An Introduction to Development Finance
For the past 4 years money has been cheap.
At the start of this month, the RBA yet again decided to keep the cash rate of 1.5% on hold where it has been for the last 16 months.
There’s no doubt this housing boom has had a direct correlation with this current low interest rate environment. And with no signs of rates moving any time soon, what is the best use of your money to gain significant returns?
For some, completing a development such as a small block of units or the construction of 4 or 5 town homes etc has been an excellent strategy to take advantage of this historically low rate environment.
But how do developments work? What’s involved? What are the major challenges to consider
Obviously there’s a lot to consider, such as how to obtain DA approval, completing an accurate feasibility study, hiring a builder, architect and real estate agent to sell the security etc.
This post is not going to be an all-encompassing guide to developments. Instead I want to outline some of the key differences from a finance perspective, that differentiate residential lending from development lending that you need to be aware of before you embark down this strategy.
When it comes to comparing residential to development lending, there are four key differences to consider.
1. Serviceability is not a major factor (to a certain extent)
When you’re considering a development, the first question you need to ask yourself is are you looking to hold it or just sell to make a profit?
This question will dictate certain requirements that the bank places on you.
If you’re looking to hold, as a rule of thumb if rental income can pay for 1 ½ times debt coverage, there’s usually not a requirement for you to have to provide further details to justify your personal income.
If you’re looking to sell the security to make a profit, your feasibility will need to show a net profit of at least 20% but provided all the numbers work, the bank is happy to provide funding without a requirement for you to service the debt as they know you’ll be selling the security upon completion.
The other great thing about this option is they’re also happy for interest repayments to just capitalise throughout the development which really helps your cash flow.
2. How a bank determines their max LVR
Each development is risk rated individually by the banks so LVRs can vary greatly between different sites.
If you’re looking to hold onto the site upon completion your max LVR will float somewhere between 50 – 70% of Gross Realisation Value (GRV). That’s just bank slang for what the development will be worth upon completion.
If you’re looking to sel, the bank will ask that the debt you’re looking to borrow is covered by pre-sales. For instance, if you’re developing a block of 6 units that will be worth $600,000 each and you’re looking to borrow $3,000,000 they will ask that you sell 5 of those units off-the-plan (this is what they mean by pre-sales).
For the bank, this mitigates their risk of lending you the money as they can be certain that once the development is complete you’ll be able to pay them back.
3. Fees are completely different
For residential finance, lender fees are absolutely tiny – usually no more than $500.
When it comes to a development though, because of the complexity and therefore time it takes to fund this type of finance, naturally the fees involved are going to be higher.
First off, establishment fees can be anywhere from 0.6 – 2.0% of the loan amount. For $3,000,000 worth of funding this would be $18,000 - $60,000.
Next is the requirement for you to have to pay for a valuation and Quantity Surveyor (QS) report. Because there is sometimes not a requirement for you to show serviceability, both these reports can make or break a development.
You’ll also have to pay for the bank’s legal fees of producing the loan documents as well!
4. Interest rates are structured differently
When you look at your loan offer from a bank it will look something like this:
- BBSY: 2.31%
- Business loan margin: 1.39%
- Margin rate: 0.8%
- Line fee: 1.5%
Huh? I know, let me explain…
BBSY stands for Bank Bill Swap Bid Rate, definitions of this can get pretty technical but just look at it as the bank’s cash rate. Both the business loan margin and margin rate is the bank outlining the profit they will make on the funding. As such, to get the total rate you need to lump all three rates together. In this case it would be 4.5%.
Now the line fee is what stumps people when looking at the total rate. A line fee is a monthly fee that is charged on the facility limit. For example, for $3,000,000 worth of funding a line fee of 1.5% would mean that you would get charged $3,750/m regardless of what the overall balance is.
When it comes to development finance there are a lot of moving parts involved. Understanding how development finance works is critical to a successful development so hopefully this provides some insight when determining your overall costs.
Kind regards,
Tim Russell