Pre-let: What a Development Lender Reads in It

A development loan on an office, warehouse or shop is usually repaid in one of two ways: the finished building is sold to an investor, or the developer keeps it and refinances with an investment loan. Both buyers and investment lenders price a commercial building on its rent. A building with no tenant has none, so a valuer of a speculative scheme allows for months of vacancy, the incentive needed to win a tenant, and the fees of finding one, and the value falls by all three.

A pre-let removes most of that guess. The rent, the term and the start date are agreed before the money is spent, and the valuer can work from a contract rather than an estimate. The RICS standard on development valuation counts pre-lettings among the inputs whose certainty lowers a scheme's risk and so the profit a developer should need. The lender's question shifts from whether anyone will want the building to whether it will be built in time for the one who already does.

In the UK and Australia the document is an agreement for lease; in New Zealand it is usually called an agreement to lease, and for smaller buildings it is often the Auckland District Law Society's standard form with design and construction terms added. The working parts recur. Conditions come first, commonly the developer obtaining consents and finance. The works are specified, with the tenant's approval of plans and of any later changes. Practical completion, as the agreement defines it, starts the lease, and in New Zealand often also needs the code compliance certificate. A sunset or long-stop date sets the latest completion the tenant will accept, after which one or both sides may cancel.

Around those sit the commercial terms: rent-free months or a fit-out contribution, any damages for late delivery, and the security the tenant gives, often a bank guarantee. A development lender commonly adds its own layer, a side deed in which the tenant agrees to tell the bank before terminating and to let it cure the default or step into the developer's place.

A logistics developer, constructed for this page like every figure in it, is building a warehouse. A national distributor has signed an agreement for lease: twelve years at US$1.95m a year, nine months rent-free, and a right to cancel if practical completion is more than six months late. The development loan will stand at US$18.0m at completion, with interest capitalised. The yield, the vacancy and the refinancing limit below belong to the example, not to any market. The arithmetic is simplified; a valuer's would be more detailed.

With the tenant, the refinance repays the US$18.0m loan with US$0.62m to spare. Without it, the developer is US$1.02m short. Now suppose the build runs eight months late. At the example's US$110,000 a month of interest the loan reaches US$18.88m, and the tenant has passed its six-month limit and may walk away. If it does, the file is back on the speculative line with the delay's interest on top: a take-out of US$16.98m against a loan of US$18.88m. The pre-let was worth US$2.74m of value, and a late finish can cost the whole of it.

Presales repay the bank directly: a buyer settles and the money goes to the loan. A pre-let repays nothing by itself. Its rent arrives after completion and in small amounts, so it reaches the bank through someone else, the investment lender who refinances or the investor who buys a let building. A pre-let is therefore read twice, once by the development lender and once, in its mind, by whoever must take it out.

The money each counterparty has at stake also differs. A presale buyer usually pays a deposit it forfeits by walking away; a tenant commonly gives a guarantee of a few months' rent. The Basel Committee's standardised approach reflects the point. It lowers the risk weight on residential development lending where pre-sale or pre-lease contracts make up a significant share, but counts them only if they are binding and backed by a substantial cash deposit the buyer or tenant would forfeit. A commercial development stays at the higher weight under that text, however well it is pre-let. Once the building is finished, the tenant's lease also sets the building's weighted average lease expiry and its debt yield from the first day.

DEFINED IN ONE PARAGRAPH → · PRODUCT FILE: DEVELOPMENT LOAN → · PRESALES, DEFINED →

A lender that relies on a pre-let commonly makes it a condition of the first drawdown, signed and unconditional except for completion, because a pre-let still subject to the developer obtaining finance is a pre-let the bank's own approval has to satisfy. The credit paper then reads the tenant as it would a borrower: its accounts, any parent guarantee, and whether its business needs this building or could live without it.

The sunset date is read against the building contract. If the builder's date for completion leaves little room before the tenant's cancellation right, every delay the builder can claim an extension for eats into it, and the lender is the party left holding a speculative building. A completion guarantee and a realistic programme are the usual answers. On a part pre-let, the lender reads how much of the income is fixed and how much is still a guess.

DRAWING A DEVELOPMENT LOAN → · PROPERTY DEVELOPMENT FINANCE → · PRACTICAL COMPLETION →