How Do Lenders Assess The Funding Risk Of A Proposed Property Development?
The first thing to mention when discussing property development risk management, is that risk assessment is far from an exact science. Decisions are made by human beings, which means there is an element of emotion and gut feeling as well as some science.
However, there are some general guidelines that lenders will use to assess risk when looking at funding development projects, and these are generally accepted across the industry. In the points below, we’ll outline the factors that typically inform a lender’s decisions over whether to lend on a project and how to price transactions.
In a nutshell, “market risk” refers to the risk of units not selling at the end of the project in order to pay down debt. General market factors can significantly influence this, but the location, type of security, and the marketing plan presented by the developer can be a big influence on perceived market risk.
Strong levels of pre-sales can heavily mitigate this level of risk, and in general, banks will want to see sufficient pre-sale levels to pay down the debt at the end of the project before they even consider approving a loan.
Whereas banks will generally require the pre-sales at the end of the project to fully repay the debt before approving the loan, private lenders are more open to taking a higher market risk - sometimes they’ll even lend with no pre-sales, but they’ll charge a premium for taking this higher risk.
Market risk is also affected by the type, layout, and location of the security. For example, a residential townhouse in a middle-class suburb of Melbourne or Sydney that is in the average price range for the area would be considered a relatively low market risk, as there is a large pool of potential purchasers for this type of product. Conversely, if the type of product being built is unusual or not subject to a good number of comparable sales in the area, the market risk would be considered higher, which may affect the available lending terms.
Any decent lender will thoroughly consider what will happen if the development starts to experience problems.
Does the developer have the experience and knowledge to pick up problems early and address them? If there are cost overruns, does the developer have the cash flow to be able to meet these, or will they need extra funding? Has the developer demonstrated good character in the past?
If there is an issue with any of these factors, they can be mitigated. For example, an inexperienced developer can partner with a more experienced developer or employ an experienced project manager.
Alternatively, an experienced but undercapitalised developer can partner with a money partner or raise higher levels of equity. If the developer is well-capitalised but lacking in experience, this can be partly mitigated by the appointment of an experienced project manager to oversee the project.
At MFEG, every single project we have seen go bad has started with the builder.
Construction is the key area of risk, yet it often isn't given the attention it deserves. The factors that go into assessing construction risk are very similar to those associated with the developer – asset position, experience, and character.
However, there’s also the difficulty of the build, which will take the site and the building design into account. For example, a site with a basement car park will bring into play issues under the ground that may delay building or cause cost overruns, so these will be looked at as slightly riskier than a project with ground-level parking.
There are also legal considerations with regards to the construction contract. For instance:
- Does the contract contain liquidated damages clauses that sufficiently incentivise the builder to deliver on time?
- Is there a "retention sum" or bank guarantee required by the builder to incentivise them?
- Will the builder sign a "trip-partite deed"?
- Is the builder adequately insured?
As with developer risk, the appointment of an experienced project manager to keep the builder accountable and ensure early detection of problems is a good mitigant for any weaknesses regarding construction risk.
This is related to all the risk factors mentioned above, but an overall project risk will also consider the project's profit margin. A project with a healthy profit margin will be able to absorb considerable cost overruns and potential delays, whereas a project with a thin margin may not be able to absorb this, and the developer will have less incentive to make all efforts to address such problems. Furthermore, a highly leveraged project carries a much higher risk when there is an issue, when compared to a lower-geared project.
Other Factors in Real Estate Development Risk
While the above four factors summarise the primary points of due diligence conducted when assessing a project to finance, other risk factors often come into play among more experienced lenders. These are:
What is the risk of the lender's position being compromised legally? This goes into the borrowing structure of the entity and guarantees given. Therefore, there is generally a large set of legal documents to be signed for each development project funded. Lenders will also be careful to ensure that all parties to a transaction are properly educated about the implications of borrowing for their project, and that legal advice will generally be required for all guarantors.
The legal risk extends to the consultants and other stakeholders in the project. For example, as discussed earlier, the wording in the building contract can affect the risk to the developer and, by extension, the lender. This is also true of purchasing contracts and, to a lesser extent, contracts with architects, selling agents, shareholders/investors, and other project stakeholders.
In addition to the above factors, adequate insurance will need to be taken out to cover public liability risks and eventually building damage. Usually, the builder will hold the public liability insurance during the construction period, as they have responsibility over the site as soon as it's locked up.
This relates to market risk where there may be a risk of legislation that prevents the units from being sold at the end. For example, around 2015 we saw regulations introduced that made it difficult for foreign purchasers to settle on their properties, and this, in turn, increased market risk for developments with a high level of foreign sales.
Site risk relates to construction risk, and considers factors such as contamination, soil type and zoning. Some relatively common cost overruns are hard rock formations or water tables being found under the ground. Also, some sites will be more difficult to build on and therefore enhance construction risk, such as if they are on a big slope.
And finally, most lenders will generally be reluctant to lend on assets that may affect their reputation – this might include various types of mining projects, casinos, brothels and so on.
What risks are associated with your property development? Find out the specifics, with MFEG
At MFEG, our team of consultants are highly experienced in assessing the funding risks associated with upcoming real estate property development projects. We’ll work closely alongside you to determine what these risks are, how to mitigate them, and how to secure the highest lending amount possible for your project.
We are a trusted partner for developers seeking mezzanine finance, preferred equity finance, residual stock finance, and other forms of property development finance.