The banking system in Barbados has been liquid since the end of 2008 and there remains considerable excess liquidity in the economy. During this time not much has changed with the fundamentals of lending. Getting repaid remains the focus of a lender when assessing a loan proposal and with development funding that focus is on getting paid for the finished property.
What seems to have changed is demand for the development product. We have seen a reduction in the quantity of loan applications, and that may be the result of a reduction in demand for real estate. As the media has already given access to many points of view on demand in the real estate market, this article will discuss some of the features of a good development funding proposal in an effort to improve access to the available development funding.
The experience of a developer is arguably the single most important feature of a good lending proposal for development funding. A developer with a good record in the type of development being contemplated is more likely to be able to complete the development, and may also have the experience necessary to address the problems that can arise with a construction project. Lenders also look at the scale of the projects that a developer has undertaken in the past. A new project may be of a familiar type, but it may represent a large step up from previous experience. A developer’s lack of experience with a project of a comparable size will increase the risk of encountering difficulty with delivering the project, and this will be of concern to a lender.
A developer is the lead risk taker in a development project, and should expect to make a sizeable equity contribution to the project. To set the context for equity contributions we need to discuss that the ultimate risk to a project is complete failure, where the project’s assets are liquidated to satisfy its liabilities. At liquidation, assets may be sold for less than their open market value and to improve the chances of fully recovering a loan should liquidation occur, a commercial bank lender will normally lend up to 60% of project costs. The contribution of a lender will be senior debt, which means that in liquidation its loan will be repaid before equity. The lower risk taken by a lender reflects its return which is limited by the interest rate on the loan; whereas a developer’s higher risk reflects the potential for relatively higher return in the form of profit.
While a lender’s contribution will be cash, a developer may contribute cash or the land on which the project is to be constructed or a mixture of the two. An important point is that in most cases project land is recognized by a lender at cost and not value. Developers ask lenders to contribute cash to projects, and the value of cash is clear. Similarly, lenders want to be clear on the value of a developer’s contribution. Where a developer’s contribution is land, a lender will rely on the purchase price of the land unless it was purchased many years prior. Unless the market has experienced unusual price increases, it is unlikely that a buyer for that land could be found at a price that is significantly higher than its recent historical cost. In any case, where a developer could sell a parcel of land for three or four times a twelve month old purchase price, that developer could avoid a risky construction project which may or may not deliver profits in 2-5 years, and make a 200-300% profit right away.
Source of Repayment
This is common ground for a lender and a developer. A lending institution needs to have its loan repaid and earn interest, and a developer needs to have its equity repaid and earn a profit. Neither of these outcomes can occur if there is no source of repayment. While in practice the source of repayment is common ground, the naturally different perspectives that guide lenders and developers make this a challenging topic. Developers tend to be optimistic and believe that the market will accept their product, even if this takes time. While a lender will respect the sales record of a developer, lenders are by nature conservative and tend to plan for an outcome where there are fewer sales than projected.
As the source of repayment is so crucial, for the benefit of both parties, lenders require that developers arrange prior contracts for the sale or rental of the finished development product. Such contracts reduce the risk that both the developer and the lender will have to wait for an extended period to obtain repayment. Where the project involves constructing units to be sold, lenders also encourage developers to arrange for their purchasers to make progress payments for the units throughout the construction period. This is because a purchaser who has paid more than 50% of the purchase price of a finished unit is more likely to pay the balance than a purchaser who has paid 10%. Where the project is to deliver units to be let, it is best for both the developer and the lender if the risk of prolonged vacancies is reduced through a process of pre-letting.
A few parting thoughts on security. Development projects need cash, not security. A lender’s view of security is different from a pawnbroker’s view because lenders are not in the business of selling assets. A lender who thinks that security will be needed to complete a development project is probably not going to fund that project. As long as a project is adequately funded with debt and equity, project security only needs to be the project itself.
Despite the effects of global economic uncertainty, not much has changed with the availability of development funding. Opportunities still exist for persons to obtain development funding for projects that among other things feature an appropriate equity contribution and a good source of repayment.
 Review of Barbados’ Economic Performance for 2011 and Prospects for 2012, Central Bank of Barbados, December 2011