Ever thought about doing a small property development?
With the recent RBA announcement to reduce the cash rate down to 1.75%, Australian interest rates continue on a downward trend. We’re now at the lowest rate ever seen in Australia!
With the cash rate being so low, this means that home loan repayments are more affordable than ever. With change comes opportunity and one option a lot of people have considered during the last couple of years is completing a development such as a small block of units or the construction of a 4 or 5 town homes etc.
When it comes to a development there’s lots to consider such as how to obtain DA approval, an accurate feasibility study, hiring a builder, architect, and real estate agent to sell the security etc.
This article is not going to be an all-encompassing guide to development. Instead, I want to outline some of the key differences from a finance perspective which many people are not aware of when they embark down this path.
When it comes to lending, the banks have two different areas; residential finance, which is the one we’re all used to and commercial finance. If you are looking to obtain finance for a development it is classed as a commercial transaction. With commercial lending comes a number of positives and negatives when compared to residential finance. However, below are the four key differences you need to be aware of.
1. Serviceability is not a major factor (to a certain extent)
When you are considering a development the first question you need to ask yourself is are you looking to hold onto the security upon completion or are you just looking to sell to make a profit?
This question will dictate certain requirements that the bank places on you.
If you’re looking to hold onto the security, 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 about your income.
However, if it doesn’t then the bank will either require you to show you can service the loan via financials etc or they will ask for further cash that they keep in a term deposit. The amount of money they ask for is usually whatever they deem as the shortfall between the rent and interest payments for one year.
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 be able 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 sell the security 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 from the bank, 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 – 1.0% of the loan amount. For $3,000,000 worth of funding this would be $18,000 – $30,000.
Next is the requirement for you (what they call ‘the sponsor’) 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.
When thinking about the valuation, as you can imagine, there is a bit more involved in determining the value of 6 units which aren’t even built yet compared to a family home. In terms of fees, obviously, they are going to range immensely depending on the size of the development. However, for a block of six units, you should expect to pay somewhere between $3,000 – $5,000.
The QS report determines that the costs you’ve put down in your feasibility represent fair and market costs for what you’re looking to fund. Similarly to the valuation report, if this report comes back differently to how you’ve priced your costs it can also ice your development. For a small development, you’re also looking at around $3,000 – $5,000.
Finally, the other thing that a sponsor needs to pay is the bank’s solicitor fees (in addition to your own!). Yes, this can be a shock at first but it is the norm for all commercial lenders. Just like the other costs these can vary greatly depending on the complexity of the deal e.g. multiple borrowers all with complex trust structures. The cost for solicitor fees are usually around $5,000.
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%
What? 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.
This is particularly important for a development because funding is broken up into stages. For example, if you invoice $400,000 for your first progress payment there would be two fees:
- Interest rate charge. $400,000 x 4.5% = $1,500
- Line fee: $3,000,000 x 1.5% = $3,750
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.
Tim Russell is the Principal of Blueleaf Mortgage Solutions