The author of this article, Anton Flynn, is the Development Director and Strategist for the FLYNN Subdivision Experts based in Perth, Western Australia. He has authored a 225-page guide, The Infill Developer: a Concise Guide to Small Lot Subdivision and Development in Western Australia, and has also developed a 14-module online course on infill real estate development in Western Australia.
For real estate developers, securing financing for their next project is essential – as many developers know, it has not been an easy task in recent years. This article will walk you through the different developer financing options available and what you need to do to get the best financing solution for your real estate development project. Understanding the different types of loans and lender policies is essential to launching your project and maximizing your profit margins.
If you cannot finance a real estate development project on your own with cash (full equity), you will need a loan to finance part of the development costs in the form of debt. This will usually be in the form of a loan facility. You can review loan facilities to fund site acquisition, development costs, or a combination of the two under one or more loan facilities.
The type of loan, loan terms, loan amount and deposit required (the initial principal will be determined by the policies of the chosen lender. The lender will ask you to comply with these loan policies to repay your debt . project at a specified loan-to-value ratio (LVR) and / or loan-to-development cost ratio (LDCR). Compliance with these policies and ratio criteria determines 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 an assessment by the lenders of the project's risk factors against its policies and current market exposure.
This means that it matters not only how a transaction is presented (it must meet the selection criteria of the chosen lender), but also to which lender the transaction is presented. Some transactions, either due to geographic constraints or simply due to the nature and type of transaction, will be presented better to some lenders than others.
The important risk factors evaluated by the lender are:
The tax structure put in place for the development (i.e. the Special Purpose Vehicle (SPV) and then the recourse to the debt / loan title to this structure).
The type and size of the layout (number of lots / dwellings, single-family, collective or collective).
The location of the development (suburb / postcode).
Personal profile (your experience as a developer).
Are you developing to own and rent or develop to sell (trading or holding activity)?
Proof of pre-sale in the form of contracts if you are developing to sell (whether pre-sale is a requirement of the lender's policy or specified for your project given the level of debt sought, type of product and / or location development).
The terms of service of the loan (you and / or the other participants involved in the project).
The higher the LVR or LDCR, the less input capital is required for the loan. Naturally, the higher the debt load, the more interest will be paid for the life of the project. This interest is a cost and must be included in the feasibility calculations. Lenders will see more risk in the transaction as leverage increases (higher LVR) and they should consider recourse against individuals that extends beyond the first mortgage .
Types of Lenders for Real Estate Development in Western Australia
Simplistically, there are two types of lenders available to infill developers, depending on the type and scale of the project they are embarking on. They are:
1. Residential lenders
It is possible to use residential credit facilities to finance real estate development. It depends on the scale of development and the intention of the developer (holding company or business activity). Residential loan facilities are generally not offered to finance development projects to sell model projects (business entities) as these products are designed as long term credit facilities with their interest rates set accordingly .
Bank lenders can provide residential loans to finance land acquisition and development costs. The main parameters of residential credit are:
Underwriting requirements typically allow an LVR of 80% or less, but loans over 90% are available in certain circumstances by using onerous mortgage insurance (LMI) for lenders to underwrite the risk of loss in the event of default. repayment of the loan by the mortgagee.
Residential loan rates are lower than commercial loans, as the term is expected to be longer (typically around 3-4% at time of posting, but this is subject to change). Residential lenders expect development to be owned and not ceded as part of the evaluation criteria of their lending policies.
Buying sites to develop and sell is called land banking and is a cause of loan rejection under the policies of most residential lenders.
Residential loan is possible for 2-4 development lots if the intention of the entity is to own, as opposed to selling as a business entity. Developing to sell is considered a different kind of business 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 today's lending climate, residential lenders are reluctant to get involved in real estate development. Active developers are now turning to commercial loan providers for financing for their transactions.
2. Commercial lenders
Bank and non-bank lenders can provide commercial loans to finance the acquisition of land and the costs of developing a development. If you are going to be developing real estate on a regular basis, your business will be assessed as commercial and commercial activities, and you will need to familiarize yourself with the business lending space.
From a lender risk perspective, commercial loans are the appropriate product for commercial property development entities (selling products rather than owning). While interest rates are higher and LVRs lower, the assessment and qualification criteria are more suited for development purposes.
For example, the value at the end of the project is usually appraised (not the value of the land and construction), interest is capitalized under the loan facility (added to the loan amount) and your assets are more likely to be appraised than your income for recourse purposes (since this is a short term loan).
Subscription in the commercial space requires a higher initial contribution from the promoter. This is because the lender exposes himself to a large capital for a short time in a high risk activity. They generally accept an LVR of 70% or less (50-60% is not uncommon). Other things to note for commercial loans:
Commercial loan rates are typically above 4%, as these are short term loans (usually 1-5 years), plus set-up, appraisal and brokerage fees. .
