@Timothy Havard 2002

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 -~

134 Contemporary Property\Development

3 Finance and development

3.1 Introduction

3.2 Fundamentals of development finance

3.2.1 Phases in development funding
3.2.2 Relationship between project characteristics and funding
3.2.3 From where does the finance come for development?
32.4 A note about debt
3.2.5 Development finance in detail
3.2.6 Forward sale agreements

3.3 Retention financing

3.3.1 Mortgage finance
3.3.2 Variations on lending
3.3.3 Corporate finance \
3.3.4 Corporate debt
3.3.5 Equity funding
3.3.6 Other options
3.3.7 Part disposal options
3.3.8 Equity sharing
3.3.9 Joint ventures and partnerships
3.3.10 Other financing options

3.4 Risk reduction and finance

3.4.1 Fixed rate loans
3.4.2 Derivative-backed hedging
 Finance and development 135

3.5 Taxation
3.5.1 Introduction: tax and development
3.5.2 Taxes that may be encountered by developers
3.5.3 Conclusion to the tax section

3.6 Conclusion to Part 3

I
I 136 Contemporary Property Development

Glossary
Caps A vehicle used to limit the level of interest
rates on a loan.
Collar Similar to Caps but cheaper as a lower limit
is also agreed, below which the rate of
interest cannot fall, which gives security to
the lender.
Commercial paper Short-term (loans of less than three
months’ duration) available in the money
markets.
Debenture stock Stock market issued debt.
Derivative-backed hedging Using the futures and options markets to
reduce the level of risk in interest rate
movements.
Equity returns The return on an investor’s own (as
opposed to borrowed) funds used in a
project.
Forward fund A way of securing cheaper funding for a
development involving selling the scheme
prior to construction to a financial institution
who then provides the short-term project
funding during the life of the development.
On completion and letting of the scheme,
the institution pays the balance owing to
the developer and ownership is transferred.
Forward purchase and Similar to the above, but the agreement is
Forward sale only to purchase the completed scheme at
an agreed price and with an acceptable
occupier and lease in place. The developer
must secure their own project funding.
Gearing/leverage The percentage of borrowed money to the
developer‘s own money invested in a
project.
Interest-only mortgage A property-backed loan where none of the
principal sum is paid back until the end of
the loan period, the borrower only paying
interest on the loan.
Investment yield The return on an investment expressed as
a percentage.
Joint venturing The practice of entering into a partnership
with one or other development partners,
such as a public sector body or bank, to
carry out a development project.
 T Finance and development 137

Limited Liability Partnerships Two versions of special investment vehicles

(LLPs) and Limited used to save tax on a development or
Partnerships (LPs) investment project in the UK.
Limited recourse loans A loan where the lender has limited ability
to seek repayment from a parent company
when a subsidiary defaults.
Loan stock See Debentures.
Loan tovalue ratio (LTV) The percentage of value or cost of a
development scheme that forms the basis
of how much a lender will advance to a
developer. For example, if a scheme has an
end value of € l m and a bank has an LW
limit of seventy per cent, then the
maximum that will be lent is €700,000. This
ratio protects the banks' money from drops
in value in the property market.
London lnterbank Offered The rate of interest that banks charge each
Rate (LIBOR) other for loans between themselves. This
forms an important benchmark for other,
less secure, lending.
Mezzanine finance Debt financing of a project above the LTV
limit, usually at a premium rate of interest.
Negative cash flows Cash outflows, i.e. expenditure.
Non-recourse loans A loan that is specific and secured on a
project only, with no recourse from the
lender to any other party should default
occur.
Opportunity cost An economic term referring to the highest
value option given up to do something such
as invest in a project. It gives a measure of
that project's worth.
Overage Extra receipts over and above those
originally expected.
Public Sector Borrowing The amount of money the government and
Requirement (PSRB) public sector need to borrow to fund
activities.
Real Estate Investment US tax efficient property investment
Trusts (REITs) ve hicles .
Repayment/amorticised The traditional property-backed loan where
mortgage the borrower pays off both interest and
capital over a fixed time period.
Retail debt Effectively a corporate debt agreed for
general business operations rather than
project specific debt.
I

138 Contemporary Property Development

Retention financing Financing that allows a developer to retain,

rather than have t o sell, a development
scheme.
'Rolled-up' interest A debt where the interest is not paid each
period but is instead added to the total
amount owed which is then paid back as
one lump sum.
Sale and leasebacks Where a property owner receives capital by
selling their property to an investor and
immediately takes out an occupational
lease on the property.
Securitisation Property investments divided up into
shares like a company.
Senior debt The main loan on a project, usually the debt
that is not the mezzanine layer.
Swaps A form of derivative hedging for interest
rates.
Taper relief A tax allowance given on inheritance tax.
Texas agreement A document drawn up for a
partnership/joint venture that deals with
what should happen if the partnership is
terminated early.
Utilised Securities Market A cheaper, less formal version of the main
(USM) London Stock Market that allows smaller,
less well established companies to trade
their shares and raise finance.
 :'- Finance and development 139

3.1 Introduction
All types of property development have some similar characteristics. They
tend to be capital intensive, requiring large amounts of funds. The funding
characteristics tend to fall into broadly similar patterns in that there are
requirements for regular outflows of funds for long periods whilst the
positive receipts from development tend to be delayed. These features
mean that securing sufficient funds on the correct terms to suit the
requirements of the development is one of the critical elements required to
move a development from the conception stage to reality.

This is the main reason why finance gains a section of its own in this book.
Finance is a complex element that needs to be looked a t in detail. There are
many different ways of financing developments though, to be realistic, the
options for smaller developers are limited.

The basic options for funding developments are as follows:

(a) Use the developers own resources - either from retained profits
or from corporate funding routes - t o undertake the
development. This is referred to as equity funding.
(b) Borrow the money, either on a long-term or short-term basis,
using the site as the security for the loan (though other security
may be required by lenders).
(c) Find an investor who will buy the completed scheme and
who may provide funding for the project during its construction
phase.

I
These are the basic options, though combinations are possible and, indeed,
are common. Thekhoice of which to use, as w e will examine in more detail,
will depend upon the aims and objectives of the developer, the type of
development being undertaken and the financial standing of the developer
themselves .

This section will work through all the options, starting with an examination
of the fundamental nature of development and the influence these have on
finance.
140 Contemporary Property Development

3.2 Fundamentals of development finance

In order to understand the way in which developments are financed it is
important to first review the characteristics of development as it is these
that shape the behaviour of both developers and financiers.

To explain this we will take the example of the development of an

investment property by a private sector developer. This is, in any case, one
of the most common circumstances where funders need to be involved.

3.2.1 Phases in development funding

As can be seen in Figure 22, below, development breaks down into distinct
phases.

Developments of this sort usually commence with the purchase of the land,
a major capital outlay. There is then, typically, a period of negative cash
flows, i.e. payments, as the development is planned, constructed and whilst
an occupier is-sought. Once a letting is achieved the property settles down
into a hopefully long and stable life as an investment. Once it is fully let it

Project cash flows Project stages Typical timescales

E -tive I Et
4 Land 0 - 12
f

I
Time

Completior
Letting-up 0 - I 2 months
period

e
0

-
6
0
Y

Figure 22: Analysis of the stages of a development.

 I Finance and development 141

becomes a valuable, saleable asset but until then a development property

can only be sold at a substantial discount to full value.

This illustrates that two distinct phases with different cash flow and risk
, characteristics exist. In the development phase, the project is high risk.
I
There are large negative cash flows, there is little or no income and the
asset is largely unsaleable. After completion and letting, the asset is a
relatively low risk investment, with a high underlying value, a steady but
relatively low income stream and low, sometimes negligible, outgoings.

3.2.2 Relationship between project characteristicsand funding

These differing characteristics usually force developers to consider finance in

two phases and, in most cases, to obtain the finance from more than one
source. The first phase is the project or development finance phase. This
tends to be short-term finance bearing a high risk and is thus usually
expensive. The second phase is concerned with long-term ownership,
investment finance, which bears a low risk.

This need to consider the two phases separately is illustrated in Figure 23.

Typical timescales

f -tive f +
Land 0-12 I
4-
Time
+
t
4-
e-
Completion Completion I
Letting-up
period
0 - I2 months I

/I
Figure 23: Distinction between project finance phase and long-term
investment finance phase of a property development.
142 Contemporary Property Development

The choices that the developer makes regarding finance are greatly
influenced by this situation. They are also shaped by three key
va r ia bIes :

(a) The identity of the developer.

(b) The intentions of the developer.
(c) The attitudes of the financial community towards development
risk at the time the financing decision is made.

The identity of the developer is critical in determining the options available;

the size and experience are the key factors. Larger, well established
developers will have many more options available to them, and will have
much less difficulty raising finance than smaller, less experienced
developers who may well be confined to obtaining debt finance from the
high street banks or specialist property lenders. The former, particularly if
they have a stock market listing, will be able to consider a number of
financing options including debenture loan stock, new equity and
commercial paper, as well as conventional project-secured lending. This
gives great advantages in terms of being able to obtain finance at the most
competitive rates and terms.

The intentions of the developer also greatly influence the choices made.
Developers have two fundamental choices: to sell on or to retain the
development. The former is the option chosen (or sometimes forced on)
developer traders, the latter the choice of developer investors.

The attitude of the financial community is a critical factor in determining

what forms of funding will be available or, indeed, if funding is available
a t all. The investment market will at times readily fund certain types of
schemes and will buy the end product of development. This will normally
occur when funds perceive that that a sector will perform well in the
future and where the funds portfolios are underweight in these sectors.
This occurred with the retail warehouse sector in the early 1990s in the
UK and then again with the leisure sector between 1998 and 2001. At
other times, usually when the equity or bond markets are demanding
large flows of funds, pre-selling developments is virtually impossible.
Similarly the banks, which provide the majority of debt finance to the
development sector, have periods when property lending is more or less
attractive.

Given that two of these three factors are out of the direct control of the
developer, we will continue our examination of funding options by way of
the one in which the developer has the choice: funding choices according to
the future intentions of the developer.
li) Selling on the development and funding

The first option is relatively simple. The developer only needs to arrange
short-term finance as the sale made on completion and letting should raise
sufficient funds to pay off all the costs of development, including the project
finance, leaving a surplus which makes up the developer's profit. This is
illustrated below in Figure 24.

There are a number of ways of achieving the funding for this, including
traditional project linked debt. Ideally, a developer will seek to achieve a
'forward sale'. The details of forward sale will be considered below but in
outline this is a situation where a developer negotiates the sale of a scheme
prior to completion and, indeed, preferably before the scheme has even
commenced. The developer contracts with an investor to achieve a number
of goals, on completion of which a sale will occur at an agreed investment
yield. These goals are laid down in the contract but usually it requires the
developer to build the property, and to find a suitable tenant on a suitable
lease at. an acceptable rent. The attraction of this to the investor is that they
get a new property investment but are insulated from much of the risk of
the development and are often obtaining the property at below its market
value on completion. The attraction to the developer is that they have a
defined exit for the project. This usually enables loans to be obtained at a
more advantageous rate from sources of project finance or, indeed, when
market conditions are poor to obtain a loan at all.

Project cash flows Project stages Typical timescales

f -tive ~

Land 0 -12

Time 4-
e-
t
4-
t- Completion
0 - 12 months
period

Sell to third party investor, realise profit

and repay development finance

Figure 24: Forward selling of a development.

I
144 I Contemporary Property Development
There is a variation on this, which will be covered in more detail below,
where the investor agrees to forward fund the scheme as well as forward
purchase it - hence a greater degree of risk is involved in the development
phase of the scheme. However, this risk is limited as money is drawn down
from the investor as the project proceeds with the final payment (including
the developer's profit) not being made until all the conditions are met by the
developer.

lii) Retaining the building: funding options

The second option, the retention of the scheme by the investor, is rather
more complex but with more options available. The two phases of finance
are usually split up, as with the first option, but project finance is arranged
for the development phase and longer-term finance found for the investment
part.
I

Project cash flows Project stages Typical timescales

E -tive &+

1 I Completion
Letting-up
period
Completion
0 - 12 months

_1
I

Refinance project as long-term investment based on value on completion either by way

of mortgage or corporate debt and retention of ownership. Long-term finance repays
development debt

I
Figure 25: The refinancing route to the retention of the development scheme
by the developer.
 1 Finance and development 145

One traditional method for financing the investment phase is by mortgage,

i.e. a property secured loan. The income from the property services, the
debt and the principal is paid off by way of entering into a repayment
mortgage as per house purchase or by way of an interest-only loan, where
the principal is paid off by the sale of the asset. Alternative ways of financing
long-term ownership include corporate debt, equity raising ventures and
joint ventures with financial bodies, especially banks. This is illustrated in
Figure 25.

