Obtaining development finance for private construction is still tough. This week we take a look at how bank financing has changed since the heady days of 2007-2008. Given the new environment what steps should developers take to maximise their chances of raising finance?

The first thing to recognise is that the cost paid by banks to obtain the finance that they lend has jumped up, and this is now being passed on to clients.

The typical bank depends on a mix of sources to fund their loan books. These include customer deposits (around 50%) and capital (7%) short term. However the rest (around 43%) is a mixture of short term, medium term and long term debt raised on the inter-bank market.  

The resultant mixture of short and long term inter-bank loans and their maturity profile is monitored and managed carefully by the banks to ensure that they always have sufficient liquidity to repay their debts, and can also make new loans. 

Feasibilities are getting harder

The global downturn and the high profile collapse of several major banks has caused a substantial fall in both trust and liquidity in the inter-bank lending market. The result is that the cost paid by banks for their mix of finance has jumped up.  

Prior to the downturn banks could obtain short term money at 20-40 basis points above BBSY (the 30 day Bank Bill Swap Rate). This subsequently increased to 150 basis points. Similarly medium and longer term inter-bank loans currently carry a 100 basis points liquidity premium as well as an additional 70 basis points premium for the Government’s bank guarantee.

There has also been a reduction in sources of funds for banks. For example, the securitisation market (in which loans are bundled together and traded on financial markets) has almost disappeared after the damage done to this sector by the sub-prime meltdown.

Finally banks have to compete for limited depositor’s funds. This generally means offering higher interest. As a result they need to pass on higher costs in their loan products to retain their margins.

Currently the overall interest rate environment is lower than prior to the downturn. Variable home loan rates are in the range of 5.5%-6%. However the effect of the increased costs of interbank lending largely negates this for developers. For example, according to Stephen McDonald, Director of Property Finance at BOS International, typical interest rates paid by the developer will be in the region of 8-9%. This figure takes into account the BBSY liquidity premium, government guarantees, and line costs.  

Now let’s look at what banks are expecting to see in the feasibility study. Here there are also new challenges.

The first is the move away from non-recourse loans. Prior to the downturn it was common for a developer to set up a Special Purpose Vehicle for developing a project. This fenced the project for lending and development purposes away from other activities of the business. Should the project go bad the banks recourse was limited to the value of the project. Since the downturn very little lending is done with non-recourse loans, meaning that the developer often has to include additional equity, liquidated damages, and guarantees, or use other buildings and assets as additional security.

Another key consideration is the value of land. Prior to the downturn a developer could obtain a raised valuation on the land once a development approval was in place and this raised their equity stake. Given the uncertainties in the property market banks are now reluctant to recognise this increase in valuation for the purpose of lending, preferring to use the true cost (unimproved or purchase price) of the land.

Currently senior debt maximums tend to be 70% of total project costs down from 80%. In the past hard costs (construction, land, consultants) and soft costs (stamp duty, marketing and sales and interest costs) were often used as the basis for lending. This effectively allowed development finance up to around 80% of total project costs (or sufficient to cover hard costs only). This distinction is less frequently used now.

With only 70% funding coverage of total project costs by senior debt and the mezzanine debt market almost non-existent, the onus is on the developer to obtain at least 30% equity. Banks also look for equity internal rates of return of more than 30% as a test of the project’s feasibility.  

Banks also may conduct due diligence on pre-sales to minimise the risk of default as a result of the buyers perception that the market has fallen. Developers that demonstrate that they are staying very close to their pre-sales clients will help alleviate some of these concerns at the banks.

Generally presales targets are higher.  According to Stephen McDonald the banks would have typically accepted 25-35% of pre-sales for funding to proceed prior to the downturn. The required pre-sales is now more likely to be 50-70%.

Developers who conduct detailed sensitivity analysis to show the impact of slower sales, presales defaults, and higher costs on overall returns, will stand a better chance of obtaining funds. Risk analysis and well considered mitigation plans for such adverse situations are likely to be better received by the banks. If a developer can demonstrate that their pre-sales clients are not likely to pull out the bank is likely to accept a lower pre-sales rate.

In this more competitive construction market banks also look for construction contracts that offer lowest risk to the developer at the expense of the builder. Guaranteed maximum price contracts, design and construct (AS4300) with shared savings, or managing contractor, open book with fixed profit and overhead are some examples.

Banks also look for evidence of benchmarking against industry norms for consultants fees (6-9% of total project costs), project management fees (3-4% of construction costs) and construction costs. Developers that use quantity surveyors and other means to demonstrate that they have tested their costs against industry benchmarks will get a better reception.

Developers need to include substantial contingency in their feasibilities to satisfy bank requirements.  Between 5-10% of construction costs to cover project time extensions and higher are required.

Generally existing clients with a good track record of delivering projects and making timely payments will be preferred. Those industry segments that are out of favour such as luxury apartments and commercial will be less successful in obtaining finance than those projects targeted at first home owners.

The above conditions are typical for the Australian lending market in 2009 after the global downturn. It is clear that banks have a far lower risk appetite for lending to developers than before the downturn, and look for evidence that risks are measured and mitigated.  Developers that work closely with their banks and can provide as much proof as possible that a project will work and that appropriate checks and balances are in place are likely to be more successful in these challenging times.

 

After the downturn - summary of new conditions: -

·         Development interest rates 8-9%

·         Pre-sales increased from 25-35% of total to 50-70% of total

·         Increased valuation of land through DA not recognised as increased equity

·         Loans require full recourse, guarantees, additional equity or security. No Special Purpose Vehicles.

·         Maximum loans 70% of total project costs

·         Additional due diligence on pre-sales

·         Benchmark costs against industry norms

·         Construction contracts favouring the developer

·         Includes simulation analysis, risk analysis and mitigation plans

By Gary Emmett