Property Development Finance in a Tough Lending Market
Getting the Right Property Development Finance for Your Project
Have you heard of the expression “no money, no project?”. Nothing is truer said. Many developers fail to get projects off the ground or delude themselves about a projects viability because they make erroneous assumptions about how easy it will be to fund a project and the conditions of their finance. The reality is that it can be easy to fund a project only if you know what are the most suitable financial products for your project, which lenders are offering these products, and how to present your deals to these lenders. This article will explore all of these themes around obtaining property development finance. Your understanding of finance is critical, because if you make erroneous assumptions about who and how your project is going to be financed, you may commit to buying a project site that you either wont be able to afford to develop, or your forecast return will take a big hit because of higher interest charges and fees.
Property development finance is currently perceived to be very tough to get in the west Australian credit market. Fairly recent regulatory changes and investigation into lending practice by various regulatory bodies such as ASIC, APRA and most recently a Royal Commission into banking misconduct has certainly resulted in the perception of a more restricted lending market.
Many small-scale developers who rely on development finance from major lending institutions may have experienced the frustration of having finance inexplicably knocked back where hitherto it was approved. You would be surprise dot know that , in most cases development finance is still obtainable, you just hav eot know how and where. You have to understand:
- Who the right lender is to present your deal to
- How the project is best presented to them
Presenting to the Right Lender for Property Development Finance
While in Australia there are a multitude of lenders for your scenario there may only be a short list that would finance your development. Knowing who these lenders are and their lending criteria will assist enormously in improving the chances of obtaining property development finance.
To illustrate the great variation amongst lenders with some simple examples you may be surprised to know that:
- Many lenders will consider any application for residential development loans where three or more units are proposed as more suited to a commercial loan. This will attract higher interest rates and fees , and see the deal assessed very differently, more as a business case. There are a handful of lenders who consider up to four units as a residential development loan, but this is dwindling. In this case standard rates and fees will apply to the loan. This can be an important consideration for project feasibility and cash flow .
- There are some lenders who will approve uncontrolled ‘cash out’ based off land value. What this is means is that the borrower has full control over the release of funds. This can have a positive effect on the often-critical timeline of the project by reducing project stage progress when release of capital is being held up by the lender. By comparison many lenders control the release of funds in pre-approved stages. This can frustrate timelines as an inspection by an officer of the bank may be required before funds are released. This is often subject to usual bank delays.
It is worth considering that one of the marvellous things about having so many lenders in the Australian financial market is that there is almost always someone who will finance your project – albeit sometimes with more restrictive or expensive lending conditions. What is poorly understood is that getting initial finance is often the hardest part. Where an alternative lender is the only option, this does not mean that you are ‘locked into’ that lending institution. Once the project has been completed, most major lenders are happy to refinance an established development. This usually comes with a sharp drop in rates and holding costs.
For small lot infill development projects, you will typically be choosing between residential (home loan ) products for small projects, and commercial lending products for larger projects (3+ units) in the current finance market.
Residential or Commercial Property Development Finance?
It is possible to use residential loan facilities (homeloans) to finance property development, but with severe limitations. This depends on the scale of the development and the intention of the developer (holding or trading activity). Residential loan facilities are not typically offered to fund develop to sell model projects (trading entities) as these products are designed as long-term debt facilities, with their interest rates set accordingly. The risk profile of each activity and the lenders exposure is very different- do not assume that you will easily be able to obtain a sub 3.5% interest rate at 80% LVR for a property development 3 lots and over. Bank lenders can provide residential loans to finance the land acquisition and development costs.
Key residential lending parameters are:
- Underwriting requirements typically permit an LVR of 80% or less, however lending upwards of 90% is available in some circumstances using expensive Lenders Mortgage Insurance (LMI) to underwrite loss risk in the event of the mortgagee failing to repay the loan.
- Rates for residential loans are lower than commercial loans, given that the term is expected to be longer (typically around 3-4% at the time of publication however this is subject to change). Residential lenders expect the development to be held, not disposed of as part of the assessment criteria in their lending policies.