An alternative way of retaining ownership is to finance both phases of the

project in a single step - a common procedure with the larger developer
investors who raise debt finance via the stock and money markets, but a
more rare procedure for the smaller developer as the cost of lending,
overall, would tend to be higher with conventional debt. Large companies
raise medium to long-term money by offering corporate debt on the market
against their track record or, more rarely, to carry out a specific project or
projects. This debt, usually a debenture, pays the investor a guaranteed
coupon or rate of interest and will be repaid at a fixed date. This gives the
developer a pool of money with a known cost to use in general
development projects. This is illustrated in Figure 26

Project cash flows Prqject stages Typical timescales

1
f -tive E+

Time :g
25
g.+

3. ?

Completion Conipletion
Ixttinf-up 0 - I 2 inonthr
period

\L .............................................................................. ........................................................................... .......... ...........

/I
Figure 26: The 'whole project' route to retention financing.
146 Contemporary Property Development

More rarely these funds are raised via equity issues, i.e. the sale of new
shares in the company. This is usually a more expensive option than raising
debt but is advantageous under certain market conditions.

3.2.3 From where does the finance come for development?

Before some of these aspects of development finance are examined in

more detail, we need to explore where the finance comes from for
development. This requires an understanding of the workings of the financial
system.

This is illustrated in Figure 27. Basically, money flows from the top of
diagram to the bottom, though there are, of course, flows back as investors
hopefully get a return on money invested. These have been omitted for
clarity. Savers and individuals, and parties from abroad outside the system,
place funds (usually through the second tier - financial intermediaries) into
the system. These financial intermediaries’O invest funds on behalf of the
investors, usually in the stock market and money markets but also directly in
property, which is not shown on this diagram. These funds are then available
for the corporate sector and government.

This is very much the traditional economist view of the financial system. In
Figure 28 the development sector is represented as being an additional part
of the system for the purposes of our understanding as to where the funds
flow from.

Three types of funding have been distinguished. Firstly, there is debt

funding, which is defined as money that must be specifically repaid to the
lending body. The second type is equity funding. This includes corporate
funding of the development sector (e.g. money raised by share issues) as
well as monies flowing for the purchase of completed developments (which
can be loosely viewed as long-term finance). The final source of funds which
we have not mentioned to date is grant funding. This generally flows from
the public sector (central and local government, quangos and the European
Union).These funds usually flow to support development in deprived areas
to encourage private sector participation.

The source and weight of the arrows indicating the flow of funds of the
various types illustrated in Figure 28 gives an idea of the proportion of

Note that in this diagram building societies, which are a financial intermediary, have
been excluded. This was t o simplify the diagram but also reflects that most of the
larger building societies in the UK have, in any case, converted to banks under the
powers given to then under the Building Societies Act 1986.
 I. Finance and development I 147

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148 Contemporary Property Development

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 I Finance and development 149

where the funds come from that flow to the development sector. Further
reference will be made to it later in this chapter.

3.2.4 A note about debt

There is an old saying about property development finance: the most

important factor to take into account when financing a development is the
OPM principle - Use Other People’s Money!

Though this rather jocular line might underline some people‘s opinions of
property developers as fly-by-night shysters, in fact there are some very
sound principles behind this statement. Better returns from the
development to the developer can be obtained by using OPM. The reason is
‘gearing’, or to use the American term, ‘leverage’.

Let us use a simple illustrative example of a development that gives a 20

per cent return on cost:

I 100~0equity finance
Total development costs €1,000,000
Completed development value €1,200,000
Return on equity 20.00%

Let us now look at the return on equity, i.e. the developer’s own money, if
50 per cent of the money is now borrowed:

50% equity finance I SO% debt finance

Total development costs €1,000,000
Made up of
Debt €500,000
Equity €500,000

Completed development value €1,200,000

Repayment of debt €500,000
Surplus to repay equity and give profit €700,000

Return on equity 40.00%

The developer has invested €500,000 to get €700,000 back, a €200,000

profit which is a 40 per cent return.

Borrowing or gearing up further increases the return further:

 -. I

Total development costs €1,000,000

Made up of
Debt €750,000
Equity €250,000
Completed development value f 1,200,000
Repayment of debt €750,000
Surplus to repay equity and give prc.., f450,OOO
Return on equity 80.00%

The question might be raised as to the validity of this calculation. Is it not

true that borrowed money has a cost, an interest charge, whilst equity is
free, i.e. you would not charge yourself interest. Does this not, therefore,
increase the cost of debt over equity? The answer is no, not if the developer
is accounting for costs correctly. All money used in projects has an
opportunity cost, a cost equal to the highest opportunity with similar
characteristics forsaken in order to put the money into this project.
Simplistically, the opportunity cost of all funds used in a project should be
similar to the cost of money borrowed to carry out the project.

So debt in projects tends in theory to be good. There are down sides,

however, to gearing up. Firstly, debt does have to be serviced. Equity
returns do not have an immediate charge, the owner of the equity has to
wait. Lenders will not, they expect the debt to be serviced. Excessive debt
over a large development portfolio can drag down a company, particularly
when interest rates rise. Also gearing works in reverse. If the project does
not do as well as expected then equity destruction takes place much more
rapidly with gearing. This can be illustrated below:

100% equity finance

Total development costs f1,000,000
Completed development value €800,000
Return on equity -2O.0O0h
50% equity finance I 50% debt finance
Total development costs €1,000,000
Made up of
Debt €500,000
Equity €500,000
Completed development value €800,000
Repayment of debt €500,000
Surplus to repay equity and give profit f300.000
Return on equity -40.00%
 I

25% equity finance I 75% debt finance

Total development costs €1,000,000
Made up of
Debt €750,000
Equity €250,000

Completed development value €800,000

Repayment of debt f 750,000
Surplus to repay equity and give profit f 50,000

Return on equity -80.00%

Hence, gearing has its dangers. Lenders usually limit the extent to which
developers can swap equity for debt, as they prefer developers to have
some equity stake in a scheme for obvious reasons. If a scheme goes
wrong, a developer with no equity can walk away with no loss except the
chance of an opportunity to make a profit. Developers with equity are much
more likely to work hard to protect it.

A further attraction with long-term debt is tax relief on interest

3.2.5 Development finance in detail

(i) Project finance

This is the most common type of finance used by property companies of all
sizes though it is used particularly for individual projects and occasional or
new developers. It is provided from a number of different sources including
banks and specialist property financiers.

(a) Features

Project specific lending has many variants but there are some common
characteristics:

Finance is short term, only for the period of the project or

sometimes until the first rent review. This means that most loans
of this type are of a two- to three-year period, extending to seven
to eight years if funding continues to the first rent review. These
latter, longer arrangements usually occur when there is an option
with the lender to convert the loan from a development to an
investment loan. As noted, there is usually the need to
renegotiate the loans, due to the very different risk characteristics
of development projects and standing investments.
 152 1 Contemporary Property Development
There are a number of options regarding the security required by
lenders. Many loans are on non-recourse or a limited recourse
basis. With the former, the only security for the loans is the value
of the development itself. This is particularly attractive to smaller
developers who rarely have other sufficient assets to provide
security for lenders. It is also attractive to larger developers who
have stock market listings. Excessive borrowing that appears on
the balance sheet of these firms reduces the net asset value and
thus the share price. Such developers try to achieve lending 'off
balance sheet' by carrying out developments in subsidiary
companies, sometimes in partnership with their financiers.
Lending is limited to a proportion of the value of either the
completed development or of the predicted development costs.
With project finance this is usually the latter. Loans are available
up to around 70-80 per cent of the development cost.
Interest can be charged on any interest calculation period, for
example, daily, weekly or monthly, though the latter is the most
common.
The sum borrowed is usually not taken as a lump sum but is
drawn down from the lender as required. Most frequently this is
on a monthly basis to coincide with the stage payments made to
the construction team.
Interest can be payable on a regular basis but it is much more
common for interest to be 'rolled-up', i.e. added to the principal of
the loan as the project proceeds. This is a common pattern
because most developments do not produce any income to
service debt as the project proceeds. If the project is phased with
disposals during the course of the development then the loan

Total Finance Required €3 16,649.57

Interest rate per month 1%

I Month 2 3 4
~

Expenditure €100,000 €20,000 €30,000 f40.000 I

Interest f 1,000 €1,210 €1,522

Total Balance Owed €100,000 €121,000 f 152,210 f 193,732

 Finance and development 153

may be structured to see partial repayment of interest and/or

principal as cash is received.

The rolling-up of interest is illustrated below.

The interest rate charged on the loan depends on a number of

factors. Fundamentally it is the Bank of England base rate that
determines all domestic interest rates. The banks, in practice,
obtain their own money based on LIBOR, the London lnterbank
Offered Rate. The individual lenders will then add a premium to
LIBOR when lending, dependent on their assessment of the loan
risk. This will itself depend on factors such as the status of the
borrowers, their experience, track record and financial stability as
well as the characteristics of the property and the state of the
property market. Other factors include the availability of a buyer or
tenant for the completed project, and the competitiveness of the
lending market - banks are often keen to lend to property
because the level of returns available tend to be higher than from
other commercial loans.
The lenders will need to satisfy themselves about the viability of
the project before lending at all and will require the developer to
provide much of the evidence to convince them of this by proof of
market research, as well as recent lettings, market trends and
movements. The financial appraisal will be scrutinised very
carefully. This will include an examination of the rents and yields
used, an analysis of the void allowances and whether the profit
margin allowed is sufficient. The lenders may investigate the title,
planning consent and contamination issues. References from

~5 6 7 8 9 Totals
r

€40,000 €30,000 €20,000 €10,000 €10,000 €300,000

€1,937 €2,357 €2,680 €2,907 €3,036 €1 6,650

€235,669 €268,026f290,706p €303,613 €316,650 [ €316,650 I

 154 Contemporary Property Development

firms and persons of standing who have had experience of

working with the developers may be required.
Although it is most common for the site itself to act as security,
lenders may require more comfort from the developer by way of
personal guarantees and bonds. As additional security, banks
quite frequently require developers to pay for the bank's own
team of project experts to sit on the progress meetings of the
development. This team monitors progress and acts to safeguards
the lenders' investment. This enables early steps to be taken to
rescue projects that are running into difficulty.
Where the project is very large, the loan may be syndicated, i.e.
spread over a number of lenders by a lead bank or lender.

I (bl Variations

In some cases developers will seek and be able to cover all the costs of the
development from borrowing. This will normally require market conditions to
be buoyant. There are three main ways of achieving in excess of the normal
funding levels:

1. Mezzanine Finance.This is where lenders agree to close the gap in

funding by taking a higher level of risk. In return, they get a higher rate of
interest on the loan. Mezzanine finance is usually subservient to the
senior debt, i.e. the senior debt will have first call on any funds if, say, the
deve Iope r defa uIts.

r Developer's Profit

Mezzanine Finance
30% of cost at premium
Completed value (El ,200,000)

Total development
costs (E 1,000,000)

interest rate

Senior Debt
.................. Maximum conventional
loan at 70% of costs
(E700.000)
70% of development cost at
market rate of interest for
developments of similar risk
characteristics

2. Insurance. The additional money loaned is covered by an insurance

policy, the premium of which is paid by the developer.
 Finance and development I 155
Complctcd vnluc ( E l ,200,000)

Total development
costs (El,000,000)

interest rate Maximum conventional

I..................
loan at 70% of costs
Senior Debt (f700.000)
70% of development cost at
market rate of interest for
developments of similar risk
characteristics

3. Equity sharing arrangements. Here the lender becomes the partner of

the developer to share in the profits made by the scheme. The lender
frequently charges the market rate for the senior debt but lends 100 per
cent of the predicted cost of the scheme in exchange for a percentage of
the developer's profit. The actual detail of the arrangement depends upon
the status and bargaining strength of each party in each individual case
but normally one would expect the lender's profit share to have a degree
of guarantee with the developer still taking the risk of failure.

