What do you think is the number one factor that can kill even the most profitable property development project?
A: Lack of appropriate funding.
Yes, that's correct. Getting the all important development funding that is appropriate for the project. It's make or break. If you are considering investing in a property development project then you need to know...
The 7 critical factors to obtaining successful development funding that will have banks, joint venture partners and gap funders kicking down your door.
Without adequate funding on appropriate terms, even the best property development projects are doomed from the outset. With the tightening of lending criteria over recent years, understanding exactly what lenders are looking for is crucial before taking on a development (or investing your hard earned cash with a developer - an alternative investment path that is becoming increasingly common today).
Most developers cannot fund their projects purely out of their own capital and the more prudent would not do so anyway. As you become more experienced and take on more projects, you will quickly realise why it’s important to spread your financial risk across numerous projects ... even if it means sharing some of the development profits.
Let’s assume you have found a site that is economically viable, and your due diligence analysis is favourable. Perhaps you control the site by way of a contract or an option agreement.
The next step is to raise capital to get the project going.
When I cast my mind over the many developments I've backed over the years, I would say development funding and valuations are the two areas that can affect (and sometimes derail) even the best projects if not adequately understood and addressed.
It's important to step in the shoes of your funding partners and understand how they make a decision to lend (or not).
Let's first unpack some of the terminology you need to know.
Soft costs versus hard costs
Generally, development finance is lent as a percentage of the overall costs of a project. These costs are split into hard costs and soft costs.
Hard costs often refers to the costs of actual physical construction of a real estate development project but can include the land and acquisition costs, local council approval costs and professional fees.
Softs costs are less obvious than hard costs as they encompass anything and everything which is not directly related to the physical development of a building, e.g. loan establishment fees, interest, mortgage duty, valuation fees, legal and accounting costs, and marketing costs.
Although some lenders will provide for some of the marketing costs, in most cases the developer has to fund this cost by obtaining sufficient pre-sales to support their application.
Debt versus Equity
Funding packages generally comprise of debt funding and equity funding. Both are key to getting sufficient development funding ... but come with very different terms and levels of risk to the lender.
Debt funding requires the developer to pay interest and certain fees, but the Developer keeps all the profit after all costs are paid.
Sources of debt funding are banks and non-banks and comprise of senior debt (where the Developer offer the lenders a 1st mortgage) and mezzanine debt which sits behind the senior lender (2nd Mortgage) in order of payout.
Equity funding is where the lender elects to take on some of the risk by sharing in the profit. Usually this form of funding is more expensive as it reflects the higher risk including lack of mortgage security.
Equity financing is only offered by a small number of banks and non-bank lenders and, more recently, from crowdfunding providers like us at Hotspotcentral, where everyday investors provide the funds from their SMSF or other savings vehicles.
The biggest challenge for the Developer is to get as much money together to cover most of the total development costs. Unfortunately, the difference between the hard costs and soft costs available and the total costs can result in a funding 'gap' or the shortfall after all funding sources have been exhausted.
Plugging this funding gap with private money has become a lucrative opportunity for investors in recent times, particularly when the project is already quite advanced at the time of making the investment, i.e. post DA approved, with significant pre-sales and strong valuations, and when the debt funding is already approved.
7 key development funding lending criteria
Lenders ultimately ‘sell’ money to developers and compete with other lenders depending on their unique lending criteria. As a developer, it’s your job to understand these criteria and how to adequately mitigate the lenders' risk. The financiers will assess both the project fundamentals and analyse the borrower's credentials in line with their specific lending criteria.
Over the years, my Development Managers have had to kiss a few frogs before securing quality funding packages. And keeping in mind lenders are often found via brokers, who want an upfront fee just to introduce you, it can get very expensive if the application is not successful or the parameters are simply out of alignment with your funding requirements. I’ve seen fees of $20,000 and more paid to brokers only for the funding offers to be completely unacceptable or have conditions that are impossible to meet.
At the heart of raising equity and debt funding is your ability to articulate your overall vision for your project to the various stakeholders who you want to back you and part of this includes the following:
1. Internal Rate of Return
This is the interest rate at which the net present value of an asset is zero. Generally, financiers would not lend on a project that showed less than 25% IRR, unless substantial extra equity could be provided.
