Securing finance for a construction project can be a tricky undertaking. Asking lenders to hand over hard cash for an empty plot of land and a plan on paper can be a seemingly impossible task.
However, there are a few options open to you if you’re looking to secure building finance. In this article, we will take a look at the private methods of finance and a couple of the options available through the public sector too.
Private Funding Routes
Construction and Development Loans
A construction loan, or a self build loan, is a type of finance designed specifically to fund a construction project. This is usually paid for in a series of payments, known as draws, at various stages of completion of the building of a new property. The most important thing to remember is that the amounts paid are only to the total of the cost of the building and are not related to the value of the property when construction is complete.
The funds are drawn by the developer to an agreed schedule and are subject to the completion of various stages of construction within budget and on time. This helps to ensure the project stays on track and doesn’t fall behind schedule.
The number of draws are typically agreed upon beforehand by the applicant and the lender. The first draw will normally be from the applicant’s share of the fund dedicated to the project.
As with all loans, the applicant will typically be charged interest on the total amount borrowed. Unlike a normal loan, however, the applicant will only pay the interest on the draws, and not the whole loan amount. Once the project is completed, the applicant is required to source alternative funding for the property, usually in the form of a mortgage, which will pay off the total amount issued for the construction of the property.
Mezzanine finance is a combination of debt and equity finance which can be useful for large construction projects. There are two basic routes; debt, where you borrow money through a business loan; or equity, where you sell a portion of your business for a cash return.
So the borrower will take out a business loan and if they are unable to make the repayment within a given timescale they will have to release the funds by giving up equity in their business.
Mezzanine finance is typically used when a situation arises where the risk of finance means that the borrower cannot acquire a typical business loan and the only option left is for them to take up equity finance, which they may be reluctant to do as they may be unwilling to give up shares in their company.
The business is able to secure larger amounts because if they are successful in completion, the finance will be paid for by profits gained. Put simply, you can secure larger amounts of finance leading to bigger investment aimed at larger returns.
It is typically repaid in a single lump sum payment and often has tax deductible interest. There is also the option to defer the interest payments.
Bridging finance, or a bridge loan, is a type of finance that is typically only available for a 6 to 12 month period. It is usually taken out to bridge the gap between one property transaction and the next.
For example, if you were to buy a property on the spur of the moment and were unable to find the funds to finance the purchase, but had the equity in another property that you owned, then you could take out an open bridging loan.
The interest rates are usually very low for a bridging loan, as they are short term. There is however a high approval rate because the bridge loan is a secured product. The overall cost is typically swayed by the credit history of the applicant.
This makes bridging finance a quick and easy way to finance a construction project in the short term, while you search for suitable long term finance.
Project finance is the long term financing of infrastructure and industrial projects. It is based upon the projected cash flow of the project rather than the borrower’s balance sheets.
It usually involves a number of equity investors, the ‘sponsors’, a ‘syndicate’ of banks, or other lending institutions that give out loans. These are secured loans on the project’s assets and paid entirely from the project’s cash flow. The loan is secured as a non-recourse loan, which is where the borrower will levy an asset they already have, and if they were to default, then the lender can seize and sell this asset.
Public Sector Funding Routes
Private Finance Initiative (PFI)
The private finance initiative (PFI) is a way of creating public-private partnerships (PPP) with a private firm undertaking a public project, managing it themselves. This was developed initially by the governments of Australia and the United Kingdom and has been adopted by many countries worldwide as part of the privatisation and financialisation programme. PFI is not without its critics, who believe it is a way of shifting a lot of debt ‘off the balance sheet’.
PFI has been struck with controversy and in 2011, a UK Parliamentary Treasury Select Committee found that, “PFI should be brought ‘on balance sheet’. The Treasury, they said, should remove any perverse incentives unrelated to value-for-money by ensuring that PFI is not used to circumvent departmental budget limits. It should also ask the OBR to include PFI liabilities in future assessments of the fiscal rules.
Private Developer Scheme (PDS)
A private developer scheme (PDS) is a form of public procurement in which a private developer will fund the construction of a building to be occupied by the government. The rent is paid over a minimum term through a leasehold agreement. The transfer of public land to a private developer will then take place.
This type of finance is often used to procure public buildings such as hospitals or courts. PDS is suited to projects where the residual value of the development at the end of the lease, is high.
The securing of construction finance or funding construction does remain a sometimes difficult and time-consuming process, but the above are all popular methods of securing finance that should be looked into if you require funding for a construction project.