Completed value (E 1,200,000)

Total development
costs (~l,000,000)
Debt
100% of development cost
at market rate of interest for
developments of similar risk
characteristics
156 Contemporary Property Development

(ii) Project finance: sell on

A further option for short-term finance is connected with forward selling. A

variation of forward selling is forward funding where the long-term
investment owner, usually an institution, also provides development finance.

In these cases the development finance is provided at a lower rate than that
which can be obtained in the open lending market, at least if the developer
is forced to seek retail sources of debt. It is therefore a cheaper source of
finance to the developer. The developer also gets the security of an exit from
the scheme and the attraction to the investor is that they can usually
negotiate a lower price for the project. When these types of arrangements
work well they are advantageous for all parties but it must be noted that this
type of arrangement is only really suitable for institutional quality investment
properties that form a relatively small part of the market.

Over the next few pages an illustrative example is shown, using an outline
traditional development appraisal (covered in Part 4).

The first calculation is the initial market appraisal for the scheme. This is
carried out by the developer to test the viability of the project and to prepare
the case for forward funding from the institution. The appraisal illustrates a
surplus equivalent to a 20 per cent profit on cost.

AN OUTLINE APPRAISAL OF A COMMERCIAL DEVELOPMENT PROJECT

Initial appraisal assuming conventional market funding

Rental value €1,000,000.00

Year's purchase at investors desired initial yield 7% 14.286
€14,285,714.29
Less costs 6% -€808,625.34
Net value of investment €13,477,088.95
Net construction costs -€9,250,000.00
(Including all fees and sundry costs, including
land purchase)
Interest charges over development period a t
commercial rate 10% -€1,942,500.00
Profit (Loss) €2,284,588.95
Profit on cost to developer 20%

The second appraisal shows the variations as agreed in the funding

agreement.
 Finance and development 157

The fund has agreed to purchase the investment based upon a yield of 75
per cent, i.e. 0.5 per cent above the market rate of interest. The
development funding is then provided by the fund at a rate of 7.5 per cent
based upon the opportunity cost of money to the fund. In comparison with
the base appraisal this is considerably lower than the developer could
achieve in the market for funds.

New appraisal assuming forward funding deal with Investment fund

Rental value €1,000,000.00

Year’s purchase at investors desired initial yield 75% 13.333
€13,333,333.33
Less costs 6% -€754,716.98
Net value of investment €12,578,616.35
Net construction costs -€9,250,000.00
(Including all fees and sundry costs, including
land purchase)
Interest charges over development period at 75% -€1,439,531.25
commercial rate
Profit ( Loss1 €1,889,085.10
Profit on cost to developer 18%

The funds are drawn down from the fund as if it were a traditional bank-type
lender. The balancing payment, reflecting the profit, is not paid until the
building is let. The risk is usually transferred to the developer either by
requiring the developer to guarantee the rent until letting is achieved or else
by the erosion of the balancing payment by the continual accumulation of
interest on the drawn down funds.

These arrangements are carefully documented in the development funding

agreement. In particular, the funding institution is usually very careful
regarding who or what is an acceptable tenant to which the developer can
lease the building. It is normal practice to attach a draft lease to the funding
document as this forms the basis of the final lease document agreed with
the new tenant.

One major issue to deal with these types of arrangements is overage. This
is additional value over and above the base value in the agreement. This can
occur in rising markets where upward movements in rents and improving
investor sentiment can drive up prices.

In some circumstances all overage passes to the investor. This will occur
naturally where the agreement is silent regarding overage. The payments
158 Contemporary Property Development

s
a

t
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al
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al
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0
c,
c,
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sE
0
L c,
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6 2
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v)
a,
F
m
1
0
Y
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-

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 Finance and development I 159

stay the same and any increase in value is enjoyed by the investor who
acquires the asset a t a deeper discount than expected. It is, however, usual
to address this issue mainly to give the developer incentive to try to
maximise the value of the scheme. It is, after all, usually the responsibility of
the developer to find the tenants and agree the lease terms for the scheme.
Some reward for maximising the overage should exist.

The procedure normally followed is illustrated in the calculation opposite.

The example is based on the example above but here a rent of €1,100,000
has been achieved on the letting, i.e. €100,000 above the originally
appraised figure. The parties have agreed to split any overage 50/50. The
balancing payment is calculated as shown. The developer thus obtains an
extra payment of around €666,666 for achieving the higher rent. The investor
receives the full benefit of the increase in value of the asset.

3.2.6 Forward sale agreements

Forward sale agreements are very similar to forward funding arrangements

except, of course, for the provision of development finance. The purchaser
agrees to purchase the completed development a t some point in the future
at an agreed figure once the developer has met certain conditions. These
conditions include the satisfactory completion of the building and the leasing
of the building to an acceptable tenant on lease terms that are agreeable to
the funder. The investor usually has control over whom the building can be
let to.

There are numerous alternatives to this, including where the developer

guarantees the rent for a period after completion, thereby obtaining full sale
receipts from the investor on completion of the building. The developer has,
however, got the burden of meeting the rental payments over the period of
the rental guarantee until a suitable tenant is found.

These two alternatives are graphically illustrated below. The basics of the
deal, predicated on agreed rental and investment yield figures are agreed at
the time of the original funding deal. Any overage on rents is treated as per
the forward funding arrangement as detailed above.
 160 Contemporary Property Development

Base option: forward funding without rental guarantee

Project cash flows Project stages Timescales Funding
timescale
f-tive I f - ~ I- Forward funding deal

7B
signed with institutional
Land purchase 3 months investor, usually prior
to commitment to
Time 2: 12 months develop
?&

Completion Completion

Letting-up 12 months
period

On letting of the
building, the sale
completes and the
ownership of the
15-year building passes to the
lease fund
signed
with
occupier

I
Funding option: forward funding with rental guarantee

Project cash flows Project stages Timescales Funding

timescale
f -tive 1 f+ 4- Forward funding deal
signed with institutional
Land purchase investor, usually prior
to commitment to
Time I2 months develop

! I -
Completion

Letting-up
period
Completion

12 months

15-year
lease
signed
with
occupier
I-
On completion ofthe
building, the sale
completes and the
ownership ofthe
building passes to the
fund

During the
letting-upprid
the rem is paid
by the developer
 Finance and development 161

3.3 Retention financing

The next section, which examines finance in detail, covers the ways in
which developers can arrange funding to retain developments. We are
therefore examining the point where development funding moves from the
project finance stage to the long-term investment finance stage for smaller
developers. This section will also look at 'whole life' funding, as occurs most
commonly with larger investment. This requires corporate finance to be
introduced in addition to project finance. A number of options are available.

3.3.1 Mortgage finance

Mortgage finance, i.e. property-backed loans, is the traditional way of

obtaining finance to fund property, both in the residential and commercial
market. These types of instruments are mainly confined to the funding of
the completed standing investment but they can, with some funders, be
used for 'whole life' funding of the project.

There are two main types of mortgage: interest-only, and repayment or

amorticised. These vary according to the way the capital is repaid.

Example

Property value €1,000,000

Development costs €750,000
Rent produced €60,000 pa

Interest only mortgage - 25 years @ 8% (fixed or variable)

Borrower repays
f750.000 to
lender at year 25

f60.000 paid each year in interest to lender T

Lender pays
f750,OOO to
borrower to fund
purchase
 162 Contemporary Property Development I

With the interest-only mortgage, no principal is repaid on the loan during its I
course. The borrower merely pays interest on the loan, either at a fixed or I
variable rate of interest, a t regular intervals and then repays the loan a t one
step a t the completion of the loan.

Repayment mortgage - 25 years @ 8% (fixed or variable)

Repayment on f750,OOO mortgage a t eight per cent over 25 years works

out at f70,259 pa

f70,259 paid each year in interest and repayment to the lender

Lender pays
f750,000 I0
borrower to fund
~ purchase

With the repayment mortgage, both interest and the principal repayments
are made on the loan during its course. The borrower pays a single payment
either at a fixed or variable rate of interest, at regular intervals. The loan is
repaid by completion of the loan's term; therefore there is no balancing
payment at the end.

A repayment mortgage works in the following way:

Year 1
Balance owed f750.000
Interest a t 8% on balance f60,000
Capital repayment f 10,259
Total payment f70,259
Year 2
Balance owed f739.741
Interest at 8% on balance f 59,179
Capital repayment f 11,080
Total payment f70,259
Year 3
Balance owed f728.661
etc. ..
 Finance and development 163

This pattern of reducing the balance of the principal as the loan proceeds
means that in the early years of a mortgage very little principal is paid off.
The pattern is as follows:
f70,259
annual
payment

Principal

Interest

1 I
0 years 25 years

Repayment mortgages are more expensive on an annual basis than interest-

only mortgages.

Mortgages come in and out of fashion as a means of funding property. The

main reason for this is the characteristics of property as an investment.
Property yields, i.e. the relationship between income return and capital
value, are relatively low. This is particularly true at times of high inflation, as
property rents and thus capital values tend to rise in line with inflation,
making the asset a good inflation hedge. The potential for future growth
tends to be factored in by investors who pay higher prices to acquire the
investments, thus driving immediate income returns even lower. This
produces a strange paradox: property is generally a good inflation hedge yet
it is difficult to finance a purchase during inflationary times.

Let us use an example to illustrate this.

Investment 1: high street shop, inflation running at around 10% pa

Development costs €800,0000

Property value a t completion €1,000,000
Rent €60,000 pa
Yield Income yield 6% on value
(75% on development costs)

, With inflation running at these levels, bank-lending rates will be high. Bank
interest rates reflect inflation rates, as the banks are trying to ensure that
they get a 'real' return after inflation has been stripped out. In this sort of
environment, interest rates are likely to be in the 12-15 per cent range.
 164 Contemporary Property Development

With a 70 per cent Loan to Value ratio (LTV) the loan advanced will be
€700,000. This, of course, already indicates a shortfall on development
, costs. The annual debt service on the loan, on interest-only and repayment
basis respectively, at 14 per cent would be:

Interest-only loan €98,000 pa

Repayment loan €101,849 pa

This would create huge problems for securing the loan. Lenders usually
require that the income from the investment covers the annual repayment.
In these circumstances there is a very large shortfall.

Let us examine the situation that exists in a low inflationary environment.

Investment 2: high street shop, inflation running at around 2.5% pa

DeveIopment costs €800,0000

Property value at completion €1,000,000
Rent €60,000 pa
Yield Income yield 6% on value
(7.5% on development costs)

With inflation running at these levels, bank lending interest rates will be low.
In this sort of environment interest rates are likely to be in the five to six per
cent range, a level that will give the lender a similar 'real' interest rate to the
first situation after inflation has been allowed for.

With a 70 per cent LTV the loan advanced will again be €700,000. It is more
possible in this environment that lenders would extend this LTV ratio. The
annual debt service on the loan, on interest-only and repayment basis
respectively, at six per cent would be:

Interest-only loan €49,000 pa

Repayment loan €60,067 pa

The situation has very much changed. The interest-only loan annual payment
is easily serviced out of the rent. The deal is what is termed 'self-financing'.
This is almost true of the repayment loan too, indeed this very slight
shortfall would probably be acceptable to a lender.

Given this pattern, it will be no surprise to learn that mortgage finance was
the king of property deals in the 1950s and 60s which was the last era of
 Finance and development 165

low inflation prior to the current situation. This completely changed from the
1970s when inflation made such financing much more difficult. It was in this
era as well that the institutions and pension funds became major players in
the property markets, thus providing alternative sources of financing.
Mortgage finance was marginalised to the higher yielding end of the
property spectrum, particularly in the financing of secondary office and
industrial investments. It is possible that w e may have come full circle. The
economies of the developed world have seen a low inflationary environment
established since the early 1990s which seems to be sustainable. The
institutions and pension funds are less active in the investment markets,
holding lower percentages of property as part of their investment portfolios
due to the long-term performance of global equities. Interest rates are low,
therefore many more deals are self-financing. Mortgage finance may be the
future king.

