A time of opportunity in the Australian property development market

There’s a wonderful old story about two travelling shoe salesmen who walk into a dusty native village in a forgotten corner of the planet. After having a look around, they both ring their respective head offices to report in. The first salesman is inconsolable. “It’s hopeless,” he says. “They don’t even wear shoes here!” Then the second salesman rings his head office.  “It’s wonderful!” he says excitedly. “They don’t even wear shoes here!”

And, so it is with Australia’s property market at the moment. While some people will be lamenting falling prices and the tighter credit market, others are rubbing their hands in glee. They know that there’s no such thing as a bad market and a good market. There’s just the market and what individual developers and investors do with it.

I recently completed a speaking tour with Tim Lawless, the Research Director for property analytics company CoreLogic, who provided a fantastic summary of the current state of the market. We have property prices falling in most parts of the country at the same time as investor credit (particularly interest-only loans) is drying up thanks to moves by banking regulator APRA. The banking Royal Commission has meant that banks are applying tougher standards on borrowers than ever before, issuing fewer loans and demanding ever lower loan-to-value ratios. At the same time, we have one of the highest indebtedness levels in the world, and the cost of money is creeping up as offshore sources put up their prices.

Does it all make you want to run away from property developing and investing? It shouldn’t.

While the days of buying a property and passively waiting for the capital gains to come in may be over, for now, there’s still plenty of money to be made, particularly by developers with proactive strategies. And if accessing credit is a problem, there are lots of clever workarounds available involving alternate sources of finance.

One of the key factors to be aware of is that vendors will be increasingly willing to negotiate with buyers over the coming period. Some $60 billion in interest-only loans are set to expire over the next three to four years, and the tighter credit market means loan holders will need to start paying principal and interest for the first time. Many will struggle, resulting in mortgage stress, forced sales and a further softening of the market. The days of queues of buyers beating down the doors of vendors are over – for the time being at least.

So what strategies will work in with these particular market conditions? Consider trying some of these:

Joint ventures with property owners

If the tighter credit market has reduced your borrowing capacity, consider forming a joint venture with the vendor of the property you’d like to develop. Essentially, you enter into a partnership where they supply the property and you supply expertise and potentially meet the construction costs. In return, they share the profits you reap. This significantly lowers your need for cash up front. Be sure to involve lawyers so that each party’s obligations and benefits are clearly spelt out.

Rent to own (lease agreement)

While not so common in Australia just yet, this approach is used in the US and elsewhere in the world. A vendor who is having trouble selling a property enters into an agreement with a buyer who might be struggling to get a loan. The vendor agrees to lease the property to the buyer over a period of, say, three years, with the buyer given the option to buy the property at the end of the period. The lease payments count towards the final price paid. Property investors can make a profit by acting as intermediaries, connecting potential vendors with potential buyers.

Second mortgage carry back

This is another useful tactic for situations where you may not be able to borrow enough money to carry out the development you have in mind. Essentially the vendor steps in and lends you the shortfall. So, say you want a property worth $1 million and the banks will only agree to lend you $700,000. You reach an agreement where the vendor signs a second mortgage on the property for the remaining $300,000. You now have the money needed for the project to proceed and the vendor has $700,000 plus regular income provided by the interest payments on the $300,000. This works particularly well where, say, an empty nester is looking to downsize to a smaller home.

Overage agreement

An overage agreement is essentially where a vendor receives a bonus if your planned development proves to be as profitable as planned. They might agree to sell you a property at below its market value (say $900,000 instead of $1 million) with a legal proviso in the contract that if you achieve a certain profit they receive an extra payment (perhaps $200,000). This reduces your upfront investment and means the vendor takes on additional risk (and potential profit).

Option agreements

Acquiring a property before you know whether you will obtain a DA (development approval) and be able to develop it profitably is a risky business. An option agreement allows you to effectively take a property you are interested in off the market and then buy it at a time that suits you. You enter into an agreement where the vendor receives a small sum of money (typically one percent of the agreed purchase price) and agrees to sell to you at the end of, say, one or two years if you choose to take up the option.

So, don’t despair. Instead of seeing the downside of the current market, look for the upside and potential opportunities. Whether you’re selling shoes or developing properties, identifying opportunities is a far better strategy.