How Property Developers Can Close the Construction Funding Gap
For many property developers, the problem is no longer whether a project is profitable.
The problem is whether the project’s capital structure allows construction to commence and reach completion.
A development may have:
- an approved DA;
- acceptable feasibility;
- experienced developers;
- a competent builder;
- strong forecast sales; and
- substantial underlying equity,
yet still fail to satisfy a bank’s construction lending requirements.
The critical issue is often the gap between what the project requires and what a senior lender is prepared to fund.
That gap can potentially be solved through a combination of construction finance, mezzanine debt, preferred equity or joint venture capital.
What is a construction loan?
A construction loan funds the costs of developing property.
Unlike a conventional property mortgage that generally advances at settlement, construction finance is usually drawn progressively as works are completed.
Typical stages can include:
- land or refinance settlement;
- demolition and site works;
- foundations;
- structure;
- lock-up;
- fit-out;
- practical completion; and
- final certification.
Progress claims are generally monitored by an independent quantity surveyor.
Interest is commonly capitalised into the facility during construction so that the development does not have to generate operating cash flow to service monthly interest.
Why do viable developments experience a funding gap?
The funding gap normally emerges from one of four calculations.
Loan-to-cost
The lender limits funding to a percentage of Total Development Cost — TDC.
Loan-to-GRV
The lender limits exposure relative to the development’s expected Gross Realisation Value — GRV.
Presales
The lender requires a minimum level of qualifying presales before construction funding can commence.
Developer equity
The lender requires the developer to contribute a specified amount of cash or land equity before debt is advanced.
A project can satisfy three of these tests and still fail the fourth.
That is why property development finance needs to be structured as an entire capital stack rather than treated as a single construction loan.
Bank construction finance versus private construction finance
Banks can provide attractive pricing to projects that satisfy their credit criteria.
The trade-off is generally greater rigidity.
Private construction lenders can potentially be more flexible regarding:
- presales;
- borrower financials;
- gearing;
- project type;
- location;
- previous credit issues;
- facility size; and
- transaction complexity.
For an experienced developer, paying a higher cost of capital can sometimes produce a better commercial outcome if it permits construction to start earlier, preserves developer equity or allows the developer to retain another project.
The correct calculation is therefore not simply:
What is the cheapest construction loan?
It is:
Which capital structure maximises the developer’s return on equity without creating unacceptable project risk?
Construction finance without presales
Presales remain a major constraint for many residential developers.
Traditional lenders can require a significant percentage of project debt or stock to be covered by qualifying presales before the first construction drawdown.
That can delay commencement and introduce another risk: the developer is attempting to sell product before construction has materially progressed.
Some private lenders and mortgage funds will consider construction loans without presales, subject to the overall strength of:
- location;
- developer experience;
- valuation;
- feasibility;
- equity contribution;
- builder;
- project size; and
- exit strategy.
Prudential Finance currently has access to private capital sources willing to consider developments without a traditional bank presales hurdle.
No-presales finance is not appropriate for every project, but it can remove a significant commencement constraint from viable developments.
How much construction finance is available?
Prudential Finance currently facilitates construction loans from approximately $1 million to $500 million+.
Depending on the project and funder, senior construction lending can extend to approximately:
80% of Gross Realisation Value, or
90% of Total Development Costs,
subject to lender approval, valuation and transaction-specific risk assessment.
Those are upper parameters rather than automatic entitlements.
The strongest structure is not necessarily the structure with the maximum possible leverage.
What if senior debt is not enough?
This is where experienced capital structuring becomes valuable.
Assume a project requires $40 million of total development capital.
A senior lender is prepared to provide $28 million.
The developer has $7 million available.
There remains a:
$5 million capital gap.
There are several possible solutions.
Mezzanine finance
A junior lender sits behind the senior construction lender.
The mezzanine facility increases total debt and reduces the developer cash requirement.
Preferred equity
An equity capital provider contributes additional project capital in return for an agreed preferred return and negotiated protections.
Property joint venture
A capital partner participates in the project and shares risk and profit with the developer.
The correct solution depends on:
- cost;
- security;
- project margin;
- required developer equity;
- control;
- intercreditor requirements;
- risk allocation; and
- developer objectives.
The cheapest debt can produce the lowest developer return
Consider a developer with $20 million available.
If conventional senior finance requires $10 million of developer equity per project, the developer can potentially undertake two projects.
If prudent use of senior construction debt plus mezzanine or equity reduces required developer cash to $5 million per project, that same capital could potentially support four projects.
The developer pays more for the additional capital.
But the relevant metric is not merely the interest expense.
It is return on developer equity and opportunity cost of capital.
Higher-cost capital can be rational where the incremental project profit substantially exceeds the incremental finance cost.
Six questions developers should answer before approaching construction lenders
A finance proposal becomes considerably stronger when the developer can clearly answer:
What is the current land value?
What is the Total Development Cost?
What is the independently supported GRV?
How much cash equity has already been contributed?
What are the remaining costs to complete?
What is the primary and secondary exit strategy?
A professional submission should normally include the feasibility, development approvals, construction contract, quantity-surveyor information, valuation, developer experience and corporate information.
The objective is not merely to obtain an approval.
It is to create competition between appropriate capital providers.
Do not wait until the existing construction facility expires
Refinancing becomes materially more difficult after:
- facility expiry;
- default interest;
- payment disputes;
- builder delays;
- receivership threats; or
- cost-to-complete problems.
A developer with a facility expiring during the next six months should review replacement finance well before maturity.
That creates time to compare senior construction lenders, restructure the capital stack and introduce mezzanine or equity capital if required.
Prudential Finance — debt and equity for property development
Prudential Finance has more than 24 years’ experience across property development finance, construction loans and structured property capital.
Our funding network includes:
- banks and institutions;
- mortgage funds;
- private lenders;
- high-net-worth investors; and
- other private-capital providers.
Where a conventional construction loan does not provide enough capital, Prudential Finance can also assess mezzanine finance, preferred equity and property joint venture structures.
The objective is not simply to find a lender.
It is to build a capital structure that allows a commercially viable development to proceed.
For a confidential assessment of a current property development, contact Prudential Finance on 1300 550 669 or Hello@pru.com.au.
Recommended internal links:
Construction Loans → primary money page
Mezzanine Finance → capital gap
Preferred Equity → higher gearing
Property Joint Ventures → equity solution