There are, in any case, ways around both the shortfall in funding due to LTV
limitations and the low yield problem. As we have seen from the project
finance section, mezzanine finance and insurance backed extensions to the
primary loan can close the gap. The low yields of property can be offset by
clever structuring of loans to take into account the capital growth potential of
the asset.

There are a number of ways of achieving this. One way is to cap the initial
payment at or below the initial income, rolling up the debt shortfall and
adding it to the loan once the income level of the property has risen.
Let us use the same base example as w e have considered above, but now
w e will assume that w e have an 80 per cent LTV ratio and the interest rate
is seven per cent. We are assuming a slightly higher inflationary
environment. On a repayment basis, the annual debt service would be
€68,648 pa on a 25-year term. With the income a t €60,000 pa as before,
there would be a shortfall of €8,648 pa.

Most modern institutional quality leases have rent review clauses. This
allows a periodic increase in rents to the current market rental value. The
intervals between rent reviews vary, but most institutional leases have
reviews every five years. If rental growth in shop rents is at five per cent per
annum then the f60,000 initial rent will rise to around €76,500 per annum at
the start of year six. The lending pattern would then appear as follows:

Investment 3: high street shop, inflation running at around 5% pa

Development costs €800,0000

Property value a t completion €1,000,000
Rent €60,000 pa
 I
I
166 Contemporary Property Development I

Yield Income yield 6% on value

(75% on development costs)
Repayment loan 63 7% €68,648 pa
Repayment capped for 5 years to €60,000
Shortfall €8,648
Rolled-up value of shortfall
over 5 years €49,732

Adjustment after rent review

New rental income

(assuming 5% pa growth) €76,500

Amount of loan still outstanding at

end year 5 (assuming full payment) €727,258

Add: rolled-up shortfall f49,732

Actual amount of loan outstanding €776,989

Repayment on this total 63 7% on a

mortgage with 20 years of term left f 73.342

This now becomes the annual payment on the remainder of the loan -this
is easily covered by the new annual income. There is obviously a risk in this
to both parties, particularly as the success of the arrangement is dependent
upon property rents rising in line with expectations. These rises in incomes
are not guaranteed as they are determined by market factors, but historically
property rents have grown.

There are many other ways of tackling the low yield problem, in fact the
ways of achieving it are limited only by the ingenuity of developers,
surveyors, brokers and financiers. Other options include loans that are
generally interest only but have periodic repayments of capital, loans with
capital repayment holidays, balloon payments and loans with initially low
rates of interest a t the start balanced by rates that are above the market rate
later in the term. All achieve the same balancing act that match property
investment characteristics against the lending requirements of the financial
community.

3.3.2 Variations on lending

The financial markets have, naturally, become more sophisticated over time.
Many different types of instruments have become available and one
I
Finance and development 167

particular area of increasing sophistication is the removal of some of the

uncertainty about future interest rates. Most shorter-term loans are likely to
be at a floating or variable rate of interest. This exposes the borrower to the
risk of interest rate movements eroding the profit margin or creating cash
flow problems. A solution to this is to 'cap the loan' i.e. set a maximum limit
to the interest rate on the loan. This is achieved by taking out an insurance
type policy. There is a cost to this but uncertainty can be greatly reduced.
There are a number of variations on this, some aimed at reducing the cost
of the instrument such as limited or flexible caps, others aimed at providing
alternatives (hedging or 'swaps'). Developers concerned about future
interest rate movements should explore the options available with their
financial advisors.

3.3.3 Corporate finance

So far we have concentrated on the project or property-specific type of debt.

There are, of course, options that allow funding of development projects via
corporate funding, i.e. the funding of the company itself. This tends to be
limited to larger organisations with an established track record in
development and, often but not always, substantial assets to act as security
for loans. Smaller developers tend to be restricted to project finance.
Whatever the case, there is no doubt that a substantial proportion of
development in the UK is financed via corporate sources of funds.

The financing of companies falls into the same two types that we have
considered before: debt and equity. In practice, companies will attempt to
balance the two to achieve financial efficiency and it is therefore hard, in
reality, to consider them in isolation. In our case, we will look at debt and
equity sources of corporate finance separately, starting with debt.

3.3.4 Corporate debt

(i) Retail debt

Retail debt refers to those sources of finance that arise from borrowings
through financial intermediaries. The most obvious source of this is via the
company's own overdraft facilities through its own bank, or banks. This is
'normal' lending to the company and the banks will make decisions as to the
level of credit to be advanced based on their scrutiny of the quality of the
company itself. Banks lend against the security of the business, its ability to
earn profits and/or produce cash flow, as well as against the value of the
company's assets. These arrangements can be with the company's main
bank or else a syndicated loan facility arranged across a range of
organisations. Many large organisations have multi-option facilities allowing
 168 1 Contemporary Property Development
them to draw down funds as required. The loans may be open but are often
for a fixed period of time (one month, three months or perhaps up to five
years). Rather than being repaid on the date, the debt is continually serviced
then rolled over into a new loan.

The actual arrangements and operations of corporate debt finance are

complex and tend to spill over into the realms of corporate accountancy. The
detail is thus largely beyond the scope of this book.

(ii) Stock market debt

Stock market debt refers to instruments issued by companies that raise

finance, and can be traded on by the originator of the debt finance but,
unlike shares, do not give the owner ownership rights to the holder. These
instruments are debenture stock and loan stock issues. The distinction
between the two is that the former is secured on specific assets of the
company. By definition, this sort of finance is limited to larger companies
who have a stock market listing and a sufficiently good track record to attract
investors seeking a secure return. This source of finance can provide
property developers with a low cost source of long-term money, dependent,
of course, on market conditions.

Debenture stock is like a company loan. The company borrows money from
investors, usually for a fixed period of time, for example ten years. The
company pays the bondholder a coupon, an annual interest rate guaranteed
in the debenture certificate. At the end of the term of the loan, the entire
sum is repaid to the investor. The stock is often unsecured on any assets of
the company, though some floating charge can be made.

The parties involved in debenture issue are outlined in the example below.

There are a number of variants on these instruments. One of the most

common is the convertible bond or debenture. This instrument resembles a
conventional bond at its outset but there is an option, which can be
, operated by either the company or the debenture holder, to convert the debt
to ordinary shares in the company. This is normally done at a stated price or
price range and can be at a fixed date or at a floating point in the future.

The attraction to the borrower of this arrangement is that it saves the

company the need to repay cash. The share conversion is a paper
transaction without the need for a flow of funds out of the company. The
investor also gains the potential for sharing in the future growth in asset
value or profits of the firm, i.e. they move from a fixed interest security to a
growth stock. It should be noted that a convertible is only really acceptable
 Finance and development I 169

to the market where the company has a good track record and has good
long-term growth potential.

Debenture stock or loan stock has a lot going for it, but things can also go
wrong. Money can be borrowed in the long term at rates that at the time
look cheap. Market movements in interest rates, such as those that
occurred in the last decade of the twentieth century can make the money
look expensive and damage the returns of the company. Michael Brett,
Estates Gazette's finance guru illustrated the effects when examining the
property company Land Securities accounts on 5 June 1999:

The trouble comes when you look at the true value of Land
Securities' f1.59bn of gross debt. It includes various debentures
which are not due for repayment for more than 25 years, and were
raised at a time when a 10% coupon seemed to offer cheap long-
term funding. Judging by their price in the stock market, Land
Securities could raise the same money today at a cost of little over
6%. But it is committed to that 10% for the next 25 years and more.
Thus the market price of those debentures is way, way above their
face value. With the continuing fall in long-term bond yields, the 'fair
value' of Land Securities' non-convertible debt has risen by a further
f217m (an almost 11% increase) to f1.98bn against a face value
virtually unchanged at fl.3bn. Offset this f217m rise in the market
value of debt against the f333m revaluation surplus on its property
assets, and it is clear that much of the year's gain has, in reality,
been wiped out by events on the liabilities side.

Example: f lOOm conventional debenture issue for ten years paying a

coupon of 6%
Interest to bond holders
Issue bought in the open
1I 1 market an> placed with
clients of the merchant
Property Merchant bank bank. Each investor huys
a proportion of debt in
company 1 Fees
Site roccipir
return for 6% annual
Property income and [he repayment
. .
developer of the principal sum
advanced a1 the end of
year 10.

t I
Once issued, the stock
thcn flosts on the market
as a tradable asset whose
Receives f loOm price fluctuates with
in funds less fees general movement in
interest rates and denland
170 Contemporary Property Development

Variations on the corporate debt type of finance include commercial paper

and eurobonds. Commercial papers are short term lOUs issued by large
companies in return for loans from investors. They are usually issued at a
discount to their true value. The borrower pays no interest during the term of
the loan, which is generally for periods of less than one year. At the end of
the loan the borrower pays the lender the full face value of the loan, thus
giving the former a return on their funds.

For example, a borrower issues flOOm of commercial paper for 364 days,
receiving f 9 3 m from the lender. At the end of the term they pay the full
value of the loan, f 100m back to the lender. This gives a return of 7.526 per
cent to the lender.

Although this paper is short term, it can be used for long-term financing by
rolling over the loans into new ones at the end of the term.

The bond and eurobond market is another form of unsecured lending. They
are confined to being used by companies with excellent credit ratings and
are used to raise large amounts of capital. Eurobonds are usually sold
outside the borrower's own country. They are similar to debentures and loan
stock in that they are certificates that promise to repay a debt of a fixed
amount at a date in the future and rely on the trading and credit record of
the underlying company to reassure lenders that the loan will be repaid.

3.3.5 Equity funding

In this context equity funding refers to the money raised by the company
itself that is part of the assets of the corporation. It is effectively the
company's own money as opposed to borrowed money. People who own
shares in a company are sharing in the ownership of the company, they are
not lending it money. This is why shares are referred to as equities. The
fundamental value of the company arises out of its share capital. Hopefully,
this value will grow as the company trades and makes profits. Shareholders
share in that growth.

Essentially, there are two types of organisations involved in the corporate

side of development in the UK: Private Limited Companies and Public
Limited Companies. Private companies cannot sell their shares to the
general public. PLCs have the option to make public share issues and thus
raise considerable funds but not all PLCs choose to follow this route as
certainly many of the larger firms do so. We will examine this route in
slightly more detail.

A company can have its shares traded on the stock market in one of three
ways. An 'introduction' is when it already has a large number of
 Finance and development 171

shareholders and is not seeking to raise fresh capital. It simply seeks

permission for the shares to be dealt in on the market. The second method
is a 'placing'. Shares are sold privately to a range of investors and
permission for them to be traded on the market is obtained a t the same
time. Only investors who are existing clients of the proposer, a broker or
merchant bank are likely to be involved. The third method, which gives the
public at large an opportunity to apply for shares, is the 'offer for sale'. A
prospectus and application form (or an invitation to apply for them) are
publicised by brokers or banks. Normally the shares are offered for sale at a
fixed price, which is calculated by the sponsoring broker or bank by
reference to the prices for shares of comparable companies that are already
traded on the market.

Companies can launch either on the Stock Exchange itself (the 'main
market', in which case they are described as being 'listed'), or on the
Unlisted Securities Market or USM (in which case the shares are generally
described as being 'quoted' on the USM). Trading procedures are much the
same in the t w o markets, both of which are run under the Stock Exchange
aegis. The main difference is that a lower level of trading record and listing
requirements are acceptable for the USM. It is also possible to float a
smaller amount of the capital on the USM than the main market, and
flotation costs may be somewhat lower.

An initial flotation can thus raise considerable funds for a developer. The
developer can issue shares representing a proportion of the company to the
market whilst retaining control of the remainder of the equity. Further funds
can be obtained by further issues of stock, for example by way of a rights
issue to current shareholders. Stock market listing is, however, relatively
expensive and requires a good trading record over a long period before it
can be even entertained. A public company also has less freedom in its
actions as it is being monitored constantly by both analysts and its
shareholders. Ultimately, the management of the firm may be changed by
action of the shareholders. Listing does, however, open up many more
opportunities for funding, for example the issue of debenture stock as
I outlined above.
I
There are a number of different types of shares, the most common being
ordinary shares and preference shares, the latter receiving preference for the
receipt of dividends but having limited, if any, voting rights in the company.