- Buying sites to develop and sell is called land banking and is a cause for loan rejection in line with most residential lenders policies.
- Residential lending is possible for 2-4 lot developments if the entities intent is to hold, as opposed to selling as a trading entity. Developing to sell is viewed as a different type of activity from a taxation and risk perspective.
- The lender will provide debt for the purchase at an agreed LVR, plus lend an amount for construction costs (added to the mortgage) that will not exceed the original LVR.
In the current lending climate, there is little appetite from residential lenders to be involved in property development. Active developers today look to commercial lending vendors to get their deals financed.
Bank and non-bank lenders can provide commercial loans to finance the land acquisition and development costs of a development. If you are going to develop property regularly, your activity will be assessed as trading in business and commerce, and you will have to become comfortable with the commercial lending space. From a lenders risk perspective, commercial loans are the correct product for property development trading entities gien the risk profile and nature of development as an activity (selling product as opposed to holding). Whilst interest rates are higher and LVR’s lower, the assessment and qualification criteria are more suitable for development purposes.
Underwriting in the commercial space normally requires a higher upfront equity contribution from the developer. This is because the lender is exposing themselves for a lot of capital for a short period of time in a high-risk activity. They typically accept an LVR of 70% or less (50-60% is not uncommon). Other items of note for commercial lending:
- Rates for commercial loans are typically above 4% as they are short-term loans (1-5 years typically), plus establishment, valuation and brokerage fees.
- The intent is to develop to sell with these loan facilities (no holding period). If intention changes it is advisable to refinance to a different loan facility more residential in nature with a lower interest rate.
- Commercial lending offers lower LVR’s, but does cover more development costs.
- Commercial lenders typically assess LVR with the On-Completion Value as opposed to land and development costs. This can offset the lower LVR and higher rates offered over residential lending alternatives.
- Evidence of pre-sales may be required: this can have an impact on the loan terms and calculation parameters.
How the Project is Presented to Obtain Property Development Finance
How the project is presented both verbally and in the loan application documentation plays a crucial role in whether or not the loan for property development finance is approved by the lender. Just saying the wrong thing once can result in the banker running for the hills.
For example, most lenders will not approve a project for residential loan product that they consider to be ‘short term lending’. ‘Short term loans are commercial in nature, defined as financing a project where there is a complete sale and divestment of created assets and closing down of the loan facility in a short period of time -typically one to two years (‘build and flip model’). Most residential lenders are unhappy with this situation as the lender has high exposure but owing to the short time period of the loan, make little return by way of interest repayments as interest repayments generally are more substantial where loans are for a longer period (ie. 30 year mortgage). It can easily be seen how the objectives of the bank and a real estate developer seeking finance are at odds. Commercial property development finance with higher interest rates, is what is on offer from most major lenders in Australia for these sorts of projects where the intent is to sell in the short term.
By comparison, were the same request for property development finance is presented as a build and hold strategy (with a longer repayment period) the bank would have a greater appetite for the project. There is no reason that a borrower who has financed a loan based on a build and hold strategy cannot sell their assets and close out the property development loan as and when a change of circumstance requires- there is also significant benefit from a capital gains tax, capital growth and passive income perspective to warrant considering a hold.
It all comes down to risk, and you need to think about the banks risk. That is what they assessing, the safety of their money and the security of their investment.
Important risk factors assessed by the lender are:
- The tax structure set up for the development (i.e. The Special Purpose Vehicle (SPV) and subsequently debt security/lending recourse to that structure).
- The type and size of the development (number of lots/dwellings, single, group or multi dwellings).
- The location of the development (suburb/postcode).
- Personal profile (your experience as a developer).
- Are you developing to hold and rent or developing to sell (trading or holding activity)?
- Presales evidence by way of contracts if developing to sell (if presales are a policy requirement of the lender or specified for your project given the level of debt sought, product type and/or location of the development).
Alternative sources of finance
Acquiring property development finance is not limited to traditional lending. Many projects are financed using alternative means and strategies, which can be much more flexible and are possible so long as all parties benefit.
