Tips for funding a development

Over the last six months I have been approached time and time again for development lending. Many people are looking at the passive rental market and the price of Auckland properties and thinking that there could be a better way of putting their capital to work.  

In almost every scenario there is a learning curve for the client and I have at times even had to leave some clients disappointed and without finance. Today I wanted to cover off some quick things to look out for when doing a development so you don’t get caught high and dry. I will talk GST, development costs, two key ratios and second tier lenders.

First up: GST

Please note: this applies to any developments with any sale of the completed product. Quite simply just remember that this is a tax. Whilst you may claim it throughout the build (including on the purchase of the property) you must pay it on completion and therefore all of your figures should be net of GST. Lenders will only fund against GST exclusive figures (including the purchase of the property) so it is imperative to include this in your calculations. Funders may provide some short-term funding to allow you to continue between claims, however their core funding decision will be made against GST exclusive figures.

Development costs

You want to understand these as much as possible before purchasing a property. This should all be part of your due diligence. Remember, they include not just the build cost for your end product but any demolition and removal costs of the current property, professional fees, subdivision works, financing costs, marketing and agency costs and many more. They also include contingencies. If your build contract doesn’t include any contingency then you will want to add 7.50% to this cost as each lender will. If you fail to understand these in full you could find yourself struggling to find funding and looking at a development that will at best return only a small amount and at worse make a loss.

Development costs lead me perfectly onto my next point, some key ratios. From this point forward, the article will be broken into banks and second tier lenders.

Firstly, let’s look at profitability. This is quite simply the GST exclusive value of the end product less the GST exclusive costs of the development (remember finance costs are not subject to GST). Banks will seek 15.00%+ profitability in each project, a second tier lender may be more comfortable at 7.50% – 10.00%.

Next, Loan to Cost Ratio (LCR). This is the ratio of the loan to the total cost of the project. Banks typically will cap their funding at 70% (i.e. fund 70% of the project cost). Second tier lenders are more relaxed on this and focus more on LVR than LCR. As a rule of thumb though you want to be able to put 15% – 20% cash into the project. You should note that this ratio does not treat additional properties as cash – it is purely a reflection of the loan amount to the total cost and a measure of the client’s capacity to fund the project.

Second tier lending

Lastly, some thoughts on second tier lenders. Whilst banks are the cheaper option (usually an all up funding rate around 7.00% – 8.00%) there are some real benefits to second tier lenders that can help alleviate this disparity.

Firstly, as above you tend to be able to secure a greater amount of funding from a second tier which is often the primary driver behind engagement. As above, they will lend primarily against the completed value of the product which tends to unlock further funds, sometimes up to 90%+ of the LCR.

Second tiers however are also more relaxed with their ongoing and up front requirements. Some will not require a valuation (complete them internally), some no QS involvement and others will be happy without a build contract. Overall, whilst you may pay a higher interest rate than at the bank, once you consider the saving in cost and more aggressive appetite it is well worth considering the second tier option.

Lastly..

The most important piece of advice I can give anyone however is to engage with an adviser early. Ensure that you have someone that you can bounce ideas off and make sure you are on the right path, if you don’t know something – ask. We're happy to chat.

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