The 3 Finance Factors That Will Make Or Break A Development
Three finance factors that will make or break a development project in the current market, according to Tim Russell.
The May CoreLogic home index values came out recently noting the 8th consecutive month-on-month fall in property values nationally since the market peaked in September last year.
So if it wasn’t clear before, I think we can all now agree that we’re well and truly entered a new phase of the property cycle with the market effectively swinging around the flat, (I wouldn’t say depressed yet, but I would suggest it is a buyer favoured environment where emotion is no longer much of a factor).
For developers planning a new project, more thought and foresight needs to be given before getting the bulldozers ready. In this post, I want to outline three finance factors that I see to be critical to the overall success of a development.
1. Presales requirement
Before banks are happy to fund a development, they want to see that there’s interest from the market first and they measure this in the form of presales i.e. off-the-plan sales. During a market that’s on the rise, banks care less about this and are pretty flexible on how many units they need to be sold before construction can begin.
However, in a mature market like the one we are in now, banks are more focused on presales and most majors these days have a requirement for what they call 100% debt coverage. This means the developer needs to sell whatever number of apartments will cover the cost of construction. For example, if the development costs $5M and they’re selling units for $500K, they’ll need to sell 10 apartments before they can begin construction.
The challenge right now for a developer is it’s becoming increasingly difficult to sell off-the-plan properties to the market. For the buyer, they’re concerned that whatever they pay now, the apartment will be worth less, when settlement rolls around.
Developers know that a completed apartment is much easier to sell than off-the- plan, as buyers have an opportunity to walk through, touch and fell the apartment which brings in the emotional factor.
For this reason, if the developer is confident in their end product, it would be an advantage to have fewer presales, so they can get construction started sooner as they know they’ll sell the apartments once the project is completed.
2. Percentage of the total development costs
In residential finance, banks determine their risk-based off a Loan-to-Value Ratio (LVR). In development finance, it is called Total Development Costs or TDC.
And just like a residential purchase, the higher TDC, the less money a developer has to put into the project and the higher the bank's risk. As such, for every development, there’s always a tug-of-war going on between the developer and the bank who are each trying to de-risk themselves.
Of course, as the market matures the percentage of TDC the banks are willing to fund usually drops.
3. Uplift in valuation as equity contribution
Every person when buying real estate hopes to purchase the asset under market value. For developers, there are many factors at play that allows them to purchase a site under market value, but the main one is working a DA to improve the overall value of the land.
As a basic example, if a developer buys three old houses side-by-side and then gets DA approval to construct 15 apartments, this will significantly increase the value of the site that they originally purchased.
A big advantage for a developer is to then factor in the uplift in value as equity contribution, which means they don’t need to put in as much cash.
As an example, let’s say that a developer purchased a site for $4,000,000 and it will cost them $6,000,000 to put up 20 apartments. The bank may say they will fund 70% of TDC or $7,000,000 which means the developer has to put in $3,000,000 to make up the difference.
However, for some lenders when they value the land after you’ve worked a DA, the valuation may come in at $5,000,000 which means you’ll only need to put in $2,000,000 to fund it.
So for developers, these are the three factors that will make or break a project, particularly in the current market. As you might imagine, if one bank can take an uplift in valuation and another can’t, that will mean a hell-of-a-lot more than the difference between 5-7% as an interest rate.
As a broker, my job is to understand what the most important points are for a developer and then work with lenders to achieve the desired result.