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Issues to Consider When Obtaining Construction Finance

Issues to Consider When Obtaining Construction Finance

The general concept of ‘real estate finance’ can cover loans to assist a borrower with the acquisition of a property (whether residential or commercial) or refinancing an existing loan secured against the borrower’s property, loans for the borrower’s business purposes that are secured against property that it owns and loans for the development or construction of property.


Borrowing against an existing property (that has already been built) will, in broad terms, follow standard(ish) legal steps with which many homeowners are familiar, to provide security to a lender. Generally, there will be some form of loan agreement that imposes on the borrower certain financial obligations (i.e. obligations to pay interest and repay the loan sum that was lent) and property obligations (to take steps to maintain the value of the property throughout the duration of the loan agreement, e.g. by requiring the borrower to keep the property in repair, to insure the property, not to cause or permit damage to be caused to the property etc.) and the borrower will be required to enter into documents to provide security in favour of the lender (usually a first legal charge/mortgage over the property and sometimes guarantees in favour of the lender). Development Finance can differ from these more familiar real estate finance methods and additional legal steps and documents may be required.


HOW IS DEVELOPMENT FINANCE DIFFERENT FROM A STANDARD LOAN SECURED AGAINST PROPERTY?


‘Development finance’ or ‘construction finance’ involves a lender providing a loan to a borrower for it to develop (i.e. build, extend, renovate or refurbish) a property. It can form part of a loan that is made to also acquire the property that will be developed. The loan is secured against the property (as with other forms of real estate finance) but security will also be given over the developer’s (i.e. the borrower’s) rights under relevant construction documents – e.g. security over rights of the borrower/landowner under the contract with its building contractor to carry out the development and overs its rights under services agreements with other professionals such as the architects and engineers for the construction project – as well as security over the borrower’s rights to proceeds of insurance policies relating to the property and the construction project itself.


COMPREHENSIVE DUE DILIGENCE REQUIREMENTS FOR LENDERS IN PROPERTY DEVELOPMENT PROJECTS


A prudent lender will usually insist on a full due diligence review not only of the property which is being provided as security, but also a full review of the planned development and all construction contracts and the contractors themselves before funding is released to the borrower. The lender will want to review:

  • the value of the property itself, which will be lower while the construction project is being carried out compared to what its value will be when the development has been completed. On a development project that will involve the sale or lease of units on a development (e.g. building a block of apartments), a lender will want to have a clear picture of (and certain controls in respect of) agreements for leases or sales of units that are in place and will be put in place;
  • the experience and skill of the project team (e.g. main building contractor and associated professionals – e.g. architects, structural engineers and other members of the design team) and what levels of professional indemnity insurance they have in place to cover any defects that may arise in their design (and in the case of the main contractor, whether they have sufficient cover to protect against the possible insolvency of any subcontractors or consultants);
  • the costs to complete the design, build and sale of the development (which, together with funding costs, should not exceed the value of the completed development) – often a lender will require its own ‘monitoring surveyor’ or ‘quantity surveyor’ to review the budgets or, as a minimum, they will arrange for their own professionals to ‘sense-check’ the costings;
  • what rights the lender will have if the borrower/developer is unable to complete the development, such that the lender must ‘step in’ and take over the construction project to get it completed.

CONDITIONS PRECEDENT FOR STANDARD REAL ESTATE LOANS


Lenders of ‘standard’ real estate loans (that do not involve construction elements) normally impose numerous conditions precedent (known as ‘CP’s) such as requiring satisfactory reviews of the property title documents, insurance, appropriate consents and authorisations and planning permissions etc. These CPs must be satisfied by the borrower before the lender will make any funds available to the borrower.


CONDITIONS PRECEDENT FOR CONSTRUCTION AND DEVELOPMENT LOANS


The list of CPs for a construction loan/development loan will include all of these ‘usual’ conditions and impose numerous further construction specific conditions, such as requiring sight of signed building contracts, professional appointments, professional indemnity insurance documents and collateral warranties, as well as detailed budgets that have been approved by the lender’s representatives.

It may be that the construction loan will be released in separate tranches when certain phases of the development have been reached, and in that case it may be that there will be CPs that need to be satisfied at each stage of the development process, possibly to be signed off at each stage by the lender’s own monitoring surveyor (who would represent the lender, but whose fees must be paid by the borrower).

It is for these reasons that the various documents required for a development loan will be more detailed and complicated and accordingly they take more time to negotiate and finalise between the parties and their lawyers than would be the case for a loan that does not involve construction elements.


