More and more Australian property investors are moving into advanced strategies such as small property development as a way to grow their wealth.
Of course, property development brings with it more potential financial rewards than traditional property investment, but it is not without it risks as well.
There a number of factors that you must consider before deciding whether small property development is the right course of action for you, including the various finance options available for your project.
So, in this article, we'll outline property development finance options, including the application process and valuations as well as the risks and mistakes to avoid.
The finance options
The world of property development finance is more complex than standard residential lending, which is because of the higher costs involved.
You may also require different types of lending for the various stages of a project, including:
- An acquisition or development loan to cover the purchase, development application and pre-construction costs
- A construction loan to cover the building of a project and
- An investment loan if you are retaining your project as a long-term investment.
Generally your development loan will be structured so the lender provides up to 70 to 80 per cent of the final cost of the project, rather than its end value, and you will be expected, as the developer, or your equity partners, to provide some funding towards the development.
Typically, you will need to provide 20 per cent of the funds for a two-dwelling project and 30 to 35 per cent for larger projects, which lenders class as commercial loans.
In other words, you will be able to obtain a development loan at 80 or 65 per cent LVR, depending on the size and nature of the project.
This means if your total development cost is $2 million, your financier will expect you to contribute $400,000 to $700,000 of your own equity into the project.
Larger projects of say $3-5M+ will potentially have lower LVR’s again and will also generally require pre-sales of a percentage of the project that is normally equivalent to the debt coverage i.e. $10M project with $6M in funding required would require sales in the project of around the $6M figure so the lender has it’s debt covered on completion.
Similar to a regular residential new build loan, development loans offer staged payments to be finalised at the end of each regular building stage.
Applying for the loan
Applying for property development finance is more time-consuming than residential loans and requires information such as a detailed feasibility analysis that considers all of the relevant factors for the project.
Your application for property development finance needs to show that you have considered all of the project's variables including allowing for contingency funds when things don't go right such as project delays due to bad weather.
The information that needs to be supplied to the lender in your application includes:
- The type of development
- Site description and zoning
- Design concept
- Cost of the land and cost of construction
- Other costs
- Projected sales figures with the profit margin
- Timelines until completion
- Financial strength of the developer
- The equity available
- The development experience or track record
Other factors to consider at this point in your development's journey include establishing the networks that will help your project.
These types of networks include being polite with the neighbours to ensure you have them on-side when you lodge any necessary development applications.
You should also always have professionals on your team, such as draftspersons or town planners, who has worked with the relevant council and who can help prepare your DA to the standard required by council.
The valuation process
One of the principal differences to the valuation process for property developments is timing.
That is, with regular property investment including off-the-plan purchases, the valuation isn't completed until the property has actually been completed.
That is not the case with property development valuations or finance.
Of course, this is because the lender needs to provide finance for the construction of the development and therefore needs to be review your financial application with a fine-tooth comb at the beginning of the process and not at the end.
The way it works is a professional valuer from the bank’s panel of independent firms will be appointed and they will usually uncover any potential issues that could potentially financially derail your project.
The valuer will examine your feasibility study, looking for any missed expenses.
They will often even include selling and agent costs in your calculations even if you have no intention of selling the project.
That is because the bank will always protect its position first and foremost.
Lenders also want to see that your project is projected to make at least a 15 per cent profit, which is why they exhaustively examine your numbers from the outset.
Risks and mistakes to avoid
As we mentioned at the start of this article, the property development sector can be one of big rewards but also big risks.
Many first-time small developers have been caught short, or much worse, by wading into development waters without properly understanding all of the risks or the mistakes that they must avoid.
One of the most obvious is not completing a thorough feasibility analysis, which doesn't include all of the expenses – especially holding costs and any taxation liabilities such as GST.
Another regular mistake is trying to make your application for property development finance "more attractive" to lenders as if it's some type of financial beauty competition!
This is a terrible idea and usually always ends badly.
By trying to make the numbers "stack up" better for your project, just so you have a better chance of obtaining property development finance, you are not only lying to lenders, you are lying to yourself.
And the likely outcome – if you manage to secure finance – is a project that is massively over-budget and one that will leave you will a gaping hole in your finances as well as your pride.
Newbie developers also often cross-collateralise their projects with their existing properties, which causes lots of problems once the development is complete and you need to discharge the construction loan.
Property developments can be an excellent way to create wealth but you really must understand what you're doing.
Part of that process is having realistic expectations of the profit that you're likely to achieve, as well as understanding what the market conditions will be once the project is complete.
This includes not over-estimating the strength of the market at that point in time.
It's always better to err on the side of caution because if you aim for a 15 per cent return on investment, well, there's nothing wrong if actually achieve 20 or 25 per cent instead is there?
The information provided in this article is general in nature and does not constitute personal financial advice. The information has been prepared without taking into account your personal objectives, financial situation or needs. Before acting on any information you should consider the appropriateness of the information with regard to your objectives, financial situation and needs.