Large Builder Developer Contagion Risk – Part 1

What is a Large Builder Developer Property Group (LBDPG)?

We deem a LBDPG to have the following characteristics:

• Consolidated turnover over $250m per annum
• More than 400 dwellings completed per year
• Funding lines in excess of $250m, often from multiple banks and non-bank lenders
• Multiple active projects with over 100 units

Furthermore, the following operational characteristics are indicative of a higher LBDPG risk:

• Non-consolidated and or unaudited financials
• Large number of lenders, particularly, non-bank lenders
• Large land bank portfolios, particularly development sites under option
• Developments located in recently re-zoned or growth areas that are not traditional high-density markets and more vulnerable to over supply
• High density, multi-staged developments that have long dated programs that run longer than the property market cycle and expose the development to price fluctuations
• High density developments and complicated integrated or mixed-use developments where the risk of defect claims post completion increases

How are LBDPGs structured?

The flowchart above illustrates a generic LBDPG structure. The benefits of such a structure are as follows:

• Construction and development (asset holding) entities are segregated to minimise the impact of insolvency of one entity on the broader group and quarantine assets from liabilities, i.e. statutory warranty claims
• For the same reason as above, each development is held in a Special Purchase Vehicle (SPV). Further lenders prefer this to ‘ring-fence’ their borrowing entities from other group activities
• ‘Grouped’ for income tax and GST purposes, allowing the offset of losses and profits
• Any residual stock can be transferred to a ‘Hold Co’ entity to quarantine it

How have LBDPGs grown so quickly?

We consider the following to directly relate to the growth and concentration of LBDPGs:

1. 1. Residential property cycle has seen strong price growth

However, this is changing in most residential markets. Until recently, developments have been underwritten by an influx of predominantly Chinese investors with an insatiable appetite for property and a willingness of investors and owner occupiers to commit to presale contracts.

2. 2. Low barriers of entry to construction

Excluding Qld, which has a more stringent licensing regime, any licensed building entity can undertake a project regardless of balance sheet size (i.e. no financial test for capacity). Licensing can be obtained relatively easily.

3. 3. Non-cash equity leveraging

Development generally requires substantial capital investment (equity). LBDPGs can mitigate or manage their equity commitment by purchasing sites under delayed terms. For example, they may negotiate terms of up to 12 to 18 months on a relatively low capital outlay with option fees of around 2%.

In circumstances where the project receives a favourable planning approval (i.e. additional unit density) and or market prices escalate, the valuation of the development site will often be significantly higher than the sale price agreed under the option. The LBDPG will endeavour to use this ‘uplift value’ as part equity combined with senior and mezzanine loans to finance completion of the development. This minimises the LBDPG’s cash equity contribution allowing it to spread its equity over a number of developments.

4. 4. Tax planning[1]

This is complicated, depending on the circumstances of the LBDPG and the development, but generally takes two forms:

• Growing year on year: When the size and or number of developments undertaken increases year on year, generally, turnover and overheads of the business will also increase. Given the time lag on profits realised on a completed development (say 18 to 24 months from development site purchase), these profits can be partly absorbed in the profit and loss by increasing overheads of the larger business (rents, staff, systems, processes, etc.). Overheads are increased in the same year that the profits are made, but for the purposes of facilitating a larger business when profits will be realised in the next year. This has the effect of partly deferring profits (and income tax) until the LPDPG ceases to grow; and
• Holding Completed Stock: For a mature LBDPG, tax payable can be managed by holding some completed stock and leveraging it to defer taxable profit.

What are the risks faced in the short-term?

Subject to individual circumstances, such as the level of gearing and access to capital, LBDPGs concentrate risk in the following areas:

• Finance risk: LBDPGs are often highly geared, with short-term development specific funding from a large range of banks, non-bank; and, private lenders. We believe heavy reliance on private lenders is a greater risk than reliance on banks and large no-bank lenders. This is because private lenders, often:
  • Are small illiquid funds
  • Have limited ability to meet cost overruns and loss provisions where new investor funds are not obtained or recycled
  • Have thin balance sheets, unlike a traditional bank

  If a lender declines to recycle funding lines, cash flow issues may cause problems for a growing LBDPG that is continually purchasing new development sites. Also, finance facilities are often cross-collateralised, with cross-default conditions with each lender.

• Cost overruns and subcontractor failure risk: LBDPGs assume full delivery and construction risk, unlike the transfer of risk that occurs between an independent developer and a contract builder. Should a key subcontractor fail, the LBDPG absorbs the cost within the development. If a key subcontractor fails, chances are they’re involved in the construction of several other developments for the LBDPG.
• Market risk: The degree of market risk is subject to market movements. This is multiplied within highly leveraged balance sheets that are generally not diversified by property class and location. In the current cycle, the focus has been on metropolitan, high-density residential development in areas where zoning has changed.
• Tax risk: It is difficult to maintain the growth necessary to defer tax long-term. Leveraging residual stock leaves minimal cash flow to meet GST and income tax when these liabilities fall due. For LBDPGs the amounts payable can be substantial and can cause immediate difficulties.

Keep reading

Part 2 – In the second part of this series, we provide a discussion on mitigation strategies to minimise risk and the fallout from failure of a LBDPG.   [1] Newpoint Advisory are not tax advisors. These comments are provided for general information purposes only and should not be construed as legal, tax or investment advice to any holder. We would recommend seeking specific advice for your individual set of circumstances.