After a few chats we have had from the end of last year through to now I thought I would put a quick blog together going over some of the more common mistakes we see from inexperienced property developers around their finance requirements.
Familiarity with these 4 guidelines will enable any property developer to better anticipate any potential bottlenecks in their project and ensure its success. This is by no means an exhaustive list but rather a couple of common errors we see when clients are applying for development finance.
Use of Customer Deposits
This is probably the most egregious error we often see, but it is very common. It normally comes about with people building turnkey properties but occasionally we will see it on bigger developments as well.
This is where a client will make some sales off the plans, with these sales unconditional they then intend on using the deposits paid for these sales (normally 10% of the purchase price) as cash towards funding the property development. Often this forms a significant if not entire slice of their equity in a transaction.
This is a BIG no no for lenders. Whilst the contract may be unconditional and using the deposit not strictly illegal, the major risk is that the product (home) is not delivered. In that event the purchaser should have their funds returned but cannot as those funds are normally expended. This is a major reputational risk for lenders and something that they will avoid like the plague. It is something that has been in the press a lot lately with builders and tradespeople failing and customers losing their deposits.
It is also a big indication that the developer is short on traditional equity and in fact using other people's money to meet that requirement. A lender will like to understand a client's capacity to fund cost overruns in a project and if they are not able to meet the equity requirements up front it is unlikely they can raise further capital down the line.
More or less in all transactions we do it is required that any deposit paid on a home is held on trust until the property is complete. Lenders will require confirmation of this as part of their legal documentation. If you are looking to develop some units, ensure you have some traditional equity in the project, normally somewhere in the region of 20% of the total project cost.
Treatment of GST
If you are developing a property to sell this is a taxable activity. As such, GST can be claimed on expenses but must also be paid on the sale. We often see feasibilities that are all GST inclusive or worse still have GST exclusive costs and inclusive revenues.
This is a risk as it will misstate your true net position either way and affects things such as equity required, risk of the project and finance requirements.
If you are leaving GST on your revenue line item it will be inflated by 15%. If you have then taken GST off your costs your margin will be out significantly. Unfortunately, just being consistent here isn’t the answer either. Given your revenue line item is typically larger than your costs (otherwise why do the transaction without margin) the GST on revenue will be larger than the GST on costs. If you have all revenues and costs as inclusive then your margin will still be overstated as the difference in GST will bolster it (albeit slightly).
This is a very important consideration when preparing your feasibility.
One last thing to note that isn’t commonly known, is that finance costs are GST exempt. This means that the interest and fees (including brokerage) on a loan do not bear GST and therefore you cannot claim on these costs and they should be recorded as their headline numbers in a feasibility. This can often be missed.
Not understanding your contract(s)
Often when we work with inexperienced property developers we can find that they don’t have a good understanding of the contracts they are entering into. A number of new developers with smaller projects will contract builds under a Master Builders contract, and whilst there are some benefits to this the payment schedules can often find themselves in favour of the builder. This may be in the form of a deposit or just the agreed schedule front loading payments under the contract effectively enabling the builder to capture profits and cash flow early.
This isn’t necessarily a bad thing, all businesses require cash flows to succeed and you want your builder to be on a sure footing. However, it does present a risk for yourself and the lender and is important to understand as funds are being released to the builder prior to that value of work being completed. If the builder does fail it could leave you behind the 8 ball.
Further, there can be other key items in a contract such as Liquidated Damages, Retentions and Bonds. It is important to understand these mechanisms and how you can utilise them and maximise your security and control under the contract.
Understanding your finance costs
We have written a blog on this previously (link to) and it is a crucial thing to understand for property development. Finance costs usually make up a significant part of your overall budget and accurately understanding these is crucial to ensuring you manage them well.
Typically there are 3 finance charges to recognise from a lender being the interest rate, establishment fee and line fee. Too often we see people just add these 3 items together to get their finance rate, however, this isn’t a fair representation of your cost.
Each of these items are charged differently and understanding how that then relates to your actual dollar cost is important. An example of this is your interest rate vs a line fee. You are charged interest on the funds you utilise in a development whereas a line fee is charged each month against the total limit of the loan regardless of the utility of funds. In this scenario a 12% interest rate would be cheaper than a 9% interest rate & 3% Line fee. Both add up to 12% overall, however, the fact that on average your utility of funds would sit at 60 – 65% means that the effective rates are as follows
12% x 65% = 7.80%
9% x 65% = 5.85% PLUS 3% = 8.85%
This may vary depending on your utilisation of funds and the rates and fees, but is important to ensure you accurately work through your cost of funds.
The other common mistake we see is a misunderstanding of how finance costs are presented. Finance costs will be presented differently throughout a loan offer. The interest rate is stated as a percentage, the establishment fee often as a dollar figure and the line fee a percentage but on a monthly basis as opposed to annualised cost. This can lead to people misunderstanding the true costs.
These are just some of the common mistakes we see developers make, however, there are many more. It always helps to engage a professional like Lateral Partners in this space to help you navigate your finance journey and make the right decisions.
As always reach out if you have a project and need some help.
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