electric.
- Proof showing no conflicts with local developments and neighbourhood plans
- Any known or potential community/political objections must be identified as soon as possible as they may impact approval
- Details of any Section 106 obligations/restrictions
- Confirmation there are no extraneous factors which could negatively impact the economic viability of the development
- Reliable surveys confirming there are no adverse ground conditions or exposure to asbestos/other dangerous materials
- Proof there are no contamination issues
- A detailed business plan showing a deep understanding of cost, cash flow and timescales which need to be backed up by quantity surveyor reports and factor in any potential risks
- Evidence of experience with similar property developments
- Details about all third parties involved in the project from architects to engineers, planning consultants to construction workers
- Evidence of fixed-price contractual agreements you have in place
The exact terms of a finance agreement will depend on the project but typically there will be a first charge on the asset and/or any additional collateral required. In some cases the lender may also require certain personal guarantees. Appointed parties such as surveyors will be used to assess the initial site and progress, with constant assessment of the project’s end value and stage targets.
While joint ventures can be the perfect way in which to leverage your own experience and skills with those of other parties, they can also be particularly risky. As a consequence, great caution should be exercised on the part of the investor with a similar strategy undertaken by any lenders.
As you would expect, whether the project is part or wholly funded by an equity investor, lenders prefer to see all parties having a direct financial interest which helps to focus the mind (often referred to as “skin in the game”). The requirement to have “something to lose” is one which lenders are extremely conscious of so that all parties are pulling in the same direction.
Joint venture partnerships are potentially more complex and more risky than traditional property development projects. As a consequence there are a number of issues to be aware of:
- Read up on the Financial Conduct Authority’s policy PS13/3. This covers unregulated investment and how equity partners should be classified.
- Know Your Joint-Venture Partner – taking a joint venture partner’s credentials at face value is extremely dangerous and naive. Credit reports, bank statements, bankruptcy history and identification checks should be central to the due diligence process
- Ensure that legally binding contracts between joint-venture partners cover all aspects of your particular venture as opposed to an off-the-shelf “one agreement covers all” approach
- The legal structure of the joint venture should be recorded in detail so that all parties are aware of their potential liabilities and role within the project - and potential rewards
- Refinancing options should be investigated and, where possible, preapproved before they are required
- All joint venture partners should have life insurance written into the deal structure
- The transfer of funds should always be done via trusted parties or escrow accounts to ensure maximum transparency and protection
- Regular meetings and updates between all joint venture partners helps avoid confusion and misunderstandings further down the line.
While still recognised as a fairly new form of finance, crowdfunding is now an integral part of the property development sector. As the name suggests, crowdfunding platforms offer the opportunity to attract a pool of investors to contribute to your project. The person-to-person nature of crowdfunding can keep costs relatively low while offering investors the opportunity to diversify their portfolios. Whether utilising personal funds or pension fund assets, crowdfunding is proving to be extremely popular.
In some ways the rise of crowdfunding has taken the authorities by surprise and long-term regulations are currently at the consultation phase. That said, there are already a number of regulations which cover crowdfunding platforms, offering protection to both investors and developers. Various platforms seem to focus on specific types of property development opportunities from long-term capital appreciation to high rental yields. You will also notice that many crowdfunding platforms will invest in projects themselves, adding a degree of confidence for third-party investors.
Many people who have used crowdfunding platforms are very complementary about the speed of processing and the raft of information available for each project. Potential investors also have the opportunity to discuss individual projects which in itself creates a form of “self-regulation”. Those which cut the mustard will be raised to the top while those prompting caution and concern may languish ahead of further details.
While the details of each property developer and project will differ, there will likely be entry and exit fees together with administration charges to take into account. The opportunity for investors and developers to communicate directly, while removing a layer of third-party costs, seems perfectly suited to the property sector.