Residential property development funding

With the very real need for increased housing over coming years, residential development is an attractive property investment option for many people.  It has the potential to generate significant equity when well planned and executed.

The most common project undertaken by individuals is the construction of two townhouses or units on one block of land.

So let’s look at how to finance this type of project.

The first step in the process is to purchase a property which is appropriate for redevelopment.

Good choices are older properties, those that are ‘ripe for renovation’, but still habitable and on suitable blocks of land. These are often located in inner ring suburbs of capital cities, those areas that are well established and have good infrastructure.

Once the purchase has settled, most people choose to lease the property for at least twelve months, which is the average time it takes to arrange the project plans, permits and building quotations. For the purposes of this example, the loan size for the purchase settlement is $400,000 (80% LVR of the purchase price of $500,000).

Once the project groundwork is done, it is possible to apply for pre-approval for the construction loan. This pre-approval process will also factor in any capital growth of the property since settlement. This equity can effectively be used to contribute towards the client’s funds that will be required to complete the construction.

This ‘manufactured equity’ is a factor of the increased land value. In this example the property is now estimated to be worth $550,000.

In determining what loan size to apply for as a pre-approval, the land value is added to the anticipated cost of the fixed price building contract and in this example, an 80% LVR is assumed:

Land value                                          $550,000
Fixed price building contract         $650,000
Total value                                       $1,200,000
New loan maximum                         $960,000

At settlement of the new loan, the original $400,000 loan will be paid out. This leaves $560,000 available from the new loan towards the construction cost and so the client will need to contribute $90,000 of his/her owns funds at settlement. The lender will control the payments to the builder to ensure that the construction is completed as stipulated in the building contract.

If the property had not appreciated at all and remained worth $500,000, then the calculation would be:

Land value                                            $500,000
Fixed price building contract           $650,000
Total value                                          $1,150,000
New loan maximum                           $920,000

After payout of the existing loan there would only be $520,000 available and so the client would need to contribute $130,000.

The client’s funds to complete may take different forms. It may be cash savings, available redraw or come from an existing line of credit. Whatever the source, the lender will need to see evidence of the client’s contribution by way of formal account/loan statements.

Final figures in terms of loan size and client contribution would of course be determined once an independent valuation of the project was undertaken.

(For the purposes of these examples, the payout of the existing loan does not include any accrued interest or early repayment fees as may be applicable).

It is also very important to ensure there are sufficient funds for other costs associated with the project including loan interest repayments that will be payable during the construction phase, project management fees, council fees and a buffer for unexpected costs.

Once the pre-approval for the construction loan is in place, the client can sign the fixed price building contract and proceed to obtain full finance approval and commence with the construction.

In most cases, once the construction is completed, the title is subdivided, thereby increasing each townhouse’s value because each then has its own separate title. Depending upon a client’s particular circumstances and servicing capacity, it may be possible to tap into this increased equity to generate funds to repeat the purchase and construction process.

The concept of residential property development on the scale outlined here is relatively simple; however the exercise should be approached with careful consideration.

An experienced finance broker can provide valuable assistance in planning this type of property investment.