In this article we are talking about development loans. They are often the riskiest commercial property loans, but they can produce attractive returns. Even the most experienced lenders will have problem development loans from time to time.
The major banks have been the dominant providers of development loans in the past, and as corporations they have extensive systems and experience to manage risk. Their lending, credit, advisory and workout staff are all well-trained and hindsight reviews are the norm, but similar problems will continue to occur, sometimes for reasons outside the lender’s or even the developer’s control. Murphy’s Law is often proven. If anything can go wrong, it will.
We can divide development lending risks into five general categories:
Prudent lending requires that these risks be mitigated where possible.
Sponsor and finance risk
With residential development, the sponsor is critical to a project’s success. So Sponsor risk should be weighted accordingly.
Reputation is extremely important. A proven history of completing similar scale and complexity of projects is very valuable. Access to adequate resources (physical and financial) is also critical.
For new customers, or inexperienced ones, the lending team should assume that the Sponsor will somehow get it wrong. With this as a starting point, it’s easier to accurately assess and properly mitigate or manage other risks.
Generally, lenders mitigate where they can and then initially rely on the Sponsor to manage the other risks, with their oversight.
Planning, construction and market risks
Appropriate mitigation can minimise Planning risk (by requiring a development consent) and current Market risk (by requiring qualifying presales). Construction risk is much more difficult to deal with. It persists throughout the project delivery process, and poor quality can impact repayment risk afterwards. Please read our recent article Residential Build Quality and the Impact on Buyers, Developers and Builders.
Builder selection is a key risk that requires significant due diligence. In our experience, the probability of a loss on a loan is substantially higher where there is builder failure over other risks such as presale failure or market correction. The tier of the builder, their reputation and resources (physical and financial) should all be considered. Please read our recent article Builder Tier System.
As a general rule, lenders require a fixed price and time contract, and enter into a tripartite deed with the borrower and approved builder. The loan will have conditions dealing with progress payments and PCG meetings and the approved feasibility will provide details of the program and cash flow forecast. A lender’s representative will be appointed to report on progress claims.
For performing loans, during construction, the lender should regularly meet face to face with the developer while written monthly reports should also be obtained. Lender’s representative reports should be reviewed and PCGs should be attended.
Ultimately, what we should be looking for are things that will affect time, cost and quality.
Proactively manage to the approved cash flow. Remember that QS reports are backward looking and expect there to be a lag in the QS reporting delays. Any slippage should be immediately investigated.
Be mindful about the builder or developer deferring important program sensitive issues. These issues could become the developer’s and lender’s problems if time is running out (e.g. sunset date approaching).
Be mindful that builders are motivated to claim as much as possible in the early stages of a new build, commonly known as “front-end loading”. Understand the provisional sums and complete designs and obtain the necessary approvals as early as possible. Monitor variations carefully, considering whether changes are compliant with presales contracts.
Poor workmanship may not be immediately obvious. Inspect regularly and be thorough. Messy sites and those where there are lax OHS systems have often proven to be of poor quality. Gut feel is important.
Poor quality has to be nipped in the bud. It is better for all parties to fix quality issues before the trade in question has finished. There can be flow on issues requiring additional work from multiple trades. Also, the builder may not be as accepting of arguments about poor quality when the project is nearing completion and all the profit has been extracted.
Following are things to keep in mind when managing development loans:
- Attend with the Site Manager and PM and DM where appointed
- Inspect the site at the commencement of the meeting so that issues identified can be discussed
- Is the design complete and have the staged CCs issued? Is it the builder that is slow?
- Is the builder following the design? Layouts and elevations should be checked.
- Is the builder following the specification for presales?
- Progressive as built surveys should be required. Location, floor heights, roof height etc.
- Are engineering certificates being issued as structural elements are being undertaken?
- Are the critical stage inspections being undertaken?
Following these five recommendations will set you up for the successful management of your development loans:
- Ensure you completely understand the development
- Presume that your Sponsor will get it wrong
- Presume the same about the builder and ask yourself “what is the solution if the builder fails?”
- Leave nothing to chance, undertake comprehensive financial due diligence on the builder
- ensure the sponsor has material “skin in the game”
Newpoint Advisory provides loan management solutions for lenders as well as builder reviews and presales reviews. We always advocate prevention over cure.
If you would like further information about this article or would like to learn more about how Newpoint Advisory operates, please contact us.