Credit squeeze in construction and development finance – What is the cause and what you can do about it!
Being in the business of helping Property Developers access finance for their projects, we are one of the first to notice when banks start to tighten their funding practices.
At Development Finance Partners, we’ve been warning developers for months that they will find it harder to access finance for Development Finance and Construction Finance.
So what’s causing the credit squeeze on Property Developers & Residential Property Investors?
The credit squeeze is being caused by a number of global and local market factors. These are:
- The Chinese Stock market bubble bursting
- Falling Iron Ore prices impacting local exports
- APRA (Australian Prudential Regulation Authority) forcing banks to credit ration to property investors and raise more capital
- Media speculation of property bubbles in Sydney and Melbourne
- The Greek and Eurozone ecomoniccrises
To break down each individual factor and it’s impact locally we investigate:
What is going on in China?
- The sell-off in China’s stock market in recent weeks has caused widespread global concern.
- After reaching a seven-year peak in mid-June, the Shanghai Stock Exchange (SSE) Composite Index has nosedived by 30% in the past three weeks, wiping more than RM 2.0 trillion off share values, a figure equivalent to 1/3 of China’s 2014 GDP.
- On July 8, one thousand three hundred (1350) SSE listed companies or 51% of A-shares in Shanghai and Shenzhen were suspended by the Chinese Government for trading in an attempt to stave off further losses.
- The crash has been caused by the creation of a stock market bubble reflecting an abundance of liquidity and a lack of solid economic performance. When the upward trend seen since 2014 was reversed, investors naturally cashed out and sought to lock in profits. This process was accelerated by the de-leveraging of margin financing which grew alongside the bubble.
- The current financial crises in China realises concerns raised several times by the RBA in recent months. “The risk of a large repricing and associated market dislocation in the commercial property sector has increased” the RBA said in is March Stability Review.
- According to research analysts “In the residential market there have been some anecdotal reports of individual buyers postponing purchases or forfeiting deposits owing to unexpected changes in their financial situation”.
- Kalai Pillay, a senior Director at Fitch Ratings in Singapore believes while Chinese Developers are in reasonable shape to weather the share market down turn, property buyers may be harder hit. “We could see a pull back in purchases by Chinese buyers overseas, including Australia”.
- Several listed Chinese Property Developers who have been influencing our local market have been caught in the Chinese Stockmarket collapse including Fuxing Huiyu Real Estate (Starryland Australia), Beijing Capital Development Holding (Ausbao), China Poly, Greenland and R&F all suffering – with between 9% and 26% of their market cap’s being written off.
- According to S&P the average group LVR based enterprise value of a listed Chinese Property is now sitting at 75%.
- According to the Weekend AFR Australia Agents selling dozens of property developments to Chinese groups are showing some apprehension over how Chinese developer’s Developers debt and share prices will effect their demand for property in Australia.
- Speculation that we are seeing “China’s 1929”, the year the biggest stock market crash in history marked by the onset of the Great Depression or is it simply the crash of 1987, which saw big falls but relatively little lasting fallout, time will only tell.
What’s going on with Iron Ore Prices?
- In the last month iron ore prices plummeted to a new six-year low, falling to $A59.83 ($US44.59) a tonne, their lowest level since 2009 following the chaos in China’s stockmarket.
- Iron ore has just logged its worst trading week on record. The steel price in China is now cheaper per tonne than cabbage!
- After Joe Hockey was forced to announce a $20 Billion write down in forecasted revenue in May 15, economists are warning that Commonwealth government tax receipts could shrink by another $6.5 billion over the next two years – with implications for the federal budget deficit – if the iron ore price remains near its record low. This obviously means Treasurer Joe Hockey’s budget repair task could become even tougher.
Tightening macro prudential lending standards
- Last December in an ffort to slow housing price growth in a historically low interest rate environment APRA announced a tightening in home lending standards particularly for property investors.
- In response a perceived worsening in housing affordability and the ever accelerating growth in housing investor credit, APRA in May 15 announced further tightening to more conservatively test serviceability and reduce Loan to Value ratios.
- APRA has set a speed limit to the growth in lending secured by residential investments to 10% pa. In the months leading up to the latest move that served to tighten housing, investor credit was growing up
- Benchmark stress tests on servicing have risen from circa 6.25% to 6.5% pa to 7%-8% pa.
- Banks are no longer counting 100 per cent of rental income, negative gearing benefits, dividends, bonus pay and other highly uncertain earnings.
- Banks are now looking at borrowers’ actual spending, not just using a standard poverty-line benchmark, which many had used previously.
- The Australian Prudential Regulatory Authority has urged the banks to reduce their loan-to-value (LVR) ratios to see more capital from developers whilst insuring pre sales exceed generally 100% of the loan they borrow.
- On Monday of this week Westpac (Australia’s biggest lender to Landlords) announced to the market they now require a minimum deposit of 20% on all new investment property loans.
- From a pricing perspective the Banks have removed all discounted pricing to attract new property investors to the market.
- Increasing the cost of debt and increasing equity requirements will increase holding costs and decrease investors return on equity.
- Recent data suggests the significantly tightened credit conditions are now having a significant effect on new investment lending.
- According to AFG, loans to residential property investors were down from 49.8% to 41.6% in the month of June.
- Nationally the proportion of new AFG brokered home loans to property investor was at 39.6% down from 50% as the national average in the previous months.
- If you want proof the downside risks are real you need to look no further than APRA’s very recent moves to force the major banks to sell down their risker assets and capital raise up to an additional $28 Billion dollars to repair their Balance Sheets and become “unquestionably strong” for what may come.
- The target capital adequacy ratio benchmark as per the Basel Accord is 10%. To achieve this all of the Australian Banks have a lot of work to do.
