The Interest Rate Conundrum

RBA reduces rates causing real interest rates to increase Australian Bank Funding Costs Surging . I warned this could occur in WE SHOULD THANK THE RBA FOR HIGHER INTEREST RATES . What’s concerning is how quickly rates have surged and what impact expected, future interest rates decreases may have on Bank costs. If this trend continues, we will see our Banks retain either part or all of any future RBA rate decreases.    


Recently I had a discussion with a broker who specialises in construction funding and he advised me of some of the problems he was having placing several of his construction loans.

After listening to his complaints, I found myself questioning his experience; as it contradicted my own experiences of the past 5 years post the GFC.
As many of you would be aware, we at Folio Finance are very active in raising loans for construction particularly in the transaction sizes of $5m-$20m and have been from our inception back in 2005. During this time we have funded over $300m in projects, with the majority in and around the South East of Melbourne, CBD and Bayside Melbourne.

So what has changed during this time?

Below I discuss the major areas that need to be addressed when applying for construction loans and provide you with examples of how things may have been done pre GFC and what has changed since. I’m hoping this will clarify some of the misconceptions out in the market regarding project funding/construction funding.
Note, the examples and advice below are specific to Bank finance and not loans from Private Lenders or Non-Bank Lenders.

1. Lending Ratios & LVR’s – Whilst Banks (and some brokers alike) may talk about a Loan as a percentage of ‘End Value’ (when discussing loans for construction), lending for development has ALWAYS been provided on a Loan to Development Cost Basis. Banks and Brokers tend to talk “End Value” as it is an easier concept to grasp, but in reality, Banks always lend the lower of a percentage of costs (i.e. 80% of Costs) or a percentage of the Net Realisation Value (NRV ie.65% of NRV). A simple way of looking at this, is that for every dollar of agreed Project Costs the Bank is willing to lend you a fixed percentage. This ensures that the Developer has an adequate amount of equity throughout the project cycle and not only once the Construction is completed and majority of risk reduced. I can’t tell you how many times I have had developers come to my office and advise me that they have millions of dollars in equity in their project, based on the end value of the finished product (not a good sign).
Some lenders did change their Lending Ratios post GFC, in particular WBC, CBA and NAB, but there were many others who didn’t and continued to offer construction loans in Australia, at an “80% of Costs” level.

* NRV i.e. Gross Sales Less GST and Agent’s Commissions

2. Presales – Construction Loans in Australia have always required pre sales for larger Commercial Projects, when the project sponsor lacked the capacity to service the proposed debt, from external cash flow.
Pre GFC, many banks were proceeding with transactions based on pre sales of 50% of debt coverage.
Post GFC, this condition was tightened to 100%.
More recently, some Banks have relaxed this condition back to 50% pre sale cover providing a strong signal that Banks are once again, very willing and keen to fund residential and commercial construction loans.

3. Developer Experience. You can’t buy experience and as such, the most desirable developments to fund (for Banks) are those that are supported by experienced Property Developers. Its experienced Developers who are able to make decisions quickly, on site, ensuring the project is completed on time and on budget. A project Folio Finance recently funded, was completed 4 months in advance and saved the client over $400k in interest on their 1st and 2nd mortgages. It was a highly profitable project and I attribute this to the experience and expertise of the Project Sponsor. His experience meant that he was personally able to project manage the development and quickly and efficiently sort out many of the issues that appeared during construction. Conversely, at a similar time, we assisted a Developer who had years of building experience, as well as a solid level of property development experience (in building Townhouses), who required assistance with construction finance to assist with his first apartment property development. Despite his building experience, his lack of property development experience (of a similar nature) resulted in the project incurring heavy delays and the project timeline blowing out over 9 months. Ironically the Bank had forced the Developer to extend out his sunset clauses on his presold apartments (which the Developer strongly contested, as he was adamant he could complete the project within his estimated timeframe) and this meant that none of the buyers were able to cancel their contracts, due to his delays.
A developer’s Balance Sheet will also go a long way in validating a Property Developers previous success and its highly unlikely that Bank would be willing to lend a Developer , tens of millions of dollars, if they don’t have a healthy balance sheet (would you ?).

4. Financial Statements of the Borrower – we receive many enquiries from Developers who claim that they don’t have, or are unable to provide financial statements. The assumption they make is that their weak financial statements will render them inadequate to attain funding from a Bank. THIS IS COMPLETELY WRONG. Construction loans should be structured on a “stand-alone” basis with the Cash Flow or Debt Repayment generated from the sale of the end product and NOT the sponsor’s historical financial statements (unless the Developers Strategy is to build & retain). There are very few Developers or Developments that are funded on the strength of the sponsor’s cash flow (in the market segment I work in anyway being <$20m in value) which is why pre sales are so important. Recently we had a 6 x apartment development approved for a Developer who had a taxable income of $8k in 2012. 5 of the 6 apartments had been presold which meant that the Banks could be repaid in full on completion of the project. This, along with scoring strongly in areas 1 – 3 above, meant the funding was approved through a Big 4 Bank at very competitive rates,

So taking the above into account, my assessment of the current market for Construction Finance in Australia for Projects of <$20m in value is:

1. The market is more Dynamic post GFC and despite the policies of some Banks changing during this time, funding has continued to be available at traditional LVR’s,
2. Brokers need to control the application process by organising their own valuations and other supporting reports, and ensure that their Credit Submissions are detailed enough to allow an application with a number of lenders at one time. During the past 5 years Brokers and Developer’s who have been willing to work with a number of Lenders would have experienced little to no change in the level of funding they could access for construction loans,
3. Projects that have the right fundamentals are always highly sought after by Banks and Lenders in general,
4. Anecdotally, I believe a high majority of projects that are not funded or declined by the banks, simply don’t qualify for Bank funding and wouldn’t have qualified even in friendlier times,
5. The biggest impact in changes in Construction Lending, have been at the lower end of the markets (i.e. small townhouse development ) where Developers became accustomed to raising construction finance, based on the projects End Value and had little to no equity in the project. This type of funding where the majority of risk was transferred from the Developer to the Lender was unsustainable and whilst it was a great form of finance for Developers, was always expected to be tightened up,
6. The market for Construction Finance is not nearly as bad or tough as people make out and Banks and Non Banks alike, have shown a strong interest to work in this space in 2013,

I welcome your comments and opinions on your own experiences, even if they contradict my own.

Con Katsiouras – Director Folio Finance Pty Ltd