With economic uncertainty, including rising interest rates, companies involved in property development and construction face both challenges and opportunities in an evolving Australian financial market. As traditional banks move away from ‘riskier’ business lending, non-bank (and foreign) lenders continue to provide an ever-growing range of financing options.
How companies structure their property development and construction projects is paramount to their ongoing success and profitability. Achieving the right balance between debt and equity financing is complex and requires careful planning.
Challenges for property and development financing
In recent decades, banks in Australia have moved away from business lending, including financing property development, which is more speculative and riskier compared to the safer home loan banking market. Property development and construction projects are problematic for bank lenders as projects may be hard to value under restrictive lending requirements.
Development land values, which provide collateral for loans, may represent a relatively small portion of project costs, and project costs can fluctuate. To protect against risk, Australian banks will generally only lend up to 75% of the Loan Cost Ratio (LCR) of a project. They may also require 100% pre-sales, which at times is not always feasible for property developers.
Non-bank lenders look at property developments and construction financing more flexibly and may lend on the more generous gross realisation value (GRV). Lending based on 65-70% of GRV means that, unlike banks, non-bank lenders require no pre-sales and less developer equity. With less lending constraints, non-bank lenders allow companies to structure finance arrangements that work best for them and provide capital more quickly.
With significant risk for all lenders (and borrowers) in property and construction financing, both quantity surveyors and valuers play crucial roles in assessing the level of financing provided to borrowers. Quantity surveyors oversee a project from early feasibility through post construction and evaluate project and construction costs. Valuers assess the likely value of a property at completion which is key for assessing the initial loan estimate value. Lenders financing a construction project may also insist on a “Builder’s Side Deed” or “Tripartite Deed” to further protect their interests. Tripartite Agreements between a lender, borrower and builder may include a range of terms but are generally designed to ensure clear communication and expectations around financing and payment. These agreements benefit all parties and facilitate project completion on time and on budget.
Types of finance
A range of financing options exist for companies involved in property development and construction.
Senior lending forms the bedrock of a company’s capital structure in property development and construction. Senior, because it has first priority in the event of default, is secured by borrower collateral, usually in the form of property. This lending is debt financing and although the cheapest finance for a borrower with the lowest interest rates, the consequences for a company defaulting is loss of the property used as collateral.
In Australia, both bank and non-bank lenders provide senior lending. Bank lenders generally have the advantage of cheaper access to capital and can provide senior loans to borrowers at generally lower rates of interest, perhaps 1-2% lower. Although banks are generally able to provide senior lending at lower interest rates, non-bank lenders may be the preferred senior lenders where a company requires greater flexibility with their finance arrangements.
The requirement for regular repayments, and a senior lender’s requirements around borrower financial ratios and expenditure limits, encourages a company to carefully structure its other financial arrangements to ensure it can meet its senior loan obligations.
Whether a bank or non-bank lender provides a senior loan, a company is likely to have a capital shortfall on the property development or construction project and require additional finance. This finance may be sourced either through debt or equity but will have a lower priority for repayment compared to senior lending.
Mezzanine financing (or junior lending) is a key form of debt financing in property development and construction. Mezzanine financing may be secured with collateral and, combined with the senior loan, will cover up to 90% of total development costs. Offered by both banks and non-banks, given its riskier nature (as it does not have first priority on collateral), a bank lender may be more reluctant to offer mezzanine finance. As both senior lending and mezzanine financing may be secured by the same collateral, lenders may require a borrower to enter into a Deed of Priority and/or a Deed of Subordination. These Deeds ensure borrowers are transparent about their financing arrangements and all parties understand the ranking of lender security interests on collateral in the event of borrower default.
Although more expensive than senior lending, with interest rates from 15-30%, mezzanine finance provides borrowers with greater project flexibility and can serve a variety of functions. Mezzanine finance can provide additional capital for a downpayment, a cash injection to keep a project progressing or fund project closing costs. Although expensive debt, mezzanine finance has several advantages over raising equity. It enables a developer to maintain control of a project (and not dilute the company’s equity), is cheaper than raising equity, allows existing capital to be used on other projects and interest repayments are tax deductible. Mezzanine loans only require interest repayments prior to loan maturity and borrowers may replace the loan with a lower interest senior loan if market interest rates drop.
As senior lending and mezzanine finance will generally not cover the entire cost of a development, borrowers will need additional capital, perhaps 10% of the total cost. Non-securitised lending provides borrowers with further capital and provides borrowers with the flexibility to fund different stages of a project including early feasibility stages or use additional capital across other projects. This form of finance is not secured by collateral and therefore represents the riskiest form of lending, with high rates of interest for borrowers.
There are broadly two types of non-securitised lending with preferred and common equity, which reflect the priority in payment in the event of borrower default. Preferred equity allows lenders to invest in a project but rather than obtain collateral and defined interest like debt financing, lenders gain equity in the project and a share of the profits.
Companies in the “start-up” phase of their operations may seek financing from lenders under a “convertible arrangement” where a loan for a project may subsequently convert to shares/equity in the company. Under convertible arrangements, at the maturity date, a borrower will either repay the loan or the loan converts to equity in the company.
How Madison Branson Lawyers can help
Structuring finance for companies in property development and construction is complicated. Not only do borrowers need to strike the right balance between debt and equity but lenders may need reassurances about proposed structures.
The team at Madison Branson Lawyers have decades of combined experience in complex, high-value, banking and finance deals for projects across the property development, construction and infrastructure sectors.
We understand that a property developer may require up to three different loans to complete a development from purchase, construction, through to refinancing at completion. Madison Branson Lawyers works with its clients to understand which finance structure will work best.
We have a strong track record working across banking and finance deals with fund managers, banks, non-bank and sophisticated lenders, developers, and investors. A selection of highlights undertaken by members of our team include:
- Advising on, structuring, and settling commercial syndication, and commercial and residential development financing for senior, junior and preferred equity transactions with gross realisations in excess of $1bn+
- Advised on and settled a client’s site purchase and facilitated its $145m commercial 11-storey tower development.
- Advised an Australian funds management group and settling its $100m offshore facility.
The information provided in this article does not, and is not intended to, constitute legal advice; instead, all information is for general informational purposes only.