An increasing number of property developers are shelving projects because they can’t raise funds through a traditional major bank. But have you explored all of your options before shelving the project? And have you considered all the expenses involved in shelving a project?
Here’s a little history on why it’s more difficult borrowing for property development purposes today.
Going back three or four years, major banks were funding a significant level of apartment and developments primarily in Melbourne, Sydney and South East Queensland. Because the banks were particularly exposed to risk in this area, they decided to tighten their property development finance lending. Now, instead of asking for 50-60% debt in presales for a property development, they’re ask for up to 120% in presales in some cases. Unfortunately, because bank policies are national, not regional, the exposure in these areas has affected borrowing for property development Australia wide.
What’s a Presale?
A presale is when a purchaser buys an apartment or dwelling ‘off-the-plan’ (ie based on the development plans) for a proposed development. They are required to provide a deposit (typically about 10%) to secure the future sale. That then qualifies as a presale for the developer. When the developer approaches their financier with presales it provides a certain amount of confidence that they will be able to sell the development when it’s built, which equates to less risk and exposure for the financier.
Three to four years ago, if a developer was looking at borrowing for property development and approached a bank for $5m, they needed about $2.5-3m in presales to get the deal over the line. Now they typically need 120% in presales – that’s an additional 20% cover in case some sales fall over.
The issue with presales
In past boom times people were not as cautious about buying off the plan, but these days people are more conservative and more reluctant to buy this way, preferring the certainty of an already built property.
Added to this is the problem of the passage of time between signing the contract and the property being available for settlement. People buying properties off-the-plan are doing so at what is perceived ‘market value’ at that time. People may commit to buy but when it comes time to settle, the property gets revalued, and if there is a discrepancy between the price at sign up and the current valuation buyers may seek to walk away because there is such a significant fluctuation in pricing. Even if this means losing their deposit.
Developers are keen to get presales in order to get property development finance and often discount the purchase price to make a presale. But if a developer discounts across presales, and presales make up the majority of the sale of the development, what’s the impact on their profit from the project?
Three Options for Property Development Finance
So, what’s the best way of borrowing for property development? We take a quick look at 3 options:
Borrowing through major banks – if you want to go ahead with your development now, you typically need presales totalling at least the proposed development debt. The question is how much profit do you have to give away to get presales? If you need to discount by $1m to achieve that, are you better off by discounting?
You go to a 2nd or 3rd tier lender – you pay a higher interest rate of 8-12%, but they don’t require as many presales. This means the developer is taking more ‘on completion’ sales risk.
You defer the project – you then run the risk of interest rate increases, construction cost increases, consultant cost increases, holding costs and increases (e.g. land tax, water rates, land rates, interest on loan facilities etc.), all these costs accumulate. How much does this impact your profit? And then do you still need presales? That’s the big unknown.
Consider if there is an opportunity cost of deferring your development vs the cost of doing it now.
Traditionally you may raise funding of 5-6% for a typical construction. If you go to a 2nd or 3rd tier lender it’s 8-12%. Are you better taking a deal now with a second tier lender, e.g. an additional 3% interest on $5m is $150,000. But then you have to weigh up the opportunity cost in not going ahead with your development. Consider the cost of the higher interest rate against your holding costs if you don’t go ahead.
Which Option is Right For You?
To explore options 1 & 2 – Speak with your broker. A finance broker can help you decide which option for property development finance is right for you.
Option 3 – Until you know what will happen with the price of rates and costs, events that happen over next two to three years, you won’t know if option 3 is the best option. Only the individual developer can make this decision based on the development circumstances.