3.3.6 Other options

Other corporate type funding routes explored include securitisation.

Securitisation has been a holy grail for property financing over the last 25
172 Contemporary Property Development

years or so but, in the UK at least, has largely failed to be achieved. Property

has a number of disadvantages as an asset, particularly that it comes in large
lumps and is illiquid. Also there are tax disadvantages in holding property
indirectly. Securitisation is viewed as a solution to this. Securitisation or
unitisation involves the dividing up of the underlying property asset into
tradable shares which would be floated on the market and which would be
treated like any other share for tax purposes. An alternative approach is to
create a unit trust approach but based around a single investment.

Various vehicles have been tried (Property Income Certificates (PINCs),

Single Property Ownerships Trusts (SPOTS)and Single Asset Property
Companies (SAPCOS))but all have run into problems regarding taxation
transparency and/or legal problems. In contrast, in the US Real Estate
Investment Trusts (REITs), a tax efficient vehicle that largely achieves the
goals of securitisation, have been very successful. To date, securitisation in
the UK remains a holy grail, and one that the market is not sure is really
wanted.

3.3.7 Part disposal options

It may seem odd that this section includes what is, in many ways, a
procurement option for development rather than a financing route per se.
However, one of the main motives for entering into an equity sharing deal or
partnership is often financial. It is inevitable that there should be some
blurring of the division between financing the development and how it is
executed.

There are a number of different ways of either achieving part disposal or

involving shared ownership of the benefits that flow from the scheme.
These are:

'True' joint ventures These are situations where the parties I

genuinely enter into the scheme together to I
carry it out. Risk and expertise are shared
(not always equally) between the parties in
some respect.
I
Ground rents or building In this situation, common where a local
leases authority is involved, one party brings only ~

the land to the deal. The developer takes on

the risk of completing the scheme, usually
receiving a long lease on the property
(99-150years for example). The local authority
shares in the investment performance in the ,
long term via a ground rent.
 Finance and development I 173

Lending with participation Equity sharing loans as discussed in the

section above and detailed below.
Sale and leasebacks Sale and leasebacks exploit the fact that a
number of different interests can be created
out of property. Developers can retain an
interest in a scheme by selling on the
freehold interest in a property but taking a
lease from the freeholder at a rent that is a
proportion of the market rental value. There
are a number of ways of setting up these
arrangements, some of which will be
reviewed below.
Forward funding A combination of forward funding
arrangements with and sale and leasebacks.
leaseback

Developers are quite frequently in situations where they need a partner to

complete a scheme successfully. The reasons why these situations occur
are many, including where the partner possesses a key component for the
development, such as the ownership of part or all of the site, or where a
partner possesses specialist expertise either in a technical aspect or in a
particular sector of the market, or that the financial resources of the
developer are insufficient to undertake the development alone. Often a
combination of reasons contribute to the arrangements coming to pass,
though there is little doubt that finance questions are usually central.

There are a number of parties that enter into relationships with developers.
These include local authorities, property investment companies, institutions
and banks. Of the different types of arrangement there is one that tends
to be more closely associated with financing rather than any other motive
for entering into the partnership arrangement. This is equity sharing, and
will be considered below, separately from other joint ventures and
partnerships.

3.3.8 Equity sharing

Equity sharing is an extension of the bank lending arrangement. It is

concerned with situations where a developer has a shortfall in funding a
scheme through traditional debt. The arrangements have been outlined in
the section above. Usually the bank and the developer form a joint venture
company that shares in the rewards of the development. The bank has the
opportunity to gain a return in excess of the normal margin that would be
obtained from lending. Most banks do not have the practical experience and
knowledge to become involved with development so, for a relatively small
174 I Contemporary Property Development

extension of their financial commitment, are able to enter into the

deveIop m ent market .

Equity sharing schemes can be simple, involving the developer and one
bank. They can also be intensely complex, with many banks involved in the
scheme lending different amounts with varying levels of risk, and with some
of the financiers acting as true joint venture partners in the scheme. Below
is a diagram illustrating the financing arrangement for a major scheme
carried out in the UK in the mid 1990s. The listed property company was the
initiating developer. It entered into a joint venture agreement with a major
UK PLC and an international bank that both became equal equity partners
and who therefore shared the profits and benefits that flowed from the
scheme. The bank in the partnership used its financial expertise to arrange a
consortium of banks to provide the debt finance for the scheme, both in
terms of senior debt but also a degree of mezzanine finance. The UK PLC
took some of the space in the scheme. The joint venture partners formed a
limited life joint venture body to carry out the scheme; thus they were a
distinct legal entity from their parent organisations. This is typical of joint
venture schemes.

The example illustrates some of the complexity that can exist in these
relationships and also how there is blurring both between the types of
financing arrangement (here between equity sharing/participation loans and
joint ventures) and between finance and the mode of execution of the
development .

UK plc Listed Property Major Bank 1

Cornpany
f25m equity f25m equity f25m equity

Major Bank 2 f15m of mezzanine debt

3.3.9
Major Bank 3

Share in f80m
of senior debt l-Major Bank 4

Share in f80m
of senior debt

Joint ventures and partnerships

Major Bank 5

Share in f80m
of senior debt

Partnerships and true joint ventures can be defined simply as where two or
more organisations come together to carry out a development project. As
noted above, there are a number of different motives for entering into such
arrangements and also a number of different parties who become involved.
 Finance and development I 175

Examples of partnerships include:

LocaI author it ies/p r ivate deveIope rs

Financial institutions and private developers
Banks and private developers
Government and private developers
Property investment companies and private developers
Property companies and property companies
Owner occupiers and private developers
Private developers and private developers

The motives for entering into joint ventures are varied and they often
depend upon the identity of the parties involved. Local authorities enter into
joint ventures to achieve goals within their remit such as urban regeneration
or the encouragement of economic activity by linking with the
entrepreneurial qualities and skills of the private sector. Traditionally this was
done on a development lease/ground rent type of arrangement but
increasingly the trend has been towards more direct involvement by the
public sector body.

Joint ventures can occur with purely private sector bodies and companies.
Again, the motives can vary. It may be that the joint venture is formed to
spread the risk from a large scheme. It may be to bring in specialist skill and
knowledge, such as the financial acumen and links as per the example given
above, or between parties such as landowner, developer and building
contractor.

Whatever the arrangement there are some common features that exist with
joint venture arrangements:

They are often formed to carry out a specific project. They usually
have a limited lifespan and it is usually necessary to define how
the arrangement will come to an end.
There are two vehicles used for joint venture projects: limited
companies and partnerships. The choice depends upon a number
of factors, including:
- the taxation position of the parties;
- the timescale of the development;
- the number of participants;
- the method of financing used.
The limited company joint venture vehicle has a number of
advantages for development projects but also has at least one
significant disadvantage. The advantages include:
- a structure that is familiar and thus is well understood by
176 Contemporary Property Development

both the parties involved, as well as their advisors and third

parties to the scheme;
- a vehicle that offers limited liability in case of failure to all
of the parties involved;
- a particularly useful vehicle where there are large
numbers of parties involved in the development; indeed
where there are in excess of 20 members in the venture,
it is the only possible vehicle that can be used under
current UK law;
- a vehicle that is adaptable as the project proceeds, with
the ability to shrink and contract and also, potentially, to be
converted into a securitised single asset property company
vehicle at the end;
- a vehicle that enables non-recourse and limited recourse
financing to occur.
The major disadvantage is related to tax. This vehicle is not 'tax
transparent', meaning that the company vehicle would be liable
for corporation tax whilst dividends on the shareholding would
also be taxed.
Partnerships or, to use the current term in vogue, Limited
Partnerships (LPs) and Limited Liability Partnerships (LLPs)
have become a popular way of owning property. There are a
number of reasons for the existence of these vehicles and
why they have become more popular as a means of Joint
Venturing (JV). As with all types of JVs, limited partnerships
enable investors to participate in ventures that might
otherwise be too large, complex or risky. Investors in a
limited partnership do not own the property itself, they own
a share in the limited partnership. The second main advantage
is tax: a limited partnership is not, in law, a separate entity.
There is no tax on capital gains or income payable at the .
partnership level. Each partner is solely responsible for their
own tax on such income and for the tax on their share of
any capital gains. This can be compared with the profits of
a joint venture company which are taxed in the hands of the
company and then potentially again on payment to the
shareholders.
This reflects some of the fundamental problems of property
as an investment. One of the fundamental problems is that
property is illiquid. It cannot be split up and traded like an equity
share in a company. Similarly, there are taxation problems with
owning property indirectly. The UK industry has looked for some
time with envy towards the US with its Real Estate Investment
Trusts (REITs) which allow liquidity, trading and tax transparency
 Finance and development 177

but so far the UK treasury has yet to be convinced to make the

changes to allow RElT type investments in the UK.
The basic features of the vehicles are as follows:
- They are a special type of partnership, originally established
under the Limited Partnerships Act 1907. At least one
partner, called the general partner, must have unlimited
liability, but others will have their liability limited by the
amount of capital they have contributed to the partnership.
- LLPs must be registered at Companies House, which will
issue them with a certificate of registration. In that sense
they are treated like companies, although they do not have
the same regime as under the Companies Acts. The key
feature to be remembered with LLPs is that they are not
legal entities. Like general partnerships, LLPs are simply a
group of individuals or corporations who are acting together
for a particular purpose. In this case this is the investment in
and development of property.
- LPs have limitations (for example, they are limited to 20
parties). A limited partner may not take part in the
management of the partnership. So the management will
usually be undertaken by the general partner. The interest
held is not easily saleable - for example, they cannot be
listed on the stock market.
- The general rule is that the partnership must consist of one
or more 'limited partners', who are liable only up to the
amount of the capital sum or value of the property
contributed by them to the partnership; and one or more
'general partners', who are liable for all the partnership's
debts. A limited partner is very much like a shareholder in a
limited company - neither risks more than the value of their
investment. However, general partners can also protect
themselves by becoming a limited company, thereby
shielding its shareholders from unlimited liability. Even
though LPs cannot exceed 20 people, it is possible to create
sub-funds to allow many more to invest and to adjust
existing shares if new partners are admitted a t a later date.
They are usually established for a finite term, often seven or
eight years (to reflect the period over which the parties
expect to realise their objectives). However, they can also be
constituted so as to continue indefinitely, or so that their
lifespan can be extended, automatically or by agreement.
They have been a number of moves to extend the characteristics
of limited partnerships, reducing some of the restrictions and
changing the tax rules to make them more flexible and attractive
I
178 Contemporary Property Development

vehicles for both property investment and development. To date,

these changes have not met the approval of the UK Government
who in successive budgets have failed to implement the
necessary legislative and fiscal changes.
Joint ventures have to be very carefully documented to ensure
that the development proceeds smoothly. This is done by way of
the participants’ agreement. This agreement must detail a number
of different aspects of the progression of the development
including:
- the functions of each member of the partnership or
company;
- the responsibilities of the day-to-day management of the
project;
- how strategic decisions should be reached;
- consultation arrangements;
- rights of veto;
- arbitration procedures;
- the timescales of the development;
- the exit strategies of the parties, including whether the
long-term ownership of the development should pass to one
or more of the parties of the agreement and under what
terms.
A ‘Texas agreement’ detailing the process that should be followed
if the parties want to terminate the agreement early.

3.3.10 Other financing options

There are a number of other options for raising the finance for property
development. These tend to be used in special procurement arrangements,
such as PFI and PPP procurement, or to provide top-up funding for
schemes, such as those provided by grant funds.

These are major topic areas in their own right and will only be explored in
outline here.

(i) PFI

PFI is not strictly a source of finance for developers. It is a procurement

route created by governments, chosen for its ability to potentially save
money but in particular to avoid making large-scale public expenditure and
thus increasing the Public Sector Borrowing Requirement (PSBR).

