A common quandary with developers centres around pre-sales and whether they are worth pursuing. With the way house prices have gone in recent years there has been a real drive to selling down developments on completion as opposed to prior and general market consensus is that people will pay for product they can see and feel. There are however some benefits to selling down developments off the plan and I wanted to touch on those below.
Risk Management
In simple terms, pre-sales are a form of risk management. This is why often it is a pre-requisite for finance and lenders, particularly banks, seek pre-sales before confirming finance.
Pre-sales do a number of things to remove risk for your development. The four most pertinent examples are;
Market acceptance of the product: Selling properties off the plans will confirm that there is market acceptance of the product (people are buying) and what price point that is. This is a particularly important consideration for product that may differ to what is traditionally sold or at a high value, for example townhouses in a region that is typically replete with standalone property.
With market acceptance of the product you have certainty what you are doing is right and some feeling over where the margin should sit on the development.
Securing an exit on completion: Pre-Sales confirm an exit on completion for the developer and lender. From a developer’s point of view, it provides some assurance that when the development is complete that there will be a flow of funds to repay the lenders debt and they won’t be left encumbered with a large obligation.
Lenders also seek an exit on completion but for slightly different reasons. A lot of lenders make their returns partially on recycling their capital on a 12 – 24 month basis. By ensuring they are repaid on completion they are able to ensure they can recycle their capital and continue to drive good returns.
Protection against market movement: It is hard to imagine in the current environment, but house prices don’t always go up. Over a long enough horizon we do see inflation in the value of properties but there are many instances in history where prices fall and markets move backwards. Having sales off the plan will manage this risk, you lock in your margin (partially of fully) giving you and the lender some peace of mind that if the market for whatever reason turns that your margin is secure.
Mitigating their residual exposure: This is secondary to points 2 and 3, with all pre-sales there is settlement risk. Someone is buying off the plans and often their finance isn’t secured until near completion. This is why a 10% deposit is sought up front, it ensures a commitment from the buyer but also manages the risk from the developers point of view in the event the buyer cannot settle. The developer will secure the 10% deposit if for any reason the buyer cannot settle and this can offset their exposure and buy valuable time to re-sell the asset.
Securing Finance
This has been touched on above and is perhaps the most obvious benefit to selling down properties off the plan, it may qualify you for finance. Lenders, particularly banks, often seek pre-sales off the plans as a requirement for finance.
Finance is a key component to most developments often the boundary to getting them out of the ground, very few people can afford to fund a development themselves. It also gives you access to first tier finance which can be significantly cheaper (sometimes up to 10%) than other options which can really impact on the margin of a development. It is a serious consideration when looking at the overall margin of a development and what that might mean.
Running Harder
This builds on the risk being managed per the above. If you achieve a high level of pre-sales (over 100% debt cover) you may be able to push the limits on the level of gearing you can achieve.
This isn’t often from first tier lenders (banks) who will have internal policies on loan to cost ratios (usually no more than 75%) but rather second tier lenders. Some in the market with strong pre-sale cover will offer to finance 90 – 100% of the total cost of the development allowing the developer to recycle their cash into a new project.
This can be a combination of bank finance supported by mezzanine debt (2nd mortgage) or a stretch first facility from a non-bank lender. The cost of this finance is more expensive to compensate for the risk and you may trade some margin selling fully off the plans but it does allow capital to be allocated elsewhere to continue generating a return. Earning $2.00 of income on $1.00 of investment is much better than earning $1.00 of income on $1.00 of investment.
Overall Pre-sales are a really important component of developments and something that can have a big impact on the feasibility of projects. It is something that should be seriously considered when looking at a project and worth taking some advice on.
If you have a development you are looking to get away and are wondering about finance or pre-sales sing out and we can help.
Please read our Disclaimer Statement for more information.
