How will the recent credit changes affect pre-sales?

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By Liam Wick

As touched on in my last blog, the recent changes to credit availability have been viewed as very controversial in the property and debt markets. Mortgage decline rates are at record highs, bank turnaround times are up, and house sales have started to slow. Apart from the obvious effects that a potential fall in prices will have on developers, I want to talk more specifically about how this may change the environment around pre-sales.

What are pre-sales?

Pre-sales are a form of risk management for both the lender and developer. They help confirm an exit on completion, protect against market movement and show that there is market acceptance of the product. One of the biggest benefits of presales for a developer is the ability to secure finance. Lenders will always look for the lowest risk option, so will favour the projects with the highest level of pre-sale cover.

Typically, the target for main banks is 100%+ debt cover (i.e. $1.00 of NET sales for each $1.00 of debt). In the near and non-bank space they will be more lenient on this, but may adjust their rates and fees (or equity requirements) depending on the level of coverage. The ability to secure pre-sales can have a drastic effect on finance costs and appetite and with the new changes in effect, finance may be harder to secure.

Appetite for pre-sales

With CCCFA changes making it now harder to get an approval, and looming future changes to credit availability (DTI, minimum test rates, low deposit restrictions etc), buyers can no longer sign on the dotted line for an off the plan purchase with the same confidence that they will be able to secure finance come settlement.

Gaining pre-approval is a good way to reduce settlement risk but it is not a guarantee of future funding. If there are changes to regulation and an individual no longer fits the new requirements, then their pre-approval will be null and void. Additionally, pre-approval periods won’t always match the time of the build. Currently BNZ & Westpac are the only banks who will offer pre-approvals for a 12-month period (although not if you read Westpac’s fine print!) and in today’s supply chain environment a lot of projects are 12+ months. With the uncertainty around finance and the fear of losing a deposit, I believe we may not see the same level of demand for pre-sales going forward.

This begs the question, how will a reduced appetite for pre-sales affect development finance?

Debt coverage ratios

Lenders who are looking to maintain their same level of risk protection may increase their required debt cover. They may decide that pre-sale cover no longer comes with the same certainty, as a portion of them won’t be able to meet settlement. Where 100% coverage was sufficient before, 130% debt coverage may be required going forward. This means the developer will need to sell down more units prior to gaining funding. In an environment where the demand for pre-sales is down, this may result in longer periods sitting on land that’s not generating any income.

What if I proceed with fewer or no pre-sales?

Proceeding with fewer or no pre-sales will mean one of two things – You will end up paying more in finance costs, or you will have to make up the difference somewhere else. By making up the difference, I mean reducing the lender’s risk in another way. This can be by injecting more equity into the project bringing the LCR and LVR down, increasing the profitability/development margin, or by having a more distinguished development team (QS, Valuer, Builder etc). Even with this it is highly likely you will end up paying more in finance costs, as the project will only be accepted by a higher priced non-bank lender.

Will pre-sale underwriting make a comeback?

Pre-sale underwriting is when a finance company agrees (for a fee) to purchase a certain number of properties in a development at a price usually well below market value. If the properties have not been sold by a certain date, they will settle on the underwritten properties at the agreed price. This may help the developer to secure main bank finance whilst allowing them to sell the properties later at full market value rather than pre-selling them at a discount.

Underwriting is more commonly used for large projects and it’s popularity has diminished in recent years due to the resurgence of off-plan sales, and the availability of non-bank finance products without the requirement for sales. We may see it become more common as ‘true’ pre-sales become harder to obtain.

What will happen to developers if their pre-sales fall over?

Let’s say a developer is building 30 townhouses through a main bank. They have pre-sold 20 of these to give 100% debt cover to qualify for funding at a bank. In 14 months when it comes time to settle, 3 of those pre-sales can’t get finance and don’t settle on the property. The developer now can’t repay their debt and is left either scrambling to remarket the properties, or offering the buyer an extension on their settlement. The developer may have to apply for an extension to their loan which may cost them another establishment fee (circa 1-2%) plus the interest rate going forward (often upward of 10%). Every extra week that goes by will be eating into the margin which may cause them to get desperate and accept a lower price.

Delays in repayment will put a liquidity squeeze on lenders, meaning other developers can’t access funding as easily as before. This scenario is similar to what we have seen over the past 3-4 months from supply chain issues, meaning lenders have limited funds and can pick and choose only the best projects.

What happens if buyers can’t settle?

If buyers can’t settle on the property, then the vendor is in their right to cancel the agreement and retain the deposit (usually 10% of purchase price) that was paid by the purchaser. They can then sue the purchaser for damages which may include;

  • the difference in sale price if they sell for lower than the original price,
  • penalty interest on the unpaid portion of the purchase price,
  • all costs and expenses required for the resale,
  • all maintenance and outgoings in relation to the property in the time between.

If the buyer is lucky, they may be able to talk to the developer prior to settlement and ask if they want to resell the property and give back the deposit. If prices have risen considerably since the unconditional date, it might be in the developers best interests to put the property back on the open market.

Going Forward

It will be interesting to see if a) the demand for pre-sales decline and b) if lenders change the way they assess pre-sale coverage when funding developments. A mitigation to the first point is the strong demand for new build properties due to their exemptions from the government introduced tax (Brightline test & Interest Deductibility) and LVR restrictions. People will still want to buy new builds, but they will want a lot more certainty around finance.

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