How to profit as a developer post-pandemic

The Author of this article, Anton Flynn, is a development manager and strategist for FLYNN Subdivision experts based in Perth, Western Australia. He has written a 225 page guidebook, The Infill Developer: a Concise Guide to Small Lot Subdivision and Development in Western Australia, and has also put together a correlating 14 module online course on infill property development in Western Australia.

For property developers, securing financing for their next project is essential- as many developers would know, this has not been an easy task in recent years. This article will explain to you the different developer finance options available, and what you need to do in order to secure the best finance solution for your property development project. Understanding different loan types and lender policies is key to getting your project off the ground, and maximising your profit margins.

If you cannot finance property development project yourself with cash (full equity), you will require a loan to fund a portion of the development costs as debt. This will typically be in the form of a loan facility. You can look at loan facilities to fund the site acquisition, development costs or a combination of both under the one or multiple loan facilities.

The type of loan, terms of the loan, the loan amount and the deposit required (upfront capital will be determined by the policies of the lender chosen. The lender will require you to comply with these lending policies to provide debt to your project at a specified Loan to Value ratio (LVR) and/or a Loan to Development Cost Ratio (LDCR). Compliance with these policies and ratio criteria drive the underwriting requirements of your loan facility.

The type of loan, terms and LVR or LDCR offered on a financial product will be determined by a lenders assessment of project risk factors against its policies and current market exposure.

What this means is that it is important not only how a deal is presented (it should address the selection criteria of the lender chosen) but also to which lender the deal is presented. Some deals, either because of geographical constraints or just because of the nature and type of deal will better presented to some lenders than others.

Important risk factors assessed by the lender are:

1. The tax structure set up for the development (i.e. The Special Purpose Vehicle (SPV) and subsequently debt security/lending recourse to that structure).
2. The type and size of the development (number of lots/dwellings, single, group or multi dwellings).
3. The location of the development (suburb/postcode).
4. Personal profile (your experience as a developer).
5. Are you developing to hold and rent or developing to sell (trading or holding activity)?
6. 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).
7. The serviceability requirements of the loan (you and/or other participants involved in the project).

The higher the LVR or LDCR, the less input capital for the loan required. Naturally, the higher the debt loading the more interest that will be paid for the project duration. This interest is a cost and must be worked into the feasibility calculations. Lenders will see more risk in the deal as the leverage increases (higher LVR) and they have to consider recourse against individuals that extends past the first mortgage.

Types of Property Development Lenders in Western Australia

Simplistically, there are 2 types of lender available to infill property developers, dependant on the type and scale of project they are committing to. These are:

1. Residential Lenders

It is possible to use residential loan facilities to finance a property development. 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.

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 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.

 2. Commercial Lenders

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 (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.

For example, the project end completion value is usually assessed (not land and construction value), interest is capitalized as part of the loan facility (added to the loan amount), and your assets are more likely to be assessed than your income for recourse purposes (as it is a short-term loan).

Underwriting in the commercial space requires a higher upfront equity contribution from the developer. This is because the lender is exposing themself 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.
• A maximum LDCR of 65-70% (dependent on the lender) is generally accepted.
• Term period and/or credit extensions are possible but can be expensive (they may require short term bridging or mezzanine finance).
• Evidence of pre-sales may be required: this can have an impact on the loan terms and calculation parameters.

It must be emphasised that commercial loans are for fixed terms. The lender will require full debt repayment by the expiry date or a penalty will be incurred. It is advisable to add a time contingency to the loan period to allow time for sales post project completion, settlement with the end buyers and/or refinance of the loan facility should sales of all products be incomplete at the end of the loan term; for example, broker a 16-month commercial loan for a project with 12 months of construction time (4 months for sales or option/time to refinance etc).

Real Estate Development Finance Options in WA

To finance your property developments, you can choose from a variety of Bank and Non-bank lenders

Bank lenders: these are traditional lending institutions, such as:

• National Australia Bank.
• WESTPAC Banking Corporation.
• Commonwealth Bank.
• ANZ 

Smaller institutional banks (second tier lenders) include:

• Suncorp.
• Bendigo Bank.
• Macquarie Bank.

These banks all have residential and commercial lending departments.

Non-bank lenders: These are alternate lending institutions that provide debt to finance development and construction projects, typically in the “commercial” assessment space. These are lenders such as:

• Latrobe Finance.
• RAC Property Finance.

Up front and borrowed capital may be required for 3 categories of costs:

1. Land Acquisition costs (mortgage or commercial loan).
2. Development costs (separate or added to principal loan).
3. Non-Borrowing costs (dependent on lender this could be design and DA costs, statutory and utility contributions/fees, accounting and legal fees, interest, land development/subdivision costs, contingencies etc).

Remember that every lender (bank and non-bank) has different credit policies on what it will include and exclude as cost items when assessing underwriting requirements for your project loan, and that these policies change with time. Work closely with your broker to capture these costs and determine which lenders in the current market have the best product suited to your project.

 It is imperative to be honest about project particulars with the lender (or broker) as project particulars will impact the LVR/LDCR offered for the deal (if they accept the deal at all). The subsequent loan parameters proposed may impact cash required up front and the overall project feasibility because of this. Risk items that affect finance and assessment of your deal by the lender will include:

• What are you building (dwelling types/methodology)?
• Are you developing to hold or to sell (intention of the entity)?
• Which builder are you using (past performance/solvency)?
• Where are you developing (postcode)?
• Do you have presales in place (if the project is too high risk)?
• Are you demolishing improvements (existing dwellings) and when?
• Can you afford to hold if the market changes and you can’t sell (or what contingencies/underwriting do you have)?

Remember, the banks first responsibility is to itself to mitigate its own risk exposure through the course of your development.

As you do more developments, accept that you will be borrowing at commercial rates (as you become a known short-term borrower). This will often require more input capital (lower LVR’s) and you may end up using non-bank lenders as the assessment criteria for developments become tougher.

Leverage in Property Development

A fundamental property development principle is leverage. To make a return on our investment in a project, it is possible to contribute less than 100% of Total Development Costs (TDC) from your own equity source (cash).

A percentage of TDC can be funded with OPM (others people money) and/or Debt (loans). The ability to minimise our own equity input and finance some, most or all of the development with other input capital sources is the art of leverage.

Leverage, in essence, is the ability to maintain a reasonable return for yourself whilst minimising the amount of money (equity) you invest personally by giving other equity and debt participants risk consideration (a return) for involvement in the project. The return on every dollar you put in actually increases (return on invested capital). An example is provided below:

Table 1- ROI vs ROIC

Table 1 seeks to demonstrate how you can make the return on your personal invested capital increase by leveraging alternate sources of money (Debt and OPM). Scenario two costs are higher to account for hypothetical interest (capitalised) on borrowed money. Consider opportunity cost- you could have two such projects happening simultaneously by leveraging capital as opposed to scenario one in which all your available capital has been committed to one project.

In summary, there are a large variety of financial products and lenders to pursue in the market for developer finance. Many developers however fail to secure finance only because they haven’t learnt how to present deals to lenders properly, and are quite possibly not presenting their deals to the right lenders who have the correct financial product for their project type.

If property development finance topics are of ongoing interest to you and you want to learn more about finding the right financial products and presenting to lenders correctly to secure finance for your deals, the author explores and discusses these topics in further detail in the publication listed above