‘Real estate finance’ is a general term which encompasses a range of transactions where a lender or group of lenders provide a loan to assist a borrower with:
1. Acquiring commercial property for the borrower’s own use, either directly or indirectly.
2. Generating funds for the borrower’s business purposes, such as expansion, by creating a rental income stream.
3. Purchasing a property or a portfolio of properties for investment purposes, either directly or indirectly.
4. Developing property.
The property that is being financed is the main asset of value owned by the borrower. The lender therefore aims to ensure that its value is at least maintained, if not increased, throughout the duration of the loan agreement. Additionally, the lender will want to see that the income generated by the property will be sufficient to cover the loan repayments. Thorough due diligence is conducted on the property being used as security. Typically, the loan is secured by a first legal charge. Lending based on the income generated by property rentals is a prevalent aspect of real estate finance. The loan-to-value ratio is also crucial when assessing factors like liquidity and the borrower’s ability to repay the loan, either through a sale or refinancing.
There is a broad range of commercial finance options available, but this guide focuses on development finance.
What is development finance?
Development facilities involve providing a loan to the borrower for the purpose of acquiring and developing a property. The loan is secured by the property itself and the developers rights under the construction documents. The lender will carry out thorough due diligence on the property and the planned development before funding is granted. The lender will consider:
The value of the site: During the development process, the value of the site will be significantly lower compared to when the development is completed. In order for the full development loan amount to be advanced to allow the project to be finalised, the lender will consider key factors such as the level of pre-lets or sales.
The cost of the development: the lender will want to ensure that the full costs of development (including the design, build and any sale of the development) will not exceed the value of the completed development.
The exit strategy: if the developer is unable to complete the project, the funder faces substantial risks as the value of the property is based on the completed development. Therefore, it is crucial for the funder to have mechanisms in place to intervene and assume control of the construction project. This “step-in” capability becomes a vital component of the security package that the funder obtains from the developer.
What is the legal process for a development finance transaction?
Once you have obtained a loan offer from the lender (this part is usually done through a financial advisor or a broker), lawyers need to be appointed. Often the lender will appoint their own lawyers and will require the borrower to appoint a separate firm. This is known as ‘separate representation’. Occasionally, the lender’s lawyers will be permitted to act for both the lender and borrower. This is known as ‘dual representation’. Once both parties are legally represented, the legal process can begin. The lenders lawyers will present the borrowers lawyers with the conditions precedent (CPs). The CPs outline the conditions that the borrower must satisfy before the borrower can request drawdown of the loan and the lender is obliged to make the funds available to the borrower.
Standard CPs are as follows:
A satisfactory report on title:
- The lender will issue enquiries relating to the land, the property, the borrower and the build. With the help of their lawyer, the borrower will need to answer the wide range of enquiries raised. The borrower should expect to be asked to provide full answers to general enquiries relating to the land, planning documents, building contracts, building regulation documentation and new build warranty documentation (this is a non-exhaustive list)
- The lenders lawyers will review the replies and all documentation given (often raise more) and generate a report to the lender to enable the lender to assess whether the borrower has ‘good and marketable’ title to the property and therefore whether it will constitute as good security for the lender.
- This process, particularly on development finance transactions, is usually the most time consuming for the borrower and their lawyer and tends to form the ‘bulk’ of the legal work on the matter.
Valuations and surveys:
- Other lenders will require a valuation of the site and where appropriate, they will instruct surveys and reports to be carried out.
Discharges of existing security:
- In the case of a purchase, the lender will need evidence that the seller’s mortgage will be discharged on completion.
- In the case of a remortgage, the lender will want evidence that the existing lenders mortgage debt, will be paid off on draw down of the new loan.
Letter certificate of non-crystallisation of floating charges:
- The lender will require a letter of non-crystallisation for any existing floating charges that the borrower is subject to. The letter will need to confirm that no steps have been taken by the floating charge lender to crystallise the floating charge.
Land registry searches:
- The borrower’s lawyer will deal with this element prior to completion. This involves obtaining a search in the lenders name, over the legal title to the property that is being used as security for the loan.
Insurance:
- Where there is a building at the property, the lender will require a copy of the building insurance policy which meets the lenders requirements, particularly with regards to insured risks and the level of cover. The facility agreement usually requires the lender to be a co-insured.
Development facilities will also include provisions requiring the borrower to take out contractor’s all risks insurance (covering contractors and sub-contractors) and professional indemnity insurance (covering contractors, sub-contractors and consultants with a design responsibility).
Borrower’s lawyers undertakings:
The lender will require the borrowers’ lawyers to give certain undertakings (legal promises) in connection how the funds will be held/released and post completion matters.
This is a non-exhaustive list. The purpose of the CPs are for the lender to ensure that they will obtain first legal charge over the property and that the property (and development documents) are acceptable security for the loan. The process of satisfying all elements of the CPs is often prolonged.
What security will the lender require?
The focus for the lender is to ensure repayment. Even if a lender obtains a court order for the amount owed by the borrower, it does not guarantee repayment. For instance, if the borrower is insolvent, the lender may need to divide the borrower’s assets among other creditors, resulting in only receiving a portion of the owed amount. To safeguard against such risks, lenders will take security over assets as collateral for the borrower’s loan obligations. This means that they acquire specific rights over the assets provided as security in case the borrower defaults on repayment.
In a typical development finance transaction, we often see the lender take the following security:
- The land itself (including any fixtures attached to the land) by way of fixed legal charge.
- Once the property (or part of it) has been developed enough for it to become tenanted (in the case of commercial real estate finance) or individual units sold (in the case of residential real estate finance), the borrower’s rights to any rental income from the property or to any sale proceeds.
- Rights under the key development contracts. This arrangement grants the lender the ability to enforce the contract by calling upon the other party to fulfil their obligations if any issues arise with the borrower.
- The borrower’s rights to any insurance proceeds relating to the property and the development of the property.
- A fixed charge over the borrower’s key bank accounts and a floating charge over all the other bank accounts of the borrower.
- A floating charge over all other assets that the borrower owns.
- A charge over the shares in the borrower company.
- Personal guarantees from the directors of the borrower. Often the lender will require the individuals providing the personal guarantees to obtain independent legal advice. This means that a third part lawyer (from a different firm) will need to be appointed to act for the individual in respect of the personal guarantee.
This security is usually contained within an all-assets debenture given by the borrower. Alongside the security provisions, the debenture will include detailed representations and warranties the borrower will need to give in relation to the property, development and borrower company. It will also include detailed covenants relating to the property and development such as the covenant to keep the property in good repair and comply with all development documents and laws applicable to development. Lewis Denley Solicitors are here to help.
This guide offers you a brief overview of the legal process and security involved in a development finance transaction. Development finance facilities are complex and the legal process can often become prolonged. Having an experienced lawyer handle the process on your behalf will help expedite the matter. Please do not hesitate to get in contact with our Commercial Real Estate team if you have any queries or would like Lewis Denley to assist you in your development finance matter.
Carrie Foley / Colin Secomb
Lewis Denley
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