This is the first in a four part series of articles on pre-sales in the residential property development sector in Australia.
When the members of our team first became involved in lending for property development, pre-sales were uncommon. Most residential developments were small in comparison to the current property market cycle. ‘Large’ projects were often staged to mitigate sales risk. At that time, a project with 50 units was considered large. In the run-up to the GFC, pre-sales had become commonplace. Typically, lenders would require 30% of the stock in a development to be pre-sold. This would provide pre-sales cover of 50% or so of a lender’s debt, where borrowings amounted to approximately 80% of the total development cost. A ‘large’ development would comprise around 100 units. To achieve the required 30% pre-sales, might take a couple of months. The analysis undertaken by lenders was straightforward and manageable due to the size of the developments and generally the local domicile of buyers. In the current property market cycle, developments often contain 200 or more lots and lenders ask for pre-sale coverage of 100% of the debt. This means around 130 pre-sold units are required to activate construction finance. Since 2013, the Australian east coast property market has boomed, and developers have achieved these pre-sales at an unprecedented rate. In some cases, developers have even sold out entire projects in a single weekend. The market peaked in the third quarter of 2017. This will have a profound impact on pre-sales. Now, more than ever before, Lenders need to undertake a more thorough analysis of each project, which can be complicated and is time consuming.
Pre-sales are a big deal
The reasons pre-sales appeal to both the lender and the developer are clear. To begin with, pre-sales ‘prove-up’ a development, establishing that buyers actually want the product on offer. Pre-sales support the developer’s applications for finance and are now a requirement for almost all Bank and non-bank development loan approvals. Pre-sales reduce the risk for both the lender and the developer, provided they remain in place. The pre-sales form part of the lender’s security (even though borrowers may sometimes think otherwise). Pre-sales are particularly important in a flat or declining market which is now in evidence.
Property development pre-sales risk mitigation – post-GFC
During the Global Financial Crisis, pre-sale settlement rates in metropolitan Sydney continued to be strong. In areas outside Sydney, settlement rates were much weaker. Other areas, such as coastal NSW, saw very poor settlement rates. In Sydney, industry feedback suggests that over the long-term, pre-sale default rates have been low. Our experience has shown that in a rising market, all sins are forgiven. Often issues don’t come to the surface because high settlement rates mean the lender is quickly repaid. The developer deals with any issues behind the scenes, without the need for a lender’s intervention. However, in a declining market, developers under pressure may consider ‘questionable’ practices to obtain and manage pre-sales. Examples of such practices, at various stages in the development cycle, include the following:
Prior to activation of construction finance
- Offering undisclosed incentives (such as contract cash or goods rebates) to achieve the required pre-sales. This would maintain ‘headline’ prices and support lender security valuations. However, this distorts market values and potentially the balance of the lender’s unsold stock
- Contracting related-party sales (such as sales to family and friends), which are cancelled before settlement in the hope that they will be replaced with arms-length sales
- Misrepresentation of the development
- Convincing purchasers to release deposits (for cashflow)
- Failing to extend sunset clauses or rescinding sales to capitalise on market price rises. Recent changes in NSW and other states consumer laws seek to offer additional protection against this practise
At project completion
- Off-set arrangements with development sub-contractors and suppliers, which hides the true value of the construction cost and potentially minimises or defers state and federal taxes
- Deferring stock revaluation (in a declining market)
Provided below is a table summarising common pre-sales risks that have arisen in distressed development matters we have dealt with:
We’ve seen it all
In this series of articles, we provide some timely insights into pre-sales:
Part 2 provides a discussion of some of the pitfalls and risks inherent in pre-sales and suggests some steps that lenders can take to mitigate risk.
Part 3 details the process lenders undertake, or at least should always undertake, to analyse and manage the risks of pre-sales.
Part 4 conveys our perspective and opinions on the outlook for the residential real estate industry
Our broad experience and industry resources equips us to assist in the most complex situations. For more information on our services or to find out how we can help you and your business, please contact us for a confidential discussion.