The Perfect Storm
How prepared are you for the current downside risk? The Banks are already preparing. What are you doing to prepare?
- In isolation any of these macro challenges increase market risk & volatility and reduce confidence.
- The downside risk to the Australian economy as a whole is obvious and real.
- Two of the most exposed sectors of the local market are the Property Development and Banking & Finance Industries.
How are the Banks’ preparing relative to the Property Development Industry?
- All APRA regulated lenders have fully adopted/embraced all of APRA progressively tightening to slow the growth of residential lending.
- Banks are competing less on risk, repricing margins, being more selective on both projects and the sponsors they are willing to lend to.
- Banks are less likely to take on new to bank clients and will likely become inward focused and support cross collateralised borrowers and lend new debt to reduce existing group debt.
- Lending volume targets are being pulled back across the board.
- New construction facilities are being approved upon greatly reduced LVR’s.
- Qualifying presales – Greatly reduced acceptance or completely restricted presales sales to non-residents.
- Higher presales hurdles to Property Developers
What can Property Developers Do To Reduce Their Exposure
With Banks’ tightening credit, there is a flow on effect to Property Developers. Reducing the concentration of debt or cash with any one bank is key. Developers should be asking themselves the following questions:
- Do you have all of your debts with one lender?
- Do you believe your debts are not cross-collateralised with the same lender?
- How many of your debt facilities are expiring in the next 6 months?
- Do you have formal conditional approval in place to finance your projects which are due to commence inside the next 3-6months?
- Are you certain your Bank will continue to honour any indicative offers verbal or in writing?
- Do you have undrawn approved LOC’s you can draw down in need?
- Do you have any loan facilities due for review in the next 3 months?
- What is your exposure to a significant percentage of your presales failing to settle?
- Do you have more than one or two Banking relationships?
- Are your working capital accounts, cash reserves, rental proceeds accounts, trading and transactional accounts, term deposits, PPR loans and other personal loans all with the same Bank?
What can you to do to reduce your risk and increase return on equity
Despite tighter conditions, Developers can undertake a number of activities to reduce their risks, such as:
- Restructuring your debts across multiple debt providers. This can dramatically reduce your debt risk, improve liquidity, provide you with control, creates healthy competition and forces your debt providers to compete more on risk and pricing.
- Put firewalls between your liquid assets, sources of your cash flow and your development risk.
- Raise undrawn LOC’s against surplus security to make you bullet-proof and give you the ability to invest counter cyclically/opportunistically if the market turns.
- Hold multiple banking relationships to reduce the risk of liquidation.
- Keep some mystery…never let any one Bank know absolutely everything about your entire group position.
- Have your debts spread across multiple lenders. This buys you substantial valuable time as it gives you the ability to address events of default long before they become registerable and contagious. It also gives you the valuable ability to manage your group position by ensuring you can finance your most profitable projects and thereby demonstrate the ability to show debt reduction.
- Don’t find out the hard way Banks will force your most profitable assets first. Why would your Bank do that? Because they will deliver debt reduction the fastest.
- Utilise no doc capitalised interest facilities secured against passive assets to dramatically improve cash-flow and reduce the need for equity partners and negate the need for you to be forced into cross-collateralising your passive income producing assets to support higher risk development facilities.
- Consider capital partners who will consider standalone facilities with high LVR’s, lower or no presales requirements, less restrictive covenants on who you can sell to, fast approvals and fast settlements so you can turn your existing debts and landbanks into profits in a far shorter timeframe.
- Utilise pref equity/mezzanine finance to improve/maintain liquidity to:
- Reduce or negate your need for equity partners
- Reduce your total sales and marketing budget
- Increase your equity IRR’s,
- Bring your projects to market faster before the end of this cycle
- Reduce the number of presales required
- Bring twice the number of projects to market at the same time
- Increase the rate of growth of your business which is limited by your ability to recycle your equity and constantly reinvest profits inside of a cycle.
If you are looking to reduce your exposure, investigate non-bank finance options or receive financial advice as it relates to your current projects contact us.
The Reason Why Mezzanine Funding is Cheaper Than You Think
In instances that a project or company has more than one cost of finance, e.g. where a Senior Debt and Mezzanine Finance for Property Development are used, Weighted Average Cost of Capital (“WACC”) is essentially the calculation of the overall cost of all sources of finance combined.
Because Bank funding is currently so cheap, combined with the fact that Mezzanine Debt is typically a relatively small percentage of the total debt, the WACC of Bank plus Mezz debt is actually very low.
As a simple and typical current example, if Senior debt is 65% and Mezz is 10% of the project’s GRV, with the true “all up” cost being say 6% and 25% respectively, then the WACC would only be:
((65% / 75%) x 6%) + ( (10% / 75%) x 25%)
- 20% + 3.33%
- 53% WACC
So what seems expensive on the surface, when averaged out is actually lower than what bank rates for development loans were only a few short years ago.
Calculating the Value of Mezzanine Debt
The key to calculating the value of Mezz is in considering:
- The WACC of the Senior and Mezzanine Debts; and
- How much less Equity you need to put into the project as a result of the Mezz; and therefore
- What the net effect to your Return of Equity (“RoE”) is.
- The low WACC, combined with resulting significantly higher RoE, is a key reason why many of the country’s leading Property Developers are currently taking advantage of Mezzanine Debt or Preferential Equity, either to complete larger or more projects than they would otherwise be able to.
- Whilst higher gearing does present higher risk on a single project, used appropriately to spread your equity across various projects or investments, it can actually decrease portfolio risk by increasing diversification.
For expert advice:
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Sydney NSW 2000
P / 02 8916 6246
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Melbourne VIC 3000
P/ 03 8692 0082
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Brisbane QLD 4001
P / 07 3041 4136
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