I have always questioned why pre-construction pre-sales are claimed to be the holy grail for good residential development lending.
I expect it has more to do with being an easily quantifiable performance indicator for regulators, rather than an actual indication of a successful project.
Experience has taught me that pre-construction pre-sales are more likely to be difficult to settle, or to not proceed at all. The delays in settlement increases the transaction and interest costs, which some borrowers think should be my problem!
There are many drawbacks to achieving pre-sales for bank funding. Here are my top 5:
1. Cost
Pre-sales are more expensive than sales made once construction is underway. A big contributor is paying half the commission upon the contract becoming unconditional. Whether such contracts are unconditional if the buyer needs finance is a separate topic.
As an example, if the bank lending requirement is 100% debt coverage, and sale commission is 8%, it adds an effective 4% to the finance application fee. Or 6.67% to the interest rate (based on an industry average rate of funds drawn of 0.6%). Bank funding isn’t that cheap when this is factored in.
2. Time
It simply takes time to achieve pre-sales, which increases holding costs.
3. Valuation Issues
Valuers may discount the sale prices achieved by marketers for pre-construction pre-sales based on what would be achieved with a standard real estate commission. At $30K or more per box, it is a sizeable reduction in the amount which can be borrowed. An increase in equity and/or mezz funding will be required. COVID-19 hasn’t made valuers any less conservative.
4. Construction Price
Builders like certainty of start dates for construction so they can co-ordinate their contractors, cashflows etc. Tendering is also a costly process for them. They like to be assured that funding is in place, and not subject to the developer achieving a level of pre-sales. Uncertainty is generally factored into tender prices.
5. Risk of Failure
Going down the pre-sale path is a gamble. If you don’t achieve the required level of sales for bank finance, then the upfront commissions paid become an unrecoverable cost, i.e. you lose money.
Can I dispel the myth that private funders, like GPS, who lend without pre-sales, discount our fees and interest rates if there are pre-sales? We don’t, our cost of funds is fixed. There is no benefit to waiting until pre-sales are achieved.
GPS has never had a regimented requirement for pre-construction pre-sales. Most of our lending is on a no pre-sale basis. We focus on old style lending; understanding the type and marketability of the product to be sold and the individual marketing strategy.
When choosing between bank finance, or private funding with no pre-sale requirements, be aware of the real cost. Don’t get hung up on the interest rate. Add in a risk weighting for the risk of not achieving the bank mandated pre-sale level.
What is certainty of funding worth to you?
Richard Woodhead – Managing Director
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