SUMMARY


Development finance or construction finance facilities are complex, and the legal processes can take a long time, involving many legal advisors acting for the borrower, the lender and sometimes for the building contractors as well. At Quastels, we have experienced lawyers in our Finance & Banking, Real Estate and Construction departments who work together as a single team to progress matters for our clients (both borrowers and lenders) as swiftly as possible.

To discuss any of the points raised in this article, please contact Jason Greenberg or fill in the form below.

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Making A Loan to Individuals – Is It A Regulated Mortgage Contract?

Making A Loan to Individuals – Is It A Regulated Mortgage Contract?

If you are considering lending money to a family member or a friend, you may believe you are acting prudently by obtaining security (for example, a mortgage) against the borrower’s home to ensure you get your money (and any agreed interest) back.

However, without getting professional legal advice, you could find yourself inadvertently straying into the realms of a regulated mortgage contract (RMC). If this occurs, the loan contract may be deemed unenforceable, and you could be in breach of the Financial Services and Markets Act 2000 (FSMA).

WHAT IS A REGULATED MORTGAGE CONTRACT?

Under article 61(3)(a) of the FSMA (Regulated Activities) Order 2001 (RAO), a contract is a regulated mortgage contract if, at the time it is entered into, the following applied:

  • The contract is one under which the lender provides credit to a person or to trustees;
  • The lender takes security for the repayment of the loan in the form of a charge over land of which 40% is used for or is intended to be used, as or in connection with a home by the borrower or (in the case of credit provided to trustees) by a beneficiary of the trust or a related person.

Under the RAO, anyone who is not authorised to carry out a regulated activity is prohibited from doing so. The contract will be unenforceable and criminal charges may be laid.

Read The Case Study

An example of how someone can suddenly find themselves entering into an RMC without meaning to is illustrated in the case of Jackson v Ayles and another [2021] EWHC 995 (Ch).

Mr Pumphrey lent money to Mr and Mrs Ayles, the Defendants. The Borrowers were property developers. The loan was secured by a charge on their family home. The Ayles defaulted on their loan repayments and declared bankruptcy.

Mrs Jackson, the Claimant, was subsequently appointed Mr Ayles’ trustee-in-bankruptcy. She applied for a declaration that the security held by Mr Pumphrey was unenforceable under FSMA.

Mr Pumphrey contended that because the activity had not been carried on “by way of business”, it was not regulated and so did not infringe the general prohibition in section 19 of the FSMA. The High Court disagreed because:

  • Mr Pumphrey’s association with the Defendants was “not built on trust”. Instead, it was a commercial relationship.
  • Mr Pumphrey made several loans to the Defendants over many years.
  • Mr Pumphrey had sought advice from a lecturer of law at Kingston University about “private lending”. He had also obtained a charge template for the purpose of securing his lending to ensure he got his money back.
  • Mr Pumphrey’s ROI exceeded market rates.
  • Since 2005, Mr Pumphrey lent more than £3.5 million (albeit not at the same time) to 14 different people and companies.

The Court ruled that Mr Pumphrey was not an authorised or exempt person for the purpose of the FSMA. He was therefore barred from carrying on a regulated activity but did so anyway. He was therefore in breach of the general prohibition in section 19 of the FSMA. Consequently, the loan was unenforceable under section 26(1).

WHAT ARE THE EXEMPTIONS THAT MEAN A LOAN IS NOT AN RMC?

Article 61A(1) and (2) of the RAC provide that a contract is not a RMC if it falls into one of the below categories:

  • An Islamic mortgage.
  • A limited payment second charge bridging loan.
  • A second charge business loan.
  • An investment property loan (this also applied to commercial borrowers as long as certain conditions are met)
  • An exempt consumer buy-to-let mortgage contract.
  • An exempt equitable mortgage bridging loan.
  • An exempt housing authority loan.
  • A limited interest second charge credit union loan.

If one of the above exemptions applies, the loan agreement is defined as an unregulated mortgage contract.

WRAPPING UP

Given that inadvertently creating an RMC can lead to expensive civil litigation and criminal prosecution and could potentially leave you with an unenforceable loan agreement, it is important to seek legal advice if you are considering providing a loan that will be secured over property.

Doing so will ensure you understand the consequences of the contract and that you are able to protect your best interests.

To discuss any of the points raised in this article, please contact Jason Greenberg or fill in the form below.

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