Greer and Farrell (1993: 375) mention that in most large-scale developments, the site will be controlled through an option agreement rather than an outright purchase.
After determining that a planned use is feasible and after receiving all necessary municipal approvals, the developer is ready to exercise the option to purchase a site. After this stage, financing are hurdles that trip up many grandiose development schemes (Greer and Farrell, 1993: 375).
Arguably the most critical part of any development is arranging the right ‘financial package’, as projects which are in all other respects sound, can go wrong because of inappropriate financial arrangements, whilst those that appear to be poorer projects can be successful as a result of appropriate financial arrangements being made at the outset (Millington, 2000: 139). Finally, no prudent developer (unless there are sufficient internal cash resources) would consider entering into a commitment to acquire a site without having secured the necessary finance or development partner to at least cover the cost of acquisition, including the interest on the acquisition cost, while the site is held pending development (Cadman and Topping, 2004: 58). The developer should aim to ensure that the financial arrangements are completed to coincide with the acquisition of the site. If no financial arrangements are in place then the developer must be satisfied that either the finance will be secured or that the site can be sold on the open market if no funding is forthcoming (Cadman and Topping, 2004: 58).
Most modern development projects require substantial sums of money for their implementation and this invariably creates the need for borrowed money if a project
is to proceed (Millington, 2000: 139). Residential developers rarely pay cash for their projects (McKenzie et al., 2011: 395). According to Reed et al. (2015: 23) developers, and especially residential developers with a focus on building owner-occupied homes typically only require short-term finance, often over months rather than years. Reed et al. (2015: 23) further elucidate that the amount of finance that residential developers borrow is comparatively small in contrast to commercial developments. McKenzie et al. (2011: 395) mention that residential developers are usually strong believers in the principle of leverage (using a minimum amount of equity funds and a maximum amount of borrowed funds to control a large investment) (Millington, 2000: 149). Millington (2000: 149) states that “gearing”
(sometimes referred to as “leverage”) of a project is said to indicate the relationship of equity and debt.
When a developer borrows most of the required funds and only puts in a small amount of equity, a development is said to be “highly geared”, whereas if only a small portion of the total funds is borrowed, a development is described as “lowly geared” and a project which is 60% geared uses 60% borrowed money and 40%
equity, and so on (Millington, 2000: 149). From the outset of a project, a developer needs to be certain of having a sufficiently large loan for a guaranteed time period, which will allow sufficient time for the design, construction, leasing and marketing of the project, which also has a contingency period built in to cater for any delays, which may occur (Millington, 2000: 141). A developer will also wish to have a definite rate of interest fixed for the period of the loan and will not wish to have a loan with an interest rate which may vary, unless it is in a downward direction only (such an arrangement being extremely unlikely to be available in practice), because
if interest rates should rise the cost of a project will increase (Millington, 2000: 141).
In many instances, it will be preferable for a developer to pay a higher rate of interest at a fixed rate than to make a loan with a lower rate of interest knowing that it may as well increase during the loan period (Millington, 2000: 141).
Developers generally look to construction lenders, such as banks, insurance companies and mortgage companies, for the bulk of their development capital and the process of obtaining a loan is relatively straightforward (Greer and Farrell, 1993:
375; McKenzie et al., 2011; Reed et al., 2015: 23). In addition to traditional sources, residential construction funds are occasionally available from pension funds, real estate investment trusts and endowment funds (McKenzie et al., 2011: 396).
According to Reed et al. (2015: 23) residential developers’ ability to raise finance for a project is based on certain variables including their ‘track-record’ (i.e. credit rating) and the level of risk to the lender. Greer and Farrell (1993: 375) share the same argument and state that a large amount of risk is burdened on responsive lenders for loans to developers. Developers, even possibly residential developers, may be unable to complete projects or may fall far behind schedule. Development costs are difficult to estimate and residential projects often run considerably over budget (Greer and Farrell, 1993: 375). This forces the responsive lenders to provide money up front (additional funds) and thereby increase their risk exposure (Greer and Farrell, 1993: 375).
Lender risk can be reduced considerably by insisting that developers acquire end-loan commitments. These are agreements from other lenders to provide long-term financing upon project completion (Greer and Farrell, 1993: 375). An end-loan
commitment ensures that funds, with which to repay the construction loan upon completion of the project, will be available. If a developer cannot obtain an end-loan commitment prior to arranging a construction loan, standby or gap financing may be used (Greer and Farrell, 1993: 375). Under this arrangement, a lender agrees to provide funds for the gap between the time a project is completed and the time an end-loan is secured. In most cases, the end-loan is secured before any funds are actually drawn in connection with a standby loan commitment (Greer and Farrell, 1993: 375).
The importance of finance cannot be over emphasized. Without adequate funding, a real estate project, as developers put it, cannot “fly” (McKenzie et al., 2011: 396).
Beyond funding the development, a developer must make sure there is sufficient cash flow during the development. The developer must compile budgets and prepare financial statements to monitor the financial health of a development (Nsibande, 2011: 63). Such budgets and financial statements must be reviewed periodically to ensure there is always money to complete the development. This must cover the developer’s overheads, staff salaries and other general expenses the developer will incur during the development (Nsibande, 2011: 63).