This is Part 1 of a 2-part series on pre-sales. In this part we conduct a superficial analysis of the current pre-sale regime and identify the pros and cons for each party. In Part 2 we take a closer look at pre-sales risks and ways they could be mitigated.
Developers are now feeling the effects of a market correction. Fall-over rates in the local market are above historical levels, and very high fall-over rates have been experienced in some parts of Australia.
APRA has been influential. We now have very tight retail home loan finance conditions – a consumer credit squeeze. Banks have curtailed lending to off-shore buyers and reduced lending to interest only borrowers such as investors. More recently, the banks have tightened credit controls around borrowers’ ability to service their loans, taking account of all their probable living expenses and a significant buffer against potential interest rate increases. The result has been lower buyer demand, reducing market value.
Updated valuations at discounts to purchase price will occur with some developments either because of market falls or because the completed developments don’t quite live up to expectations. The outcome for high LVR borrowers will be a requirement for additional cash equity (lenders will ask borrowers to make up the fall in value and reduced gearing available), which will be problematic for borrowers of limited financial means.
High pre-sale targets are often considered a necessary evil by developers, being a key requirement of development lenders who wish to mitigate market risk. But, in our view, pre-sales are imperfect and, except in a flat market, are more beneficial to purchasers than they are to developers and their lenders.
Current state of play
Prudent developers undertaking large developments or with large development portfolios will wish to presell some stock, but the level will often be governed by a lender’s requirements. Over recent times, to get developments off the ground with bank funding, developers have needed pre-sales totalling 100-120% of debt. This is referred to as pre-sales debt cover.
Developers market their product and sell to the highest bidder. They are highly motivated by sales targets but not particularly selective of buyers. Their aim is often to meet lenders’ pre-sale covenants as quickly as possible to release construction funding so that the costs of time delays are avoided. When the required level of pre-sales is obtained developers submit the contracts to the lenders’ solicitors for qualification.
Lenders’ solicitors are often instructed to review a sample set of contracts, for example 25%. To our knowledge, solicitors do not take a scientific approach to selection of the sample set, instead selecting at random. The solicitor reviews the contract conditions, assesses enforceability, checks the deposits held in trust, obtains necessary declarations etc. Qualification is against the approved lending terms, so solicitors must be cognisant of things like FIRB status, multiple sales, deposit levels etc. But many other commercial factors are not considered.
Lenders confirm that qualified pre-sales meet pre-sale loan covenants before they advance funds. In doing so they complete a further review of the pre-sales, focused on commercial matters like exceptions to pre-sale loan covenants that must be approved considering the location of buyers, whether FIRB approvals are required, the amount of deposits, the impact of historic default rates etc. A high proportion of time spent doing this is in producing the reports and securing the necessary sign-offs.
Privacy laws are a major hindrance to establishing the credit-worthiness of pre-sale buyers objectively. This would go some way to explaining why most lenders spend limited time forensically considering pre-sales risk.
Newpoint Advisory advocates thoroughly investigating the commercial aspects of pre-sales that improve or diminish buyers’ capacity to settle. This might include the composition of foreign sales versus local and interstate sales, the agent involved versus the commission paid, the rate of sale over time versus the prices paid, the concentration of buyers’ solicitors, the possible presence of rebates etc.
Newpoint Advisory uses an advanced pre-sales model that identifies these factors giving a basis on which to forecast settlement risk. Currently, most lenders’ assessment of these factors is below the level that technology allows at minimal cost. A handful of non-bank lenders are much more sophisticated in their due diligence.
The inability to easily assess purchasers’ credit-worthiness is a major shortcoming of the current pre-sales’ regime. But the fact of the matter is that, despite pre-sales being high value and long term contracts, neither party to a pre-sale are required to establish their credit-worthiness in any way. This is a failing unique to the residential real estate development industry.
Market impacts
In a flat but liquid (reasonable access to retail home loan finance) market all parties benefit fairly.
| Party | Pros | Cons |
|---|---|---|
| Purchaser | Low upfront investment Significant time to pay Locks in purchase price Confident of financing Consumer protections | Legal commitment to settle Inability to lock-in take-out finance at time of contracting Credit risk of developer Possible to over-commit |
| Developer | Low cost and achievable Proves up the development Reduces market risk Makes the development bankable | May undervalue completed product (discounts may be required) Credit risk of purchaser Exposed to rising development costs |
| Lender | Proves up the development Reduces market risk Provides certainty of repayment | Credit risk of pre-sales |
Purchasers are the main beneficiaries in a rising, highly liquid market.
| Party | Pros | Cons |
|---|---|---|
| Purchaser | Low upfront investment Significant time to pay Locks in profits Confident of financing Consumer protections Can on-sell | Legal commitment to settle Inability to lock-in take-out finance at time of contracting Credit risk of developer Easy to over-commit |
| Developer | Low cost and readily achieved Proves up the development Reduces market risk Makes the development bankable | May undervalue completed product (discounts may be required) Credit risk of purchaser Limits gains Exposed to rising development costs |
| Lender | Proves up the development Reduces market risk Provides certainty of repayment | Credit risk of pre-sales Limits security value |
At a practical level, purchasers may have limited exposure in a falling market.
| Party | Pros | Cons |
|---|---|---|
| Purchaser | Low upfront investment Significant time to pay Consumer protections Stamp duty is refunded if the pre-sale is rescinded Developer may forgo recovery | Legal commitment to settle Inability to lock-in take-out finance at time of contracting Credit risk of developer Exposure to losses Easy to be over-committed at settlement |
| Developer | High cost and hard to achieve Proves up the development Reduces market risk Limits losses in a falling market Makes the development bankable | Severely under values eventual product Credit risk of purchaser Exposure to rising development costs |
| Lender | Proves up the development Reduces market risk Protects security value in a falling market | Credit risk of pre-sales |
We hope you enjoyed reading this article. In Part 2 we take a closer look at these pre-sales risks and discuss ways that they can be mitigated.
If you would like assistance or further information about this article or would like to learn more about how Newpoint Advisory operates, please contact us.