Community Land Trust Fund

Delivering Affordable Sustainable Housing
Context setting:

Financing development: principles and issues

The appraisal of any development proposal brings together consideration of:

  • Viability
  • Risk
  • Finance.

To be viable, the value of any completed development must exceed the nett cost of its development.  This applies whether the developer is selling the completed home, or is providing it for rent long term.  It also applies whether the development is for a profit making organisation or not:  the only difference there is whether or not a profit margin is included in the appraisal.

Development carries risk, primarily in relation to costs, time and quality in the development stage, and sales or rental income following completion.  The higher the risk, the higher the target profit margin or more cautious appraisal assumptions used.  We deal with this in later sections.

An important element in mitigating development risks is to be quite clear about roles and responsibilities, and in particular the CLT’s client function.  That involves not only employing the necessary consultant support, but also having a suitable range of skills within the CLT to “ask the right questions”.  This is covered in detail in the Locality guidance mentioned in http://locality.org.uk/resources/build-house/.

Finance needs to be considered under two broad headings:

  • Type: debt, equity or grant
  • Short or long term.

Virtually all housing development is debt financed, both for the developers and the owners of the completed homes.  Private house builders buy land, build homes and sell them.  Their activities are largely debt financed through that development period.  Similarly, most purchasers of housing for sale will require a mortgage.  Landlords of rented property will require long term debt finance.

Since the credit crunch, the availability of debt funding has been limited, and lenders’ risk margins higher.  They have been more cautious, as a result of which they have been willing to lend a lower percentage of the costs or value.  They have imposed more onerous terms in relation to asset or interest cover on commercial loans, and have been willing to lend a lower percentage of the value to private purchasers.  This was a common feature of housing development of all kinds in the 1980s and early 1990s, but was abandoned as a routine practice for most of the last 15 years.

The situation has improved somewhat in the last year, following introduction of the government’s Finance for Lending programme, which has provided low interest finance to banks, for on-lending for either property purchase or lending to businesses.

For newly formed or small organisations such as CLTs, these issues have made life much more difficult.  The practical effect is that their ability to borrow has reduced:  this relates both to short term (i.e. through the development period) or long term (for rented housing).  Overcoming these problems increases the requirement for grant, guarantors or patient investors, or a combination of all three.

Mortgage lenders will only lend a proportion of the value of the home being bought.  This is known as the Loan to Value ratio (LTV).  As well as only lending a proportion of the value (thus requiring a deposit from the purchaser), many lenders are now taking a more cautious view on the value.  When a valuer produces a security valuation, they are assessing how much the property would be worth if the borrower defaulted on their mortgage payments.  Therefore, the security valuation is not necessarily the purchase price – it is usually less.

The same applies to the funding of homes for rent.  The value of a completed home for rent is calculated on a different basis.  It is effectively establishing the value of the rental stream, bearing in mind that the tenant may have security of tenure.  This is known as the Nett Present Value (NPV).  Even if the NPV is zero or slightly positive, it is likely that the cash flows of the project will generate early years’ deficits, i.e. debt repayments, management costs and maintenance costs exceed rental income.  That can be a major problem for a newly formed CLT without Reserves.  With the change from social rent to affordable rent, a smaller proportion of the cost of a project will be met by grant, which means that there is a higher LTV and higher early years’ deficits.

Commercial lenders are only willing to lend a proportion of the NPV.  This is known as Asset Cover.

We mentioned earlier that land may be provided on beneficial terms, either from a local authority or the HCA, subject to covenants; and that the same effect can be achieved on privately owned land by the imposition of planning obligations secured through Section 106 agreements.  These covenants or obligations can have a significant impact on the security valuation and thus mortgageability of the completed homes.  This is particularly the case in relation to restrictions on the sale of the homes to local people (however defined), or to the rights of the mortgagee in possession of properties for rent.  This is an area of very considerable valuation/legal complexity, and must be considered extremely carefully.  The issues are described in more detail in the Locality guidance mentioned above.