The private finance initiative was launched by the Conservative Government

in the early 199Os, its principle feature being that facilities such as
 Finance and development 179

government buildings, hospitals and prisons, amongst others, would no

longer be procured, built and financed by the Government directly but by the
relevant private sector providing the facility. The provision would include the
design, construction and financing of the facility and often the management
and provision of services over a fixed period (often between 15 to 25 years).
The public body requiring the space would then pay an annual fee to the
provider for the provision of the specified service over this period, thus
saving the need to pay for the capital provision and maintenance of the
asset.

PFI and PPP projects have continued under the Labour administration,
indeed they have increased apace. They now form a significant proportion of
public projects and expenditure and this trend seems set to continue. This
type of procurement is of limited relevance to the consideration of finance in
mainstream development.

(id Grants

Public sector grants have long been available to developers in certain areas.
They are an important tool of governments for regeneration and the
encouragement of economic growth. For around 20 years in the UK,
regeneration of economically disadvantaged areas has been property and
infrastructure led, thus grants have been specifically targeted at
development and widely used by both developers and development
agencies to complete projects. The current trend is to move away from the
support of physical projects towards the support of the community
concerned itself. This is achieved by programmes of education and training
and small enterprise support. Notwithstanding this change of emphasis,
grants are likely to remain significant to developers in disadvantaged areas
for the foreseeable future.

The principle followed by the grant regime is that public sector money
should be used efficiently to 'lever' private sector money and to enable
development. Public sector bodies administrating programmes often had -
and have - lending criteria that require them to achieve a certain ratio of
private to public money before aid can be approved. This may be four
units of private money to one unit of public grant aid. Usually these criteria
go hand-in-hand with other requirements, such as the creation of
employ ment .

The basic problem with development in disadvantaged areas such as inner

cities is that the revenues produced are often not high enough to make
development profitable. An example is shown below using a simplified
deve Iopme nt a ppra i sa I.
180 I Contemporary Property Development
Inner city commercial project: no grant funding

Income € 100,000

Year’s purchase Q investment yield 10% 10

Completed value € 1,000,000

Less

Development costs

Construction
Area 1,000m2

Unit cost €600 €600,000

Fees, etc €1 50,000

Finance €75,000

Land cost €100,000 € 925,000

Surplus € 75,000

Profit on cost 8.11 %

Profit on value 750%

An inner city project of a mixed-use commercial building is planned for an

economically disadvantaged area. The initial appraisal, below, shows that the
project is just profitable, but that the profit margin is too small to give an
adequate return to the developer, who can obtain a 20 per cent return by
developing elsewhere.

The reason for the shortfall is the combination of income (rent) and
investment yield. The tenants in this area cannot pay high rents and still
trade profitably. Investors recognise that the traders are not of a high quality,
therefore there is an increased risk of tenant default. In addition, the
investment growth potential is limited.
 Finance and development 181

inner city commercial project: with grant funding

Income € 100,000

Year's purchase @ investment yield 10% 10

Completed value f 1,000,000

Add: public sector grant € 110,000
€ 1,110,000
Less

Development costs

Construction
Area 1,000m2
Unit cost €600 f600,OOO
Fees, etc €150,000

Finance €75,000

Land cost €100,000 € 925,000

Surplus € 185,000

Profit on cost 20.00%

Profit on value 18.50%

I Private/public sector finance ratio 8.4090909 I

Without some kind of intervention the project will not go ahead and
economic regeneration will be restricted. However, with a grant of €110,000
paid to the developer, the profit margin is increased to an acceptable level
and the scheme can proceed.

In this case, the granting body has achieved €925,000 of private sector
investment for only €110,000 of public funds. It is this efficient use of funds
that most bodies try to achieve.

There are a large number of granting authorities and sources of public grant
aid. In the UK a first port of call is the Department for Environment, Food
182 Contemporary Property Development

and Rural Affairs (DEFRA) which administers many of the grants. The
European Union also is a major source of grant aid. Both the UK and EU
identify certain areas for assistance. In the EU case this is based on target
regions that fall at a certain level of average GDP of the EU as a whole. The
highest level of assistance is given to regions that fall into 'Objective 1'
status, meaning that they are identified as having a very low per capita GDP
The objective set by the EU is to raise per capita GDP towards the EU
average. The UK government also identifies towns and regions requiring
special assistance. A notable recent example is the former coalfields which
received assistance under the 'Coalfields Challenge' programme. Another
programme is the 'City Challenge'. Both are competitive bidding
programmes usually involving public/private partnerships to obtain a five year
rolling programme of central government funds for regeneration
programmes.

The funding regime is rather complex and frequently changes. Recent

initiatives include the development of the Regional Development Agencies
for England (RDAs) who have taken over many of the roles of the former
agency for regeneration, English Partnerships (EP). Rather confusingly, EP
has continued to act but in a rather changed role. In Wales, the Welsh
Development Agency controls some grant funding whilst in Scotland the
Scottish Development Agency and the Highlands and Islands Development
Board fulfil similar roles, and have done so for many years. Regeneration and
economic development have many political aspects and new initiatives are
very common. Developers are well advised to keep up to date on the
current situation.

3.4 Risk reduction and finance

It seems appropriate at this point to consider risk and financing decisions.
There are a number of aspects of risk in development but the one that is the
most common concern of developers is financial risk.
The major risks concerned with finance are as follows:

interest rate fluctuations;

project over-runs ;
withdrawal of support by lender;
incorrect forecasting of future values or cash flows.

Only with interest rates can anything be done at the beginning of the loan to
mitigate the risks involved. The other three areas of risk tend to arise from
either changing market conditions over the life of a project, failure to carry
out the project appraisal correctly, or the ability to be realistic in the
 Finance and development I 183

assumptions made. Some precautions can be taken when setting up the

finance, at least by the larger developers. This basically involves engineering
flexibility into the financing facility, both in terms of the length of time that
finance is required and also in the sources of finance. Usually, however,
problems such as these require a measure of renegotiation, refinancing and
rescheduling of debt, as well as flexibility of the financiers involved.

The sheer scale of large projects tends to give their developers a big
advantage over their financiers who simply cannot countenance failure.
Examination of projects such as the Channel Tunnel, the Millennium Dome
and Euro Disney (all of which suffered from grossly over-optimistic
assessments of cash-flow and underestimates of operating costs) show that
the projects were all in such serious trouble that they should have failed and
the financiers foreclosed. Instead, the consequences of failure led to each of
these projects being refinanced on very generous terms. This generosity by
banks does not usually extend to a small developer who defaults on their
loan; hence, the fundamental financial risk mitigation measure for this type
of body is to ensure that the appraisal is realistic!

Interest rate fluctuations are a feature of finance. Interest rates are not
constant. Fundamentally, market interest rates vary in the financial markets
on a minute-by-minute basis although the Bank of England Minimum
Lending Rate (MLR) is more stable. Even so, over the space of only a few
months interest rates can change quite markedly, particularly as many
governments use interest rates as the principle tool of macroeconomic
management and manipulation.

Interest rate changes lead to unbudgeted cost increases. This is illustrated

below:

Interest
rate % I
.................................... ................................ ............................ .... .......................................

Actual interest
Expccted intcrest
ratcs over life of
rate
projcct

Time

The effect on the project depends upon a number of factors including the
relative level of debt and timing issues. Some projects are highly sensitive to
interest rate changes, others are less heavily affected (see the section on
I
184 I Contemporary Property Development
financial appraisal that discusses project sensitivity). In this case, it would
seem obvious that expenditure on the project as a whole would be higher
than initially anticipated.

1\
-
Actual
e of exvenditure over
life of project

Time

Both the risk of and the effect of fluctuations in interest rates can be
mitigated against when the project finance is set up. There are a number of
ways of achieving this and these are discussed herewith.

3.4.1 Fixed rate loans

Fixed rate loans are the simplest way of avoiding interest rate movements.
This is a good route if either the project’s profitability is rather sensitive to
interest rate movements or if certainty on this element of future cash flow is
required. It is also one of the only hedging routes available to the smaller
developer.

There are, however, a few problems with regard to fixed interest loans.
Firstly, they are not always available. Financiers have to cover their own
commitments and the cost of money to customers is closely related to the
cost of money to the bank or lender. In times of financial volatility when
there is a risk of general interest rates moving upwards, lenders will be
reluctant to lend at low rates of interest. They will, however, be more than
willing to fix rates if there is a risk of rates moving down! It must be
remembered that banks and financiers are in the business of making profits
and will lend on the terms that are most advantageous to them rather than
the borrower.

The problem is guessing which way market rates are going to move. The
borrower can be left with fixing rates at the wrong time. The author is aware
of a university who financed stage one of a conference centre development
using variable rate finance. Interest rates then proceeded to move from
around nine per cent to 14 per cent very quickly and maintained those levels
over the next 18 months. Having suffered this painful lesson, the university
secured fixed rate finance a t around 13 per cent for phase two. Market
 Finance and development 1 185
interest rates promptly fell to six per cent! Although this looks like dreadful
decision making, the university in question was just terribly unlucky but
these things can and do happen.

3.4.2 Derivative-backed hedging

One way of avoiding this risk is to use derivative-backed hedging.

Derivatives are financial instruments that allow the borrower to take the
alternative financial position to that which will cost them the most. The
return from this alternative position balances the increased cost. Derivatives
are based upon futures and options and if the future is uncertain, people in
the market place will have differing views. For every person who thinks that
interest rates in a year's time will be higher than today, there will be some
who think that they will be lower. In simplistic terms, futures markets bring
those two sides together with one party effectively betting against the other,
buying and selling contracts that give the opposite view.

In the context of interest rate hedging, for example, if a borrower was

concerned about the possibility of interest rate rises he would arrange a loan
that would include, for a fee, a derivative that would pay out a sum that
would give a payment equivalent to the cost of the interest rate rise. This
would be achieved by the lender taking out a contract or giving an option to a
third party in the derivative markets that pays out on the contrary situation
occurring.

These types of derivative backed loans include:

Swaps: this fixes the interest rate as per a fixed interest loan. It has
the attraction of fixed interests with usually no upfront premium and
the borrower seeing no benefit from falling rates.
Collar: here the loan interest rate is restricted to a known maximum
and minimum cost.
Caps: these give a known maximum cost.

There are many other options including captions, caplets, limited caps and
flexible caps.

3.5 Taxation
3.5.1 Introduction: tax and development

Finally, in this section on money and finance, it is important to consider the

government's intervention by way of the tax system. In the past the
186 Contemporary Property Development

government has gone so far as to nationalise development land, taking all

but a reasonable return in tax. (This was done in 1947 under the original
post-war Town and Country Planning Act and again under the Community
Land Act 1975.)The Government now contents itself with using the general
tax system to deal with the property markets.

As is well known, tax is one of the two certainties in life. It is also one of the
most complex of subjects. The system in the UK is labyrinthine. The rates,
rules and regulations are subject to a regular changes. Although the basic
taxes have remained the same in the UK since 1973, tax regulations change
regularly. These changes can cause a complete alteration in the character of
taxes even though the name and the basic method of calculation stays the
same. An illustration of this is capital gains tax which was a significant factor
to developers and investors in the 1970s and early 80s. The basic principles
of the tax remain the same but changes in the rates levied and in allowances
given reduced its impact and completely altered the tax strategy followed by
investors and developers.

The topic has been introduced in this way to illustrate some of the problems
in dealing with taxation through the medium of a book. A comprehensive
review would require a considerable amount of detail and there is a risk that
it would be rather inaccessible to the reader. There is also a risk that
changes in the regulations and rules would rapidly cause the information to
be out of date.

What has been attempted here, instead, is a simple and hopefully

understandable review of the major taxes in UK and illustrations of how they
could affect investors and developers. This basic information should form the
basis of future investigations by developers into the detail of the system
operating at the time, and also an evaluation of how the specific
development is impacted by tax. All parties involved are urged to take
professional tax advice prior to the commencement of the project and also
during the financial appraisal.

