If you need financing for real estate you might consider a development loan. Learn what it is and how to get a development loan.
Real estate development requires deep pockets and a well-connected network, but there are ways to finance a real estate business without using your money. The primary option is a real estate development loan. Here’s how to get a property or residential development loan, what it is and some alternatives.
What is a development loan?
A development loan is a capital advancement issued to borrowers who need funds for their real estate projects. This can include breaking ground on a project, building and holding the finished product through the leasing stage.
Development loans also involve purchasing land or lot development for further construction for a later sale. Often, investors or developers use the money to buy the property, improve it or convert the site into a construction-ready real estate area.
Investors typically rely on these types of loans to buy raw land, build on or tear down an existing building and to build a new structure.
Development loans tend to promote job creation, especially for small businesses and all parties involved, according to Bryce Fennell, CPA and TMC Financing’s vice president of business development. TMC Financing typically deals with acquisition development loans.
Fennell said typically, the bank only provides 50% of the financing while his company works on funding 40%, and the borrower puts down 10%. Loans can go up to $5 million for small businesses.
Generally, most developers choose one or more of these four types of real estate development loans:
- Acquisition loans finance undeveloped land with no intentions of development. The land can already have buildings on it requiring minor improvement.
- Development loans, typically after recently acquiring a lot and wanting to develop or make improvements to the land.
- Acquisition and development loans for developers who want to buy raw land and turn it into a building site.
- Construction loans for building or renovating a respective real estate project.
Tips for getting property development loans
There are qualifications for getting a development loan. First, here are a few tips.
Build a good reputation
The first tip to getting a lender to fund your project is credibility and a good track record. It may be a daunting barrier, but getting experience is the best way to overcome it. For example, a job with a property developer will give you some credibility and experience you’ll need.
Fennell says lenders tend to grant loans to people and companies with a good track record and are less likely to do so with a startup. So be ready to face some extra challenges if you’re a startup.
Develop a plan
The second tip is to have a plan. Develop the project or plan to a point where people are more likely to say yes to it. For example, small developers normally begin with residential projects with only one or two houses at a time. Since acquiring funding may take months and the property you want may be sold once you get funding, identify several available vacant lands for sale as backups. Also, research any zoning limitations and special conditions for each property.
Research the local property market
After developing a plan, research the local property market. With more research, you’re more likely to get potential lenders. So make sure to include other similar property sales to establish your lots are reasonable in the area. You should also develop one or two simple graphs to illustrate the percentage change in neighborhood property values over the last few years. After that, figure out what kinds of housing sell best in these neighborhoods and develop a housing plan for each potential property.
Prepare cost estimates
Another tip is to build cost estimates. This should include materials, labor, overhead and profit. Other costs might include planning, building department permits and fees, and a 15% contingency fund.
Rehearse your pitch
After preparing and researching, rehearse your pitch and pitch your project as quickly and convincingly as possible. Expect only a few minutes, so don’t get lost in details yet. Also, memorize important figures so you can answer confidently.
Development loan qualifications
What do you need to qualify for a development loan? Being well prepared and having experience and a portfolio are the basics.
But lenders want to hear certain things, so be straightforward with your pitch. They want to know the timeline, expected profit, the loan amount required and when they can expect to see a return.
Besides that, lenders need other paperwork, such as three years of personal and business tax returns. Fennell said some lenders may require financial disclosures year to date and information for anyone else with at least 20% ownership of the company.
Pros and cons of using development loans
Here are a few pros and cons of using development loans to help you in deciding financing.
- A development finance loan is a great way to secure borrowing on properties you could not get a mortgage on.
- Even derelict and disused buildings qualify for development loans if you have a great project, allowing you to develop property that doesn’t qualify for a mortgage.
- You don’t need previous experience as a developer.
- The lender will carefully assess the timespan of the work and your requested drawdowns throughout the project.
- Some lenders may pose fees to cover valuation at both the start and end of the project.
- Interest rates can range from 4.5% to 9% and must be budgeted for.
- You will need inspections and valuations before the lenders agree to release the next tranche of funds.
Capital stack: What it means
Capital stack in real estate normally refers to the layers of financing that make up a project. It usually comprises debt and equity and has four main elements—senior debt, mezzanine debt, preferred equity and common equity.
It’s common to rely on more than one source when obtaining funding for a project, with each loan making up the resulting capital stack.
Within the capital stack, common equity normally is low priority and is on top of the stack because it receives its return after all other parties in the transaction receive their payments.
Senior debt is at the bottom of the stack because it is typically high priority and the lowest risk debt. Senior debt is typically loans secured by property.
The capital stack indicates who has the rights to the profits generated by the property throughout the hold period and sale. Capital stack also shows who has rights to the actual asset in case of an uncured default, meaning a party has failed to perform its material obligations under the agreement.
Understanding the structure, risk and rewards associated with each piece of the capital stack is important. This, along with a person’s position in the investment, can help everyone quantify the investment’s potential upside and downside.
The stack’s structure and a potential investor’s place can provide an idea of how and when they will get paid. These details show investors if they can take control of the underlying property.
Essentially, capital stack prioritizes the different financing that goes into a project.
Other funding sources for real estate
If development loans don’t fit your needs, here is a quick list of other similar loans for a real estate business.
These types are typically loans from a bank or an institutionalized lender. The interest rates are often competitive, with long periods for payoff. Often, the underwriting is extensive. Most interest rates are around 4% for periods from 15 to 30 years.
A private lender is anyone with access to money or capital and a willingness to invest it in your project. Private lenders can be family, friends or someone you met at a networking event. Private lenders are not typically banks or licensed to lend money but rather do so to make their money back with interest. So it is often easier to borrow money from them. A private lender’s terms are typically easier to meet. The loan duration is much shorter and usually has higher interest rates, ranging between 12% to 15%.
Venture capitalists are individuals or corporations worth $1 million or more that tend to invest in startups that show potential. Venture capitalists often lend far more than a traditional small business lender but are very selective, so it can be harder to receive a loan.
Like venture capitalists, angel investors are usually well-off individuals who provide funding and other resources for new ventures. The big difference is that the money from an angel investor isn’t technically a loan. The angel investor typically wants to be part owner of the company in exchange for money.
Small business administration loans
Small business administration (SBA) loans are issued by the government in a variety of packages, but they can be hard to apply for and are typically slow to process.
Real estate crowdfunding
Similar to GoFundMe and growing in popularity, real estate crowdfunding involves pooling funds from multiple sources and people. Crowdfunding offers flexible terms.
Microloans offer small business owners up to $50,000. Due to the small money amount, small business loans are typically easier to obtain than a traditional loan, but the loan usually won’t cover all of your business needs.
Hard money lenders
Hard money lenders are a quick way to get loans. They are not institutionalized but are licensed to lend money. The loan terms are typically short and leveraged with the asset. Hard money loans also come with a high interest rate around 12%.
Home equity loans and lines of credit
Home equity loans and lines of credit (HELOCs) represent a type of revolving credit similar to a credit card. However, home equity loans use your home equity as collateral.
Money partners are people you partner with because of their access to the mighty dollar. If you don’t have access to capital, it’ll be in your best interest to partner with someone who does.
Commercial loans allow investors to buy commercial properties for longer durations at low interest rates. However, it may be harder to get approved for a commercial loan.
Government funding sources
Lastly, different federal and state affordable housing initiatives serve as funding for small-scale affordable housing projects. One example of a government program is SBA 504 development loan.
Funding a real estate deal can involve several real estate development loans designed to help developers.
Knowing the basics of development loans and alternative loans can help you choose the right type of financing for your project.