Property Development Finance - What is Deferred Consideration?
Property Development Finance - What is Deferred Consideration? And, how do you finance that development?
The concept of deferred consideration is quite straightforward in that a fixed sale price has been agreed between buyer and seller with part of the price is not being paid at completion, it is instead deferred until a later date. The consideration given for the purchase has been deferred.
It may seem like something that occurs once in a blue moon but it is more common than most people realise, especially when it comes to property developers and purchasing property to be developed.
The big questions are:
How do you finance a development where deferred consideration exists?
How does the vendor stay happy with the deal?
Why does it work for all sides, developer, vendor and lender?
This video covers how deferred consideration works well for all sides and explains why, contrary to popular belief, property development projects where deferred consideration exists can be financed successfully.
Timings:
01:21 - Financing a development with deferred consideration
02:07 - A working example of how it works
03:58 - How it works for all sides
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Script:
Hello, Dave Farmer at Lime Consultancy and I want to talk about property developments using deferred consideration. So question number one is what is deferred consideration? Well, this is where the property developer, instead of paying cash for a piece of land on day one, pays the vendor at a later date, they have deferred the consideration. You might ask yourself, Why would you do that? Well, from a developer's perspective, it's positive because they're not paying out cash on day one and therefore it's easier to cashflow a development. From a vendor's perspective, they're going to expect a larger sale price, albeit at later date and a share of profits on the deal. In return, the vendor will have a second charge on the land and therefore retain an interest in it and security in return for a larger return further down the line. So it's far closer to a joint venture model although not quite there. It works very well because the vendor gets more money and a developer gets a better cash flow deal.
So, the question then is how do you finance that?
Because a lot of time we hear that deferred consideration projects can't be financed. Well, I'll let you into a secret. Yes they can. It just takes a little bit more structure around the deal to make it work. From a lender perspective, deferred consideration works very nicely because they know that the developer has got cash there to be able to fund the project and any overruns or delays. So they like that. Plus lender gets a first charge over land with a vendor retaining a second charge, so it can be done.
To explain why it works very well I’ll give you an example. So let's assume that a developer can buy a piece of land for £900,000. It's going to cost him another £900,000 to do the build and at the end, it's going to be worth £2.45 million, that’s a pretty standard structure.
So, the developer in this case needs to borrow £1.5 million because they've got some cash to put in themselves and they've got a total of £1.8 million of total build costs, including purchasing the land. So they've got finance costs on £1.5 million. Let's now defer the consideration, instead of paying out £900k on day one to purchase the land, they're not paying anything out on day one. Instead, what we're going to do is they're going to give the vendor £950k further down the line.
So give them an extra £50,000 on top of the purchase price and also give them a share of a profit. So in this case, if we say they're going to give them 10% of a share of a profit, then instead of £900k the vendor is going to get, they're actually going to end up with £105k more, and that should make them quite happy.
From a lender's perspective, They've got a client who is doing a development and has actually, got some cash behind them to do the works and fund the overruns. So they're comfortable with that. And the lender has a first charge on the land. From a developer's perspective, He's paid more for the land and given away cut of a property.
He's also got finance costs. He’s not paying interest on £600k of borrowing, and if we work that out at a nominal 10%, you start to see the figures come back round and understand why it's a really good deal for developers. We do see the structure now, and again, It does work. It can take a bit more effort to finance, but don't let anyone tell you it can't be done because it can. Deferred Consideration for property developers. You can finance it. If you need any help, get in touch.