Development finance – lenders must give due consideration to due diligence
Development finance presents one of the more hazardous areas for lenders, due to the risks associated with providing funding at the outset of a project when redeveloping or erecting a new building. Lenders will want to avoid circumstances in which the design and planning stages of a development have proceeded without proper diligence as this could limit a development or at worst prevent it from taking place.
It is essential therefore for a lender to undertake its own due diligence at an early stage. Such due diligence could well dictate the feasibility and terms of the development finance. It is also be important to identify and address any issues at an early stage to avoid delays to the drawdown process at a critical juncture and to ensure that the value of its collateral will not be jeopardised.
Due diligence essentials
Whilst each transaction is different, we have highlighted key areas for due diligence in relation to property being developed and the construction process, which includes:
Ascertaining the full extent of the title.
- If planning has already been obtained, the site plan submitted for the planning permission should perfectly match the Land Registry title plan.
- There should be no unregistered land that is to be developed and that is not in the ownership of the developer – including any vital strip of land often referred to as a ‘ransom strip’ (e.g. the edge of a kerb, which provides access to the development site from the adopted highway).
- Details of all restrictive covenants must be ascertained as they could prohibit the planning permission for the development being implemented – e.g. a covenant that prohibits anything apart from one residential dwelling being erected when a developer is planning to erect four houses. (Depending on when such a covenant was created and who the beneficiary is, indemnity insurance may be available).
- Depending on the height of the development, a right to light survey may be required if any neighbouring land could claim that the development is infringing such a right.
- The registered title may reveal ‘other interests’ which may be adverse to the development. - E.g. a pedestrian and/or vehicular right of way.
- Subsoil searches (also known as development searches) reveal what is below the surface level of the ground (for example, electricity cables, gas pipes, sewers, and drains). These searches are vital and should be obtained as a matter of course on development finance matters. If the results show any pipes or sewers, it may be that they either need to be diverted or they need to be built over. If it is the latter, the relevant utility company is likely to require the developer to enter into a ‘build over agreement’.
- In addition, the usual searches being a local authority, water and drainage, environmental, chancel and highways searches should be undertaken.
Planning & Construction Documents
Due diligence should not be limited to the viability of a site or development. A lender should also be familiar from the outset with the planning and construction aspects of the project and should review all relevant documentation, which should include:
- Full copies of the planning permission and all plans submitted together with any planning agreements.
- The initial approval of plans from Building Control together with details of who will be signing off the completion certificate once the development has reached practical completion.
- If the development is residential, lenders will want to be satisfied as to the structural warranty that the developer will be providing to the end purchasers (if the intention is to sell off the individual apartments/houses).
- In addition, the lender should have a high expectation of the competency of the contractor and other key professionals and so should exercise control over the project team to be appointed by the developer. It is important that the development team is chosen carefully, with an eye on their skills and experience in developing the project in accordance with the plan, and the contractual terms that they are willing to sign up to.
- It is common, and advisable for lenders to require construction security – usually in the form of collateral warranties from the building contractor; professional consultants; and any sub-contractors with design responsibility. These collateral warranties should allow for the lender stepping into the developers’ shoes in certain circumstances, such as insolvency or where the terms of the funding agreement have been breached.
- Depending on the size of the development, lenders should have the opportunity to review and comment on all construction documents being entered into by the borrower.
The landscape of lending on development projects is potentially changing as a result of Brexit and other market stressors, with lenders exercising a greater degree of caution before giving the green light to potential projects. With lenders facing uncertainty an unpredictability in many areas, they should mitigate any manageable risk wherever possible.
While specialist development finance providers may be able to offer creative structures to obstacles arising on development projects, the value of traditional due diligence at the outset should not be underestimated. Thorough due diligence is crucial in establishing avoidable risks and determining the feasibility, pricing and terms a lender is willing to offer. For lenders, taking shortcuts on early due diligence could cause headaches later.