Most people in New Zealand have heard of KiwiBuild but few probably have a good understanding of what it's functionally is. KiwiBuild was an underwriting scheme put together by the government to encourage and allow for greater property development of affordable properties.
It had some issues and never fulfilled its goals, however, underwrites still have a place in property development and development finance and in this blog we will discuss what these are and how they function, where they are useful and who can provide them.
What is an underwrite?
An underwrite on a property development is similar to an insurance policy. It is a guarantee provided by a third party to acquire a certain portion of units in a development if the developer fails to sell them down. This guarantee can be securitised by a lender providing development finance and utilised as a tool to provide them a form of repayment and thus allow them to lend to developers.
As we have written previously, pre-sales are an important function of development finance. In an underwrite, a third party will provide an option to the developer that they may call on to acquire a portion of the units in a development. If called, that third party is obliged to acquire those units. To provide this option the underwriter will charge a fee to the developer normally of 3 – 5% of the contract value.
The option will have an expiry date attached to it, normally near or shortly following the expected completion of the development. On or before this date, the developer (or lender if they have assignment) may instruct the underwriter that they wish for them to acquire some or all those properties included in the underwrite. The underwriter is then obliged to acquire those properties and, in that format, it can be treated like a pre-sale.
The kicker, however, is that the underwriter will agree a value on forming the contract and this will normally be somewhere between 15 – 25% below the market value of the units as a consideration for their risk. This is where most people struggle with the format of an underwrite as it isn’t a profit mechanism but rather a risk management tool.
How does an underwriter determine value and their position?
This is often just a mechanism of a valuation being prepared and the underwriter and developer then agreeing a discount rate that is then applied to that valuation. It is a negotiation, however as above, this is normally in the realms of 15 – 25%.
To take on the risk the underwriter will normally require a reasonable amount of units and discount to be agreed. The reason is that they are required to set aside funds to deliver if called upon and want to ensure that there is a good return for that commitment, particularly in the event that it isn’t called on as they could have applied those funds elsewhere.
Because it is such a big discount ideally it does not provide for all the units in the development and this can be a constraining factor in itself as it will normally mean that an underwrite is reserved really for larger projects. KiwiBuild for instance required a minimum of 20 units in a project which is a sizable development.
Purpose of an Underwrite
As we mentioned above, an underwrite is an agreement to purchase units at a fixed value if called upon. This is of value to a funder as it gives them a level of certainty around repayment. It is useful for the developer as it can allow them to get underway on a project without having the required level of sales for the funder.
The developer can then sell the units down progressively over the project allowing them to demonstrate progress on site and hopefully achieve a better price. If the units in the agreed pool do not sell down over the project then the developer or funder can trigger the underwrite and receive funds for those units to clear their debts or obligations.
This is all about providing confidence to a funder to get a project underway. The best case scenario is that the developer manages to sell down the units over the project and only incurs the 3 – 5% underwrite fee. Worst case the units are sold to the underwriter to repay the debt with the funder, it limits the downside. It is really important to understand this step, an underwrite is about risk mitigation not profit delivery.
How does a funder assess an underwrite?
Normally an underwrite will form part of the total units in a project (I.e. 20 of 40 units). The funder would treat the units with an underwrite as pre-sold. It is important to consider, however, that they will look through to the underwrite value as opposed to market value on these units as that is the effective sale price until such a time as they are sold on the open market.
This, obviously, can impact on the feasibility of a project where the considered value on a large portion of units is heavily discounted. Thankfully, a lender will acknowledge that the margin on the project would appear to be eroded. They would, however, seek for some margin in the project which would be driven off the remaining units.
The lender will also look through to who is providing the underwrite and want to understand their ability to deliver if called upon. Naturally, it is only as good as capital behind the contract so this is an important consideration.
Lastly, the lender will also consider the form of the contract. It is important for them to be able to rely on the call option if required so will want some surety on their ability to trigger that and any tags around it.
Why would I take on an underwrite?
As above, it is about getting a project underway. Typically underwrites are found on larger projects with many units. These may have high pre-sale requirements to satisfy the lenders and in a slow market, or even just by virtue of the number, that may take some time to accomplish. An underwrite will allow the developer to get their property development underway saving time and potential holding costs.
Who provides underwrites
Putting KiwiBuild aside for now, the major providers of underwrites in the New Zealand market are the more well known non-bank lenders such as ASAP, NZMS, Capital Group,
These entities have significant balance sheets and strong funding relationships with premier banks which is important as the substance of the underwrite is a major consideration for a funder.
KiwiBuild is also the other underwrite provider in New Zealand. The upshot of KiwiBuild is that there is no fee payable and therefore it is a cheaper solution for a developer. There are some drawbacks, however, which goes some way to explaining why the proposition stumbled.
These include constraint around the ability for a developer or funder to call on the underwrite option, the requirement for the units to be under a particular affordable housing value which overly squeezed margin for developers, a housing market that took off negating the need for KiwiBuild (post covid with super low rates developers could sell at almost any price) and general bureaucratic processes.
As always if you have any questions, reach out.
Please read our Disclaimer Statement for more information.
