Non-bank Residential Development: Opportunity, or Accident Waiting to Happen?

Much has been written in the past year about Australia’s major banks reigning in their funding to residential property developers and the opportunity this has created for non-bank lenders and private capital to fill the gap. But is this really an opportunity, or an accident waiting to happen?

Australian banks have traditionally played a moderating role in residential property markets, indirectly influencing new supply through their provision of development financing. When markets are sound and residential property prices are at sustainable levels, banks have been seen to increase funding to the sector on terms that may be considered expansionary. Characteristics of such a market include, for example, when bank’s actively compete for new developer clients, provide loans up to 80% of a project’s total development cost and accept pre-sale levels below the face value of their loans. Such was the case in the early years of 2000 and more recently in the period 2010 to 2013.

Today, Australia’s major banks are concerned about what many have called unsustainable growth in residential property prices, particularly in the major east coast apartment markets.  Unsurprisingly, their response to this has been to tighten their lending criteria and limit their exposure. Competition for new clients has abated, loans have fallen to around 65%-70% of total development cost and it is now the norm for pre-sales of at least 120% of the loan amount to be required before funding is provided.

In other words, banks have reacted to what they see as increasing risk in the financing of residential property development by being more selective and prudent. The net result is that developers now need to contribute more of their own money (equity) to fund a project and some developers and projects may not get bank funding at all. This is the ‘gap’ many new financiers see as an opportunity.

And an opportunity it is, for those that understand risk, structure and price their facilities accordingly and closely manage their loans through the life-cycle of the development projects they finance. Unfortunately, however, some are just focused on doing the deal quickly and moving on to the next opportunity. For those that have managed property finance businesses through cycles, signs are emerging that there is an accident waiting to happen.

Emails regularly arrive announcing the establishment of new property lending businesses to fill the gap left by the major banks. Offers of high LVR (loan to value) loans, mezzanine finance and development loans with no pre-sale requirements are becoming common place at a time when the major banks see increasing risk. Sound familiar? If it does, it’s because it is. The history books are full of examples. Lending businesses set-up to capitalise on the deals that the major banks wouldn’t fund, or to provide finance on better terms than the banks (which roughly translated, means looser covenants or none at all).

Unfortunately, a number of those businesses failed to make it through the down-turn that inevitably followed the boom.  As real estate markets turned and loan delinquencies rose, due diligence processes in both the loan origination and loan management functions were found wanting. Sources of capital that provided liquidity to those non-bank businesses dried up and loan portfolios were placed in the hands of receivers, either to be worked-out or sold – often below book value.

As lending businesses failed, even developers that were compliant with their loan obligations found themselves caught in the down-draft with little or no surety of funding to meet project cashflows. Developers failed, builders failed and even key building trades were impacted.

The simple reality is that some projects shouldn’t be funded and shouldn’t proceed. This might be due to a lack of developer track-record/experience, lack of developer equity or that the viability of the project isn’t sufficiently robust to absorb the many risks inherent in property development. These are matters of due diligence.

Non-bank financiers play a valuable and legitimate role in the Australian real estate industry as an alternative source of funds to the major banks. This has been increasingly so in recent years as private capital has been directed into lending markets in response to low returns elsewhere and at a time when the major banks have had to adjust to new capital rules.

But borrowers from and investors in these non-bank lenders should be cautious. Not all gaps are opportunities and there are valid reasons why some projects are better left on the drawing board or to a new owner in the next cycle.  Anyone considering investing in or borrowing from these businesses should satisfy themselves that the skills and experience of the managers and their application of proper due diligence and loan management processes are up to the task.

Archerfield Capital Partners is a corporate advisory business that specialises in real estate.  Its three principals have a combined 75 years of property experience spanning development, construction, financing and funds management.

Non-Bank Residential Development Financing Manager Assessment Criteria

Skill & Experience of the Manager

Do the manager and its senior personnel have the requisite skills and experience to successfully lend and manage risk? What is their track record? Is there any key person risk?

Compliance / Governance Systems

Strong compliance and governance systems are critical to long-term success. Does the manager hold appropriate licenses? Is it subject to external, third party regulatory oversight and supervision? Does it have relevant policies and procedures? What systems exist to ensure these policies are complied with? How are conflicts of interest identified and managed? Do the board and major lending/credit committees comprise independent members? How is the manager rewarded and does this provide for an alignment of interests with its investors?

Loan Origination Due Diligence Processes

Ensure the manager has a robust framework in place for the assessment of risk, including documented credit policies and procedures. Do they have the capability to properly assess risk and adequately price that risk. Do they employ a risk and pricing model that ensures that hurdle rates are met? How are third-party consultants chosen and used within the DD process (valuers, quantity surveyor, legal counsel)? Are these counter-parties appropriately credentialed and do they have appropriate insurances. Are all lending decisions properly documented?

Loan Management Processes

Risks in development financing are dynamic; they change throughout the life-cycle of a transaction. Does the manager have appropriate systems in place to monitor and manage these risks, including borrower compliance obligations? What reporting structures are in place to ensure senior managers are made aware of changes in risk that could lead to an increased probability of default or loss given default.

Portfolio Management

What policies and systems are in place to manage risk across the portfolio of loans, such as borrower, builder and geographic concentration risks (eg. across multiple projects)? How is the portfolio funded and does the manager have appropriate liquidity to deal with unforeseen circumstances, eg. the delayed repayment of a loan?