Non-bank financing may be a paradigm shift in construction lending

The rise of alternate funding may be the next big thing in developer financing following APRA's tightening oversight of banks, if we are to interpret recent commentary by Daniel Holden, director of construction finance group Holden Capital.

The pressure on major banks to meet capital adequacy levels under the Basil III accord has reduced their appetite for construction lending, says Holden in one of his posts. To achieve their objectives, banks have raised the bar for developers in terms of their pre-conditions, cut gearing levels and increased their pricing on debt, effectively implementing a flight to quality and leaving many of the their traditional but more marginal clients in terms of credit strength, looking for alternative funding sources, he says.

Record low interest rates have come as a boon then, encouraging developers to shift to alternate funding.

In FY15, Holden Capital settled 64% of its deals with the major banks but this quickly changed with 62% of the $300 million of project debt settling before Christmas likely to be set with alternative funding sources, a pre-Christmas post said.

While alternative funding sources may have some additional costs, they also come with distinct benefits to developers who do not want to be restricted in their ability to look for market opportunities due to constraints placed by traditional banks.

As an example, non-bank money can cost as low as 9-10% per annum, which when compared to the traditional bank cost on a medium sized projects of say 30 products, would add as little as $170,000 or 10% variance on normal finance costs to a project with a total cost of $6 million.

Alternative funding also offers a developer the potential for significant savings in other areas such as the chance to start the project without the need for pre-sales, unlike when approaching banks. The developer can lock in a construction price and reduce escalation risk as well as sell houses with a more certain delivery date, rather than the more speculative off the plan route required to meet banks' pre-sale criteria, Holden adds.

According to a case study by Holden Capital, bank and non-bank lenders have different requirements regarding loan ratios. Most non-bank lenders are so called gross realisation (GR) lenders and the main criterion for them is a loan to value ratio (LVR) of no more than 65%. Banks also require a maximum LVR of 65%, but in addition they impose a limit of no more than 80% of the total development cost (TDC).

The bank option benefits from a significantly lower total interest cost, but the non-bank alternative does not require the delay of between 3-6 months associated with the pre-sales requirement and benefits from a lower requirement on developer equity with the potential for a significantly increased return on investment.

Holden has also summarised the kind of developers best placed to succeed in this environment.

The 'Phoenix' developer, who were successful pre-GFC but rapidly declined during the GFC due to unfortunate dealings with their creditors but are now rising again Phoenix-like. Typically this type of developer is very experienced, but misjudged the state of the market and their level of exposure to it during the GFC, he says. Now they are back out there, wiser from experience and unlikely to make the same mistakes. They are more conservative with their own limited capital and looking for equity partners to leverage their position. Holden predicts that the 'Phoenix' developers will most likely be successful in the coming years.

The other is the cautious developer, who identifies risk upfront and finds ways to mitigate these as much as possible. They also realise that they don’t know everything, and won’t hesitate to utilise the skills of others, where there is a gap in their knowledge and skills base. In reality, they are the 'Smart Developer', he concludes.

According to Holden, Australia has a deep market of passive investors willing to take equity positions on development projects. In conclusion, developers could achieve much more if they use the right consultants and redirect their energy and time into enhancing their core skill sets, which would reflect in long-term success.