One of the first questions we ask any prospective property developer is whether they intend to sell or hold onto the properties at the end. This is an important consideration when considering the finance we are going to secure and will determine how the transaction is assessed.
In this blog we discuss how to finance these developments and investment on completion as well as some other common questions.
Development Finance
A build to rent development is assessed very similarly to a build to sell development. A lender will still want to understand what level of equity you have in a transaction, what your experience is, who the key contractors and consultants are and other standard items. For more on these please have a read of our development finance guide.
Where things differ is around what happens on completion. A primary consideration for any lender on any loan is ‘how am I going to be repaid?’. This is the same for a build to rent development. The source of repayment for a build to rent development is the ongoing rental income from the completed units.
Because of this, the lender will likely make an assessment on the investment position first and that will then inform the lending decision on the development finance. A lender is likely cap their development finance loan at a level they are comfortable the Net Rental Income from the properties can support for an investment loan – further on the investment loan criteria is below.
The lender may also consider what a lease up period for the properties is on completion of the development. It is not always a given that the properties will be fully leased at the moment they are completed and this may take 1 – 2 months (or more) to secure. It is important that the developer is able manage their interest obligation over that period and thus the lender may consider an additional capitalised interest provision to provide for this. This can increase the budget and therefore the equity requirement for the lender.
Investment Loan
If you are building 4 or more residential properties in a single development it is likely a bank will consider this a commercial proposition. This means that the investment proposition on the properties will attract business or commercial interest rates, terms and assessment criteria. We defined these in more detail in our blog about commercial property investing.
Looking at commercial property rates and terms, this will vary project to project but typically a commercial loan backed by residential property will be priced off the residential housing rates with a margin attached (normally 0.50%). For instance, if the floating residential interest rate is 7.50% then the bank will price the debt at 8.0%. Note, this may vary on the project but is normally achievable.
Commercial lending tends to attract a shorter term than a residential home loan and often we see this at 3 – 5 years. The loan will be either structured as interest only in full or with small principal repayments over this time with a view of ‘rolling the loan over’ on expiry into a further term.
This pricing and loan term relates back to the risk profile of the proposition and therefore banks capital and pricing requirements.
Lastly, the servicing assessment. A bank will normally consider an interest cover position when looking at build to rent projects as opposed to your traditional rental property servicing assessment. What does this mean? Well firstly, the bank will ignore your other incomes and debts and look purely at the assets they are funding. They then measure the interest coverage ratio of the investment which is defined as how many times the Net Rent covers the Interest Expense (Net Rent / Interest Expense).
Net rent is the rental income expected on the property after accounting for the OPEX. This might include things like rates, insurance, property maintenance, property management and other costs. This gives the lender the figure for income expected to be available to service their debt costs. If you don’t have a good steer on what these costs are then a simple way of reaching this figure is to scale your rental income by 75% as a rough approximation.
For example, if you have 10 properties that generate $500.00 per week in rental income your gross annual rental will be $260,000.00. Each property will have a rates, insurance and property management costs. These will differ but let’s assume the following;
- Rates at $2,000.00 per property ($20,000.00 total).
- Insurance at $10,000.00 for the block (single policy covering all units).
- Property management at 6% of the gross rent ($20,800.00).
- Total OPEX - $50,800.00.
Your net rent is therefore $209,200.00.
If you have a $2,000,000.00 loan against these properties at an 8% interest rate your total interest cost would be $160,000.00.
The interest coverage ratio is therefore 1.31x ($209,200 / $160,000).
Different lenders will target differing ratios. Banks being the most conservative lenders will target an interest coverage ratio of 1.50 – 2.0x (note this may vary). Some non-bank lenders will be happy to accept a ratio as low as 1.0x or even slightly lower if you can establish the ability to top up the loan / provide for some capitalised interest within your facility limits.
With that in mind, the example above would not suit for a main bank. To get to a 1.50x cover the debt would need to fall to approx. $1.750M. Conversely, if you were to look at a non-bank option you may be able to increase the debt to $2.25M.
If you have any questions or would like to run some numbers with us, please reach out!
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