Alternative methods of finance include:
- Joint Venture; two or more persons (natural or corporate) undertake to own and run a single project jointly and contribute funds, land or equity to the project. Importantly, where any finance is sought to fund the project lenders will normally assess the liabilities of all partners in the joint venture collectively. It is important to know who you are joint venturing with as cross collateralisation of their own debts may jeopardise your own borrowing capacity. Conversely, their borrowing capacity may enhance your own.
- Syndicates; Similar to a joint venture, varying in that the syndicate may not wind up at the end of the project. The syndicate members are unit holders in a trust and/or private company and may run more than one project at once. Profits may be reinvested in the syndicate perpetually until such as time as syndicate members vote to wind up the syndicate. The collective assets of the syndicate can mean larger projects can be undertaken potentially with higher returns than if any one member of the syndicate chose to peruse a development on their own. In some syndicate’s members can sell their shares to other members. New members can also be invited. Syndicates can also be a useful way to reduce the individual members’ risk as the risks of the project are shared out amongst the shareholders of the syndicate. Greater expertise can be brought to a project where a syndicate includes a number of experienced developers who bring their knowledge and networks with them.
- Private lenders – private lenders, who will assess a project on its merits upon receipt of an information memorandum or a business case may undertake to fund a part or the whole of the development in a return for a share in profits or a set fee.
Non-Conforming Lenders; some lenders are not restricted by lending practice charters or regulations which major lenders are for various reasons. These are called ‘non-conforming lenders’. Whilst these lenders may charge a higher interest rate, this can still be a viable way to fund a project where the project is lucrative and unable to attract interest or endorsement from larger lenders who may be constrained by stricter lending policy guidelines.
- Development leases; a development lease works best where a land owner has an unencumbered block of land but no cash to finance the development and no borrowing capacity. The developer is permitted by the land owner to place a mortgage over the property (sometimes a second mortgage) which the developer personally guarantees. The developer undertakes to develop the land. The land owner and the developer split the profits according to a pre-determined scale. This can be in cash, units etc. There is no transfer of land between the developer and the owner so no stamp duty. The land owner will generally have a greater capital realisation of their asset than if they sold it ‘as is’.
- Equity partnership; in an equity partnership arrangement, a supplier working on the project may agree to fund a part of the project with their own equity – either in labour capital or as a shareholder in the project. The supplier would agree to provide either cash or equity through mortgage guarantee. A share in the profits of the project or an escalated return on usual fees may be the consideration paid to the supplier in return for contributed capital to the project. For example, an earthworks contractor may be considering a project with a $250,000 earthworks component. They may agree to undertake the work for $120,00 upfront payment with a $150,000 ($130000 balance + $20,000 bonus) payment upon sale of the assets.
As well as reducing the required amount of input capital this can be an innovative way of incentivising suppliers to work harder and achieve the best outcomes for the project as they have ‘skin in the game’. This personalised interest can be a factor wholly absent in scenarios where the contractor or supplier has been paid in full and has no ongoing interest.
Property development finance is just one part of the equation that is affected by your trading intention. Taxation is the other. Whether you are trading, or holding, will also effect your tax strategy. Further, if a developer plans to make a profit (which they should all be doing!) consideration should be given to how the profits will be distributed. Often distribution of profits needs to be optimised by a tax agent who can substantially reduce the personal tax liability of the individual by using a structure involving trusts and corporate entities. Importantly, the structures used for tax planning will normally have to be in place before a project is acquired (land purchased). The structure may also change which lenders are willing to provide finance to the project, once they have assessed the difficulty or ease of recourse.
Taxation is an important consideration when getting involved in real estate development. It is highly advised to include a qualified tax professional in development planning from the start of the project.
No money. No project.
Where your property development finance is coming from is a crucial part of project planning. Put simply – no money, no project. There are many different options to explore; knowing who to talk to and how to present a project correctly is vital. FLYNN Subdivision Experts help all their clients to can help to find the optimum financing solutions for their projects, before they commit to it. This avoids stress, project delays and loss of profits. We invite you to use our expert network of brokers and finance consultants to help navigate and find the right finance solution for you.