2. Return on Cost
The return on cost is calculated by dividing the development profit by the total development cost and multiplying by 100%. Generally, financiers would not lend on a project that showed less than 20% return on cost, unless substantial extra equity could be provided.
3. Percentage of Cost
This is the percentage of funds as a percentage of the total development costs. The higher the percentage of costs lent by the financier, the greater their risk. Currently some lenders will lend up to 75% to 80% of costs depending on a range of additional factors.
4. Percentage of Gross Realisable Value
GRV is the total value of all sales in the project. Today lenders will often lend as much as 65% of the total expected sales revenue or turnover.
5. Assets and Liabilities
When a financier considers the Developer’s assets (e.g. shares, cash, property) and liabilities (debts), they are looking to see what the borrower's net wealth is... Assets after all debts paid that can be converted into cash. Obviously the lender takes the worst-case scenario – total project failure – into consideration. Usually the lender will want some degree of net assets beyond the Developer’s own equity contribution into the project.
6. Developer's Experience
I'm often asked which is more important: the Developer's experience or the feasibility of the project. In my experience the answer is BOTH. I'm often approached by Developers to raise equity from my community of investors to plug any funding shortfalls and I know if they do not have the relevant (important) experience then there could be some headaches down the track. No funding, no project. Like lenders, I am careful who I work with too.
Once the lenders and investors are satisfied with the Developer's experience they will then look at the overall risks and implement a risk mitigation plan.
This refers to the Developer’s ability to make regular loan repayments should the project not achieve the forecasted level of sales (number of unit sales and prices achieved). When borrowing large sums of money, most Developers do not have to pay the interest charges throughout the project. Rather the interest is capitalised, or added, to the original debt and repaid out of sales revenue on completion.
As an investor is can be helpful to assess the risks of a gap funding offer in a similar manner to the lender. If the risks are adequately mitigated then the application is approved.
Here are three key risk mitigation factors they will consider:
- LVR – the loan to value ratio is the loan amount divided by the value of the asset offered as security.
Asset value = $10,000,000
Loan value = $8,000,000
LVR = 80%
When deciding on the LVR, the lender will ask themselves, “if this project completely flops, what is the best price I will get for the security asset if I sell it fast today”. The lower the LVR, the greater the chance of recouping the debt plus costs. A low LVR also means the borrower has put more of their own money in and are, therefore, less likely to walk away.
- Presales – most lenders will want to see a number of pre-sales (sales of the properties prior to construction) to prove there is a market for the end product (houses, apartments, etc.) at the proposed prices.
At the time of writing, my investors and I have provided equity to plug the funding gap in a project located on the booming Sunshine Coast.
Lenders are particularly concerned about the state of the general property market so they are obviously keen to see significant market uptake before providing debt funding.
The Developer managed to achieve over $32m in presales during COVID. As a result, the lenders are lining up to fund this project alongside Hotspotcentral equity investors .
When considering investing as an gap fund equity investor in a development like this, it’s not a bad idea to ask for proof of presales from a solicitor.
While you are here, if you have $50,000 sitting in your SMSF or mortgage offset account then you too can get a 40% targeted fixed return in the next 24 months. The project is in the advanced 'pre-construction' phase with most of the risks now fully mitigated.
Typically the lenders today want the presales to equal 100% of the debt cover. In other words, if all the current presales settle on completion then there should be sufficient revenue to cover all the debt.
Without presales, the risks increase along with the cost of debt including the interest rate.
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- Builders Contract – often the lender will need to approve the chosen builder and ensure they are contracted on a full turnkey construction basis.
This means the builder will also have to have a strong balance sheet to fund all the construction costs until they are paid from settlements. In this case, the Developer’s lender may not even have to advance any of the funds.
In my experience, most builders can't carry the costs throughout and will draw down on the debt facility as needed (after a quantity surveyor has signed off on progress relevant to the builder's claim).
What if you don't meet these lending criteria?
If you do not have much experience I'd suggest you partner with an experienced Developer or engage a professional project manager recommended by the lender.
As you enjoy more success as a developer, more sources of funding will be offered to you from traditional and private sources. Over time your goal is to position yourself, via your record of successful delivery, so that you will literally find banks, private lenders and Joint Venture partners all competing for your business.
Michael is the founder of Australia's only data-driven property development and location research tech-business that educates and connects investors with highly profitable, risk mitigated property development investments.
Michael FULLER, FOUNDER - HOTSPOTCENTRAL