A further point to note is that tax is not just about payment, there are gains
to be made in certain aspects of work. Essentially these are not repayments
to the recipient but they are reductions in tax liability allowed by the
government. This is not down to the charity of the government but instead
an illustration of how tax can be used to achieved certain aims. For example,
capital allowances for industrial buildings allow their owners and developers
to offset tax by way of a depreciation allowance. This is done to encourage
the development of industrial buildings which are often the least attractive of
property development mediums. Similarly, one hundred per cent of capital
allowances were allowed against the construction of buildings in enterprise
 Finance and development I 187

zones. This was to encourage the regeneration of deprived urban areas. In

this respect, the UKTreasury uses the tax regime far less firmly than other
nations - for example, the United States and Australia - t o achieve the
desired end. However, the tax benefits from these initiatives are worth
having and are usually worth investigating by developers.

3.5.2 Taxes that may be encountered by developers

A large number of taxes may be encountered by developers. These fall into

two main categories (although there is an overlap between the two).

The first category is taxes on the developer or investor as an individual or

company. These include income tax, corporation tax, inheritance tax and
capital gains tax (although this is also strongly related to the second
category). The development can contribute to the earnings taxed under the
systems either by way of profit (corporation tax and capital gains) or income
(corporation tax and income tax).

The second category is those taxes more closely related to the development
itself, i.e. the property. These include stamp duty, value added tax (VAT) and
business rates or council tax.

Each will be briefly outlined below.

(i) Capital gains tax (CGT)

Capital gains tax is a tax on the change in value of capital assets. It thus has
a potentially great effect on property, a major capital asset subject to
increases in value over time (property is usually taken as a good hedge
against inflation as the value of the asset moves at least in line with general
inflation) as well as being subject to development and thus the release of
latent value. In fact, the way in which the tax is calculated greatly reduces
the impact of the tax.

The amount of CGT due is based on the gains made on disposals of assets
and capital sums received from assets in the tax year. The amount
chargeable to CGT can be worked out, as follows, in a table extracted from
the UK Treasury's own guidance documents:

Disposal proceeds After allowing for reliefs which

or reduce the figure to be treated as
sum received from assets proceeds.
Sometimes market value is used
instead of the actual proceeds.
 I

188 Contemporary Property Development

Less Allowable costs

Gain before indexation If this is a negative number, then
I you have made a loss, which may
be an allowable loss.
Less Indexation allowance For inflation, up to April 1998; may
not create or increase a loss.
Indexed Gain
Less Other reliefs Reliefs other than taper relief which
reduce or defer a gain.
Chargeable gain For each asset individually.
Sum Total chargeable gains Total of all the chargeable gains in
the tax year.
Less Allowable losses Losses in the tax year and unused
losses carried forward from earlier
years.
Chargeable gains after losses
Less Taper relief A relief that reduces a chargeable
gain after losses according to how
long you held the asset. Taper relief
is applied separately to each
chargeable gain.

I
Tapered chargeable gains
Less Annual exempt amount f7500 for the tax year 2001-02.
Amount chargeable to CGT

A few notes are required to explain the calculation of CGT This tax is only
charged on realised gains, the difference between what an asset was
bought at and what it was sold at. You are, however, permitted to take into
account allowable expenses, such as development expenditure. You can also
take into account the effect of inflation using the indexation allowance. This
uses a table of inflation covering the period from March 1982 to April 1998
(see treasury figures, below) and has the effect of stripping out the impact
of general inflation on the change in asset values in the tax calculation, a t
least up to April 1998. The Government stopped indexation after this date to
increase the tax take from CGT Although inflation is low a t present, this
could significantly change tax strategies in the future. Whatever the case,
only 'real' growth in the asset value is taxed. Additionally, gains made in one
area can be offset against losses made in another part of the business. The
tax payer is also allowed 'taper relief' which encourages assets to be held
over a long period by progressively reducing the tax paid over time. The rules
as they exist for the 2000-01 and 2001-02 tax years are outlined below:
 Finance and development 189

Capital gains tax annual exempt amount 2000-01 (f) 2001-02 (f)
Individuals, etc* 7,200 7,500

Other trustees 3,600 3,750

[ * Individuals, trustees of settlements for the disabled, and personal
representatives of the estate of a deceased person.]

The amount chargeable to CGT is added onto the top of income liable to
income tax for individuals and is charged to CGT at these rates:

below the starting rate limit a t ten per cent;

between the starting rate and basic rate limits at 20 per cent;
and above the basic rate limit at 40 per cent.

Indexation allowance

I The indexation allowance for corporation tax on chargeable gains is

published monthly in the form of press releases.

Individuals and others within the charge to,capital gains tax are not entitled
to indexation allowance for any period after April 1998. To calculate
indexation allowance up to April 1998 on disposals on or after 6 April 1998,
use Figure 29.

You work out the indexation allowance by multiplying the amount you spent
by the indexation factor.

The net effect of this is to greatly reduce the tax consequences of CGT. This
may change in future and the tax may return to being more significant to
developers and investors.

I (ii) Income tax

I
I Income tax is a tax that most individuals are familiar with. It is a tax on
income (as opposed to capital) received during the tax year. Income from
property such as rents to an individual are taxable as are profits on trading
properties (i.e. on properties that were bought to trade on), so a developed
property owned by an individual would produce a tax liability. The distinction
between trading and investment properties used to be significant when CGT
was taxed a t a higher rate than income but there is no such distinction now.
There are fairly complex rules about allowances and the treatment of various
sorts of income (for example, income from overseas properties and the
treatment of rental incentives and service charges) that an
190 I Contemporary Property Development

00000 0 0 0 0 0 0 0 0 0 0 0

00000000000

00000

0 0 0 0 0 00000000000

00000

000000000000

0000
 Finance and development 191

Income tax allowances 2000-01 2001-02

(f) (f)

Personal allowance 4,385 4,535

Personal allowance for people aged 65-74 5,790 5,990

Personal allowance for people aged 75 6,050 6,260

and over

Income limit for age-related allowances 17,000 17,600

Married couple's allowance for people born 5,185 5,365

before 6 April 1935

Married couple's allowance - aged 75 or more 5,255 5,435

Minimum amount of married couple's 2,000 2,070

a IIowance

Children's tax credit - 5,200

Blind person's allowance 1,400 1,450

Figure 30: Income tax allowances (Source: UK Treasury)

investor/developer should investigate for the current rules. The 2001 UK

treasury allowances and rates are presented as Figure 30.

I
The rate of relief for the continuing married couple's allowance and
maintenance relief for people born before 6 April 1935, and for the children's
tax credit, is ten per cent.

I Taxable bands 2000-01 (f) I Taxable bands 2001-02 (f) I

Starting rate 10% 0-1,520 Starting rate 10% 0-1,880

Basic rate 22% 1,521-28,400 Basic rate 22% 1,881-29,400

Higher rate 40% Over 28,400 Higher rate 40% Over 29,400
192 I Contemporary Property Development

U Corporation tax

Corporation tax is the equivalent tax to income tax but is applicable to

companies. If the company is resident in the UK, it is generally chargeable to
corporation tax on its total profits. If it is a club or charity, different rules may
apply. The company’s total profits are found by adding together the profits
from all its activities, including any capital gains. This can therefore include
investment income, profits arising from the release of development activity
and the rise in value of assets and also on the sale of assets. The starting
point for working this out will be the company‘s accounts, but there are
some special rules it must follow for tax purposes.

Companies complete a self- assessment form and pay tax for an accounting
period. Corporation tax is different from the charge on individuals, and also
on companies that are not resident in the UK and who do not trade in the
UK. Individuals and these types of companies pay tax for the year that runs
from 6 April one year to 5 April the next. With corporation tax the key period
is the company’s own accounting period rather than the government‘s tax
year. The company must assess its own liability to tax and pay the tax that is
due no later than nine months and one day after the end of the accounting
period (the normal due date). The UKTreasury will not send the company an
assessment, or work out the tax it must pay.

‘Large’ companies must pay most of their tax earlier than this date, by
Quarterly Instalment Payments.

Again, the 2001 UKTreasury allowances and rates are presented as Figure
31.

The main rate of corporation tax for 2002-03 will be 30 per cent.

Marginal relief eases the transition from the starting rate to the
small companies’ rate for companies with profits between
€10,000 and €50,000. The fraction for calculating this marginal
relief will be &. Marginal relief also applies to companies with
profits between €300,000 and €1,500,000. The fraction for
calculating this marginal relief will also be&.

Figure 31: Corporation tax rates 2001 (source: UK Treasury).

 Finance and development 193

(iv) Value added tax (VAT)

VAT is a tax that has significance to developers, though in most respects its
effect is marginal in that a VAT registered developer can reclaim all VAT
charged on inputs to the development (construction work and the like) if VAT
is charged to the end user. The repayment is usually made three months
after the expense has been incurred and this can be factored into the cash
flow appraisal. There are circumstances where VAT is significant, however.
The explanation is rather complex but of great importance.

Value AddedTax is the newest major tax in existence in the UK. It is

essentially a 'European Tax', introduced as part of our entry to the EEC in
1973. The legislation introduced then was essentially concerned with levying
a turnover tax in connection with the supply of goods and services as set
down in the first EC Council Directive of 11 April 1967, the tax being defined
to 'cover all stages of production and the provision of services', and as
'achieving the highest degree of simplicity'. In fact, VAT is one of the most
confusing and complex taxes in existence. The tax would be levied a t each
stage of the supply of goods and services, eventually falling on the
consumedend user.

VAT was introduced into the United Kingdom on 1 April 1973 a t a standard
rate of ten per cent and replaced Purchase Tax and Selective Employment
Tax. VAT is a tax on the final consumption of certain goods and services in
the home market but it is collected at every stage of production and
distribution. It is currently levied a t three rates: standard (17.5 per cent),
lower (5 per cent) and zero rated (0 per cent). Most items attracting VAT are
standard rated but some such as domestic fuel (lower rated) and books
(zero rated) are a t a lower rate for political or social reasons. Residential
property is a zero rated supply.

It was not until the Sixth Directive of 17 May 1977 that the rules for
property were clarified. Property in general was exempt from VAT. The Sixth
Directive (Article 13, paragraph B) provided that the letting and leasing of
property (with certain exclusions), and the supply of buildings or parts of
buildings, other than partly and newly constructed buildings, were to be
exempt from VAT, i.e. no VAT was to be charged on the supply. This created
a potential problem for developers and investors: it was fundamental to the
concept of the tax that, at each stage, the VAT charged on the outputs, i.e.
the supplies made by the supplying party, was available to offset any input
VAT. i.e. on supplies made to the supplier. This ensured, in the chain of
goods or services, that the VAT liability was passed down the chain,
ultimately to the consumedend user. But this could not happen with exempt
supplies.
194 Contemporary Property Development

Because of this problem, the concept of the option to tax (Article 13,
paragraph C of the Sixth Directive) was introduced, giving the supplier the
option to charge VAT in certain situations. This came into effect in England in
1989, when it became known officially as the election to waive exemption.
The VAT liability has been transferred to the developer, who then has to
make taxable supplies to recover his input VAT The VAT charged to the
developer is based upon the price of the freehold together with the stamp
duty. The developer‘s solicitor must always ask whether an election has
been made, see a certified copy of it and ensure that it relates precisely to
the description of the development being sold. The investor will normally
make the election if it would otherwise incur irrecoverable input VAT, thus
avoiding, or reducing, a VAT cost on its sale.

The basic rules have evolved considerably since their introduction. Once the
election is made, all future supplies in respect of the ‘elected’ property are
chargeable to tax. By making the election, a liability to be registered will
usually arise. In the case of an existing lease or licence, the lessor or
licensor has a right to add VAT to the agreed rent following an election,
unless the lease or licence specifically provides otherwise. If an election has
been made but, under the terms of the lease, VAT cannot be added, the rent
is regarded as VAT inclusive.

The election is a personal decision of the elector, a purchaser with an

interest in land may pay VAT upon the acquisition but is not bound to make
standard-related supplies itself.

Buildings, or parts of buildings, that are intended for use as dwellings, or

solely for residential purposes, are excluded. Other exclusions include the
sale of land (or land with buildings to be demolished) to a registered housing
association that provides the seller with a certificate stating that the land is
to be used to construct dwellings or residential buildings; buildings, or parts
of buildings, for charitable purposes (other than offices); pitches for
residential caravans; facilities for the mooring of a residential houseboat; do-
it-yourself builders in certain cases; and sales under the capital goods
scheme.

