Mike Duck

When is a development cost a 'true' development cost?



When lending into a real estate development project, it is imperative that both lender and borrower agree the development budget, both in terms of total budget as well as the detailed build-up of what it comprises.

A lack of understanding or clarity over the ‘agreed budget’ at the outset leads to confusion, not only in terms of the borrower’s initial equity calculation, but also which costs are to be considered as ‘true’ development costs.

Not all costs incurred by the borrower during the lifecycle of the project will necessarily be a true (and therefore fundable) development cost, while certain other claims will require a greater degree of consideration. A few examples are discussed below.

Acquisition

There are two ‘options’ that can inform the development cost relevant to site acquisition. The first is for the acquisition cost to simply be the amount paid by the borrower when purchasing the site, together with associated costs such as stamp duty, land tax and legal fees.

The second option is for the cost to be the ‘residual value’ of the site. This option is often selected where the borrower has owned the site for a longer period and, more importantly, where value has been created in the site by, for example, securing planning consent and/or vacant possession.

In that instance a lender will often then accept the (typically greater) residual value instead of the actual purchase price (the difference between the two figures is sometimes referred to as ‘soft equity’).

Holding costs

Depending on what stage of the project lifecycle the borrower approaches the lender, the borrower may have incurred various ‘holding’ costs.

Holding costs are costs associated with owning the development site/building prior to the construction phase, but which do not add value to, or progress, the development process.

Examples include insurance of the building, site security, empty rates and utility charges. Such holding costs are often considered as not being true development costs and are instead classified as ‘sunk costs’.      

Agency/finder/broker fees

If there is an ‘introducer’ involved in bringing the site to the borrower and/or the borrower to the lender, there is often a fee due.

In the case of the former, for that to be considered a true development cost, the merits, quantum and transparency of that fee will need to be carefully assessed. In the case of the latter, lenders are more likely to recognise the introducer’s fee as a true development cost, and in some instances will ‘share’ the arrangement fee with the introducer.

Development management fee

Depending on the type of borrower and their adopted procurement route, there may be a genuine case for an ‘internal’ development management fee to be built into the agreed budget as a true development cost.

The concern for the lender is, however, when that allowance is inflated beyond what would be considered reasonable, the extra-over element effectively being an early extraction of the developer’s (still to be realised) profit.

VAT

VAT will be incurred on a development project in some form, be that in respect of fees, construction or other development costs. There may be circumstances in which the borrower is not able to recover VAT and in those instances non-recoverable VAT can (and indeed should) be considered a true development cost and allowed for within the agreed budget.

Recoverable VAT is, of course, not a development cost as the borrower is expected to recover those costs. However, it is important to understand how VAT is funded in the period between incurring and recovering (recovery typically being on a monthly or quarterly basis).

Often the borrower is simply required to cash flow that VAT from their own equity sources, but in some instances lenders may provide a separate VAT debt facility or allow VAT to be drawn from the development facility. In the case of the latter, it is important to recognise that as a result, at any one time, there will be insufficient funds remaining in the facility to complete the development (there being a reliance on the VAT being recovered by the borrower and subsequently committed to the project).

Retention

The agreed budget should include the full construction cost, ie the cost including what will become the retention. Under most construction contracts, a borrower will only actually pay their contractor 95% or 97% of the gross value of works undertaken in a particular period.

The lender should only ever draw that reduced amount, as while the borrower’s ultimate liability to the contractor is greater (ie 100% of costs in the period), only the reduced amount is a true development cost at that time. Retention is typically released 50% at practical completion with the balance at the expiry of the rectification period (generally 12 months post-PC).

Given that loans are often due to be re-paid before those 12 months are up, the balance of retention is often never realised as a true development cost during the loan term. The fact that it is allowed for in the agreed budget and is a fundable cost is often a cause of frustration for a borrower.

Contingency

As stated earlier, an agreed budget must be in place and be fully understood by all parties by the time the loan is sanctioned and prior to commencing drawdowns. Typically, that agreed budget will include a contingency allowance.

When (as is often the case) a borrower then requests reimbursement of a development cost – which either does not feature as a category in the agreed budget or exceeds the allowance for that category – the use of that contingency needs to be carefully considered.

In particular, contingency should only be utilised for true development costs (ie where they are relevant and necessary to the development) and only then depending on how far through the construction the project is in terms of the risk curve, and the level of the remaining contingency.   

Reimbursement

A typical development loan facility does not require the borrower to have settled development costs from equity to then claim from and be reimbursed by the loan facility.

Instead, it is there to provide the borrower with funds to meet true development costs. A true development cost in that situation is a cost that has been incurred (as evidenced through invoices, bills, statutory demands etc) rather than met, although that is still subject to a test of whether it has been incurred at an appropriate time, and whether it is in accordance with the agreed budget.


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