As a specialist development finance lender who has been supporting property developers during what’s been a tumultuous past five years in the market, we’ve seen how borrowers regularly tend to look at three key elements when sent a set of terms by their lender: price, day-one advance and loan term.
In fact, the first question many borrowers ask is what the rate is, how much day-one will be offered and how much equity do I need to inject?
A common mistake many borrowers make repeatedly is to overlook the interest reserve — or in other words how much the lender is holding as interest against the loan — and the lower the interest reserve, the higher the day-one advance it is offering.
Knowing the key elements many borrowers look for, many lenders have historically competed on price and tried to win as many deals as possible by offering a larger day-one.
This trend has accelerated in recent months as lenders try to do business in a challenging environment, and as a result, we've recently seen a number of lenders being very aggressive with build terms and sales rates to max the day-one advance on the scheme and win the deal, often to the detriment of borrowers.
Why interest reserve matters more than you think
While a larger day-one advance might sound and look attractive to borrowers in the beginning, it can end up costing them more than they think and even put their profit at risk if the project runs over and is not delivered within the expected timeframe (this is very common in the current market).
If the project delivery takes longer than expected or sales rates are slower, a tight interest reserve means the borrower might run out of this reserve — if that’s the case, they might end up paying extra costs in the form of extension fees or even worse, having to pay default rates.
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In a pre-Covid market where cost of material inflation was not a main concern and where house prices were moving up steadily, being very aggressive with build terms and sales rates might have worked as borrowers didn’t struggle to sell, and refinancing didn’t take many months.
But the market has turned, and in the current environment of high cost of material inflation and slow sales market, some of the terms being sent by lenders are unrealistic and simply not fit for purpose.
The bigger picture trend is that we've recently witnessed several terms sent out by lenders where the proposed scheme is clearly not deliverable in the timeframe and under the conditions of the facility.
It is important for developers to pay extra attention to the interest reserve, to make sure they have the right deal in place that allows them to deliver their project and complete their sales with the right amount of time, and to avoid getting into unsustainable situations with their lender.
Our view is that borrowers need loans that are fit for purpose and robust facilities that aren't going to create issues for them down the line, especially in the current testing market environment.
They need to make sure that their facility has a decent cushion in the form of interest reserve, in order to avoid having to pay extra fees at the back end if things don’t go according to plan, and lenders need to have their borrower’s interest at heart when issuing terms, to ensure the facilities being provided are fit for purpose.
Our advice to our clients today is to stay positive but to also be aware that the road ahead might be bumpier than expected at first (the build can take longer, and sales can be slower).
So, work hard but expect the unexpected; be ready and plan ahead by ensuring your interest reserve is there to protect you.