This is complex but straightforward so far. However, like other areas of tax
law, the rules relating to property have anti-avoidance provisions, which
often hit quite innocent transactions. VAT is particularly problematic. Property
developers cannot recover input VAT if a development is a bank, an
insurance company or other VAT-exempt bodies that intend to occupy the
building. The key word is ‘exempt’. These bodies are exempt from VAT,
therefore they cannot recover VAT charged to them. This includes VAT on
sale of buildings and on rent. If a developer elects to charge VAT the building
 Finance and development 195

automatically becomes 17.5 per cent more expensive than a non-elected

building to these types of organisations ('normal' companies if VAT
registered can also recover input VAT including that charged on rents or sale
of buildings). In some markets these companies form a significant
proportion of the market. Developers must, therefore, choose to either
reduce the competitiveness of the building or not recover their own input
VAT. In addition, if the prospective tenant so much as pays for a small
variation to the building, the developer may be prevented from recovering all
his VAT.

There are other complexities to VAT regarding the supply of land and
converting buildings. A developer should take good advice on VAT issues
and get up to date on the regulations current at the time of development.

(v) Stamp duty

Stamp duty is a relatively simple tax paid on the 'stamping' of legal

documents by the government. These legal documents include the
conveyance of freeholds and also the grant of leases. It thus is payable by
someone, usually the purchaser in most property developments.

Again, the 2001 UK treasury allowances and rates are presented in

Figure 32.

Duty on conveyances and land transfers, as from 28.03.2000"

Up to and including f60,000, provided a certificate of value nil

for €60,000 is included in the document

Over f60,000 but not more than f250,000, provided 1 Yo

a certificate of value for €250,000 is included in the document.

Over f250,OOO but not more than f500.000, provided 3%

a certificate of value for €500,000 is included in the document.

Over f 500,000 4%

["The old rates of 1%, 2.5% and 3.5% will apply if the contract is dated on
or before 21/03/00.]

NB: all amounts are now rounded up to the next multiple of €5

196 Contemporary Property Development

Recent changes in the rates of duty on conveyances and land

transfers...

Up to and including 07.0797 1%

08.07.97 - 23.03.98 (inclusive) 1% 1.5% 2%

24.03.98 - 15.03.99 (inclusive) 1 % 2% 3%

16.03.99 - 27.03.00 (inclusive) 1 % 2.5% 3.5%

Duty payable-onleases

On the average rent...

Length of term Rate of

Not more than 7 years or indefinite 1%*

More than 7 years but not more than 35 years 2%

More than 35 years but not more than 100 years 12 YO

Over 100 years 24 yo

I* Applies only where the rent exceeds f5,000 per annum]

On the premium...

Up to and including f60,000 with an annual rent of Nil

E600 or less (certificate of value for f60,000 must be
inserted)"

[* If the annual rent is more than

f600 a certificate of value
for f250,OOO may be included and duty is charged on the
premium at 1 %I

Over f60.000 but not more than f250,OOO (certificate 1%

of value for f250,OOO must be inserted)
 Finance and development 197

Over €250,000 but not more than €500,000 (certificate 3%

of value for €500,000 must be inserted)

Premiums over €500,000 4%

Furnished lettings - a letting agreement for any definite term less than a
year of any furnished property where the rent exceeds €5,000 attracts a
fixed duty of €5.

If the annual rent on a lease for seven years or less is €5,000 or below
there is no duty to pay. This also applies in cases where the term is less
than one year and the rent for the period is €5,000 or below.

Figure 32: Stamp duty payable on leases 2001-2002 (Source: UK Treasury),

Stamp duty is the perennial bugbear of the property industry.

Governments have used it as a useful cash-cow alternative to income tax
that is now politically difficult for them to raise. As stamp duty increases
so property must perform better to justify an investor selling it on. Stamp
duty has increased from just one per cent on most transactions since May
1997.

The Budget of 2001 introduced an exemption for stamp duty on all property
transactions in the most disadvantaged parts of the UK. This was aimed a t
promoting urban regeneration through the refurbishment and return to use
of existing properties and to aid new development. In the Government's
own words, 'This will encourage businesses and families to locate in
these areas, reviving depressed property markets and providing
employment'. However, as property values are usually rather low in these
areas anyway it is doubtful whether the actual impact of the changes will
be significant.

(vi) Inheritance tax

Inheritance tax (or more strictly Capital Transfer Tax (CTT))is tax charged on
the transfer of assets such as passing on property to relatives, for example
in a will. It can also be charged on the transfer of assets between
companies. Good tax planning can reduce the burden of CTT almost to zero.
CTT is a tax for a developer or investor to be aware of in order to avoid
incurring a liability but it is one that is not of particular significance.
198 Contemporary Property Development

(vii) Business rates

Business rates are a UK-wide and nationally collected tax on business

premises. They are used to contribute to the funding of local councils but
are now completely under the control of central government. They impact on
property development and investment in two ways: firstly, rates become
due on the product of development once the construction work is complete.
There is 'empty rates relief', whereby the tax payable is reduced by 50 per
cent but the cost of the business rate has to be factored into the holding
costs of completed but vacant premises as the owner is liable to pay it until
an occupier is found. The second impact of rates is on the general
competitiveness of the product of development; rates are a significant
proportion of occupation costs even if they are normally paid by the occupier
of the building and the decision by firms as to location are determined partly
by an assessment of the total costs of occupation.

Rates are based upon the annual rental value for the property as assessed
by the district valuer employed by the government. Rateable values are a
key factor in the calculation of business rates and are not the rates bill. In
broad terms the rateable value is a professional view of the annual rent for a
property if it was available on the open market. A rateable value is a notional
rent calculated solely for rating purposes. It may, therefore, differ from the
actual rent on the property agreed or set in the open market. Occupiers of
identical rented properties will each negotiate the terms of their own leases
and the circumstances of the actual landlords and tenants and the rents
they pay may differ widely from each other for many reasons. The valuation
officer has to make a judgement as to what the reasonably expected rent
might be. All properties are valued a t a single date.

The valuation office has a legal duty to review all rateable values for non-
domestic rates every five years and to assess the rateable values of all non-
domestic properties in England and Wales and compile these in to a rating
list. They then maintain the lists until the next revaluation. The latest lists
came into force on 1 April 2000. The valuation date for the 2000 revaluation
is 1 April 1998. The list runs for five years.

The uniform business rate (sometimes known as the multiplier) is an

amount set by the government each year. There is a UBR for England and
one for Wales. It is set to ensure that the overall amount collected in rates
only ever increases in line with the rate of inflation.

For England
The UBR for 2001-02 is 4 3 . 0 ~
 Finance and development I 199

For Wales
The UBR for 2001-02 is 4 2 . 6 ~

An example of the tax due on a property is as follows:

1 ~
Open market rental value of property
~
1 €50,000 pa

Valuation office assessment of €48,000 pa

rateable value (1 April 1998
va Iuat ion1
~

Applicable universal business rate €0.43

Tax due €20,640

As can be seen this is quite a significant amount and one that developers
should budget for if it is anticipated that the property will stay empty for
some time.

Appeals against rating assessments are allowed but there are restrictions as
to when these can be made.

(viii) Council tax

Council tax is the equivalent tax to business rates for residential property. It
is based on property values but uses a much simpler system of banding.
Rather than assess a value for each premises as with commercial property,
each domestic property is placed into an appropriate value band based upon
its market value. There are eight bands, each increasing in value and, hence,
demanding a higher level of council tax. The setting of the bands and the
valuation of the properties are done nationally by the valuation office. The
setting of the rate of council tax is largely a responsibility of the rating
authority, the local council. This causes the tax rates to vary markedly across
the country.

(ixl Tax relief

As noted above, the government makes use of its discretionary powers in

the tax system to give some relief to stimulate activity in certain sections of
the market or to achieve what they desire. An investor or developer can take
advantage of these concessions to boost the return from property. Recent
examples not covered below include Business Expansion Schemes and
 200 I Contemporary Property Development
Housing Action Trusts, both of which gave tax concessions to investors to
ease the supply of affordable housing in inner city areas for rent or purchase.

(x) On interest payments

The effect of tax relief on interest payments has been covered in the earlier
finance section. It remains one of the most significant tax concessions to
investors and developers.

(xi) Capital allowances

Capital allowances allow the cost of capital assets to be written off against
taxable profits. They replaced the charge for depreciation in business
accounts, an area in which tax relief is not granted. The UK has no allowance
for the depreciation of buildings and property generally, unlike other
countries, other than with capital allowances. The reliefs given are limited
(see p.201) but can still be significant particularly if, in general buildings,
significant amounts of plant and machinery are included. Owners of
commercial property can make considerable corporation tax savings if they
take full advantage of allowances available on machinery and plant
expenditure.

(xi) Industrials, hotels and enterprise zones

An annual allowance of four per cent is allowed by the tax authorities on the
cost of agricultural and forestry land, new industrial buildings, and structures
and qualifying hotels

(xiii) Plant and machinery elements of other buildings

Capital allowances may be obtained in respect of machinery and plants in a

building. These items attract a written down allowance of 25 per cent on a
reducing balance basis against the original expenditure. Sometimes the
government give a larger first-year allowance for small/medium-sized
businesses. The allowances are deducted from the company's corporation
tax computation.

For example, if a company spends €100,000 on a new air-conditioning

system for a property it owns, in year one, 25 per cent of the purchase price
- i.e. €25,000 - can be deducted in the company's corporation tax
computation. In year two, the allowance is 25 per cent of the written-down
I
value (€75,000).This equals an allowance of €18.750. In year three, the
allowance will be €14,062.50 (25% x (€75,000 - €18,750)), and so on, until
there is no more written-down against which to set allowances.
 Finance and development 1 201
In an investment situation it is important for the investment owner to
retain ownership of the plant and machinery and not pass it on to the
tenant in order to claim the sums due.

(xiv) Brown field development and remediation

In an effort to regenerate inner cities and increase the use of previously

used land, the government has placed tax relief provisions within the
Finance Act for investors and developers of contaminated land. This
effectively creates a tax shelter for companies developing contaminated
land. Corporate investors will be able to claim an upfront super deduction
of 150 per cent of remediation expenditure, even where the costs are
entirely capital and do not normally qualify for a deduction. Developers
benefit from an additional 50 per cent deduction in calculating their
development profit. Companies that cannot utilise the additional relief may
be able to claim a tax credit from the Treasury.

(xvj Listed buildings

It is a popular misconception that listed buildings attract copious amounts

of grant aid. The system of securing grants is, in fact, complex and grant
aid is only a possibility for a small number of projects. Where they are
granted, conditions are often attached which may, in some cases, negate
or reduce the grant benefit. VAT applies, in general terms, to all listed
buildings and the developer will need to take account of this, particularly
where substantial building costs are involved. In certain cases, zero
business rating relief is possible, but this depends on individual
circumstances.

(xvil Tax strategies

It is difficult to generalise about tax strategies as each development and

each developerhnvestor tends to have a different tax status and goals.
Sensible tax planning a t the feasibility stage can, however, increase or
even create a profit margin for property development that might not
otherwise exist. It is often rewarding to keep abreast of government policy
and investigate UKTreasury tax concessions in order to be able to react to
any changes in direction and policy. Getting good tax advice is sensible for
all businesses but can be especially important in the property markets.

3.5.3 Conclusion to the tax section

Tax is an important and complex issue. It can make or break some

developments. A wise developer should seek good tax advice early in a
202 Contemporary Property Development

development project to minimise the impact of tax and engineer the

maximum benefits from tax concessions.

3.6 Conclusion to Part 3

Financial matters are often the lifeblood of development. It is very important
to secure the right amount of finance, a t the right cost and with the right
flexibility and risk profile for the development. This is easy to state but often
hard to achieve. Finance is one area where the weight of advantage is with
the bigger organisations. The options available to these bodies are much
wider than to a small developer with a short track record. There is a catch-22
situation operating here but this will probably always be the case. A small
developer can, however, have some flexibility in finance and this area will
always reward good preparation, diligent research and intelligent strategies.