The intention is to grow to sell with these credit facilities (no hold period). If the intention changes, it is advisable to refinance to another loan facility that is more residential in nature with a lower interest rate.
Commercial loans offer lower LVRs, but more cover development costs.
Commercial lenders usually value LVR with the value on completion, as opposed to land and development charges. This can compensate for the lower LVR and the higher rates offered compared to home loan alternatives.
A maximum LDCR of 65-70% (depending on the lender) is generally accepted.
Term periods and / or credit extensions are possible but can be expensive (they may require short-term bridging or mezzanine financing).
Proof of pre-sale may be required: this may impact loan conditions and calculation parameters.
It should be noted that commercial loans are for a fixed term. The lender will demand full repayment of the debt on the expiration date or a penalty will be incurred. It is advisable to add a time contingency to the loan period to allow time for sale after project completion, settlement with end buyers and / or loan facility refinancing if sales of all products are incomplete at the end of the loan term; for example, negotiating a 16 month commercial loan for a project with 12 months of construction time (4 months for sales or refinancing option / timeframe etc).
Real estate development financing options in WA
To finance your real estate projects, you can choose from a variety of bank and non-bank lenders
Bank lenders: these are traditional credit institutions, such as:
Small institutional banks (second-tier lenders) include:
These banks all have residential and commercial loan services.
Non-Bank Lenders: These are alternative lending institutions that provide loans to finance development and construction projects, usually in the area of ??"commercial" valuations. They are lenders such as:
RAC real estate financing.
Seed and borrowed capital may be required for three categories of costs:
Land acquisition costs (mortgage or business loan).
Development costs (separate or added to the main loan).
Non-borrowing costs (depending on the lender, this may include design and AD costs, statutory contributions / fees and utilities, accounting and legal fees, interest, land development / subdivision costs, contingencies, etc.).
Remember that each lender (bank and non-bank) has different credit policies on what they will include and exclude as cost items when evaluating underwriting requirements for your project loan, and that these policies change over time. Work closely with your broker to capture these costs and determine which lenders in the current market have the best product for your project.
It is imperative to be honest about the project details with the lender (or broker) as the project details will impact the LVR / LDCR offered for the transaction (if they agree to the transaction at all). Loan parameters proposed later may have an impact on the initial cash flow required and on the overall feasibility of the project for this reason. Elements of risk that affect the financing and valuation of your transaction by the lender include:
What are you building (types of housing / methodology)?
Do you expand to own or sell (entity intent)?
Which builder do you use (past performance / solvency)?
Where are you developing (postal code)?
Do you have pre-sales in place (if the project is too risky)?
Do you demolish improvements (existing homes) and when?
Can you afford to hold if the market changes and you can't sell (or what contingencies / underwriting do you have)?
Remember that the first responsibility of the bank is to limit its own exposure to risk throughout your development.
As you progress, accept that you will borrow at commercial rates (when you become a known short term borrower). This will often require more input capital (lower LVRs) and you may end up resorting to non-bank lenders as the criteria for evaluating developments become more difficult.
Leverage effect in real estate development
A fundamental principle of real estate development is leverage. To make our investment in a project profitable, it is possible to contribute less than 100% of total development costs (TDC) from your own source of equity (cash).
A percentage of TDC can be funded with OPM (other people's money) and / or debt (loans). The ability to minimize our own equity input and finance some, most, or all of the development with other sources of input capital is the art of the effect of the sink.
Leverage, in essence, is the ability to maintain a reasonable return for yourself while minimizing the amount of money (equity) that you personally invest by giving to other participants in equity and debt a consideration (a return) of risk for their participation in the project. The return on every dollar invested actually increases (return on invested capital). An example is provided below:
Total Development Cost (TDC)
Total equity contributed
% Debt and / or OPM
Return on investment (total cost)
Return on your invested capital (leverage)
Table 1 – ROI compared to ROIC
Table 1 seeks to demonstrate how you can leverage your personal invested capital by taking advantage of alternative sources of financing (debt and OPM). Scenario two costs are higher to account for hypothetical (capitalized) interest on borrowed money. Consider the opportunity cost – you could have two such projects happening simultaneously taking advantage of capital, as opposed to scenario one where all of your available capital was committed to one project.
In summary, there is a wide variety of financial products and lenders in the developer finance market. However, many developers fail to secure funding only because they have not learned how to properly present offers to lenders, and probably do not present their offers to the right lenders who have the financial product adapted to their type of project.
If you are continually interested in real estate development finance topics and want to learn more about finding the right financial products and presenting them correctly to lenders to secure financing for your transactions, the author explores and discusses these matters in more detail in the above-mentioned publication