The first sign of a distressed development is normally the request from either a developer to the financier or from the builder to the developer to fund cost overruns. Considering the high Loan to Value Ratios (LVR) and limited equity of most developers this invariably becomes the financier’s problem. Do they insist on the developer or builder solving this problem, if in fact this is possible, or increase the facility limit/LVR to fund the additional cost to complete? Furthermore, if the financier has no choice but to fund the additional costs, do they have confidence in the existing developer and/or builder to manage the process?
The underlying reasons and circumstances for the overrun are important considerations for the financier when weighing up the options:
- Provide additional funding: The financier has confidence in the developer’s ability and/or wants an ongoing relationship.
- Take possession and sell the development: Will a sale will repay the debt?
- Take possession and complete the development: Value creation or throwing good money after bad?
What happens if the financier takes possession of the development or appoints a receiver? Whilst completing a distressed development will not be a financier’s preferred course of action because of the variables and risks that must be managed, it is usually the only exit solution that offers the possibility of improving the financier’s loss position by realising any remaining development profit. Once a decision is made to complete the development, the financier and their receiver effectively become the developer and take responsibility for the profit/loss outcome.
Every development is unique, and the specific circumstances must be considered to define the exit strategy employed. Consideration should be given to every variable:
- What is the stage of completion of the development, is it at substructure, superstructure or finishing stage? The closer to completion the more likely a financier will complete the development.
- Are the works compliant with plans and presale contracts, is the quality acceptable and how much rework is required? Most if not all distressed developments by nature suffer from poor site supervision and quality issues. It is possible to underestimate the cost of rework. Some pre-existing defects are hard to identify, and they may be excluded from the new contract.
- What are the other risks? Planning issues and sales risk including sunset dates in presale contracts.
- Is it an owner builder or third-party builder? If it’s an owner builder and the group is insolvent it’s much more difficult to complete the development as a replacement builder must be found. Conversely if it’s a third-party builder the financier can take possession, exercise its rights under the tripartite deed and complete the project.
- If a replacement builder is required, will they accept the ongoing warranty risk for all the works completed? Particularly for residential development under the Home Building Act (NSW).
Financiers will have a preference to sell and exit to minimise the ongoing risk and capital cost of completing a distressed development (particularly banks, which are penalised by capital requirements for defaulting loans). However, with most distressed developments, the net sale realisation that can be achieved is less than the debt level. Financiers will compare the net loss from exiting now, with funding completion and selling down the completed development. All additional costs should be considered and sensitised to the worst case. What can go wrong often WILL go wrong:
|Risk Area||Costs and completion issues to consider|