Advanced Investment Strategy: Part 2, Financing Developments of Townhouses & Duplexes

Multi-unit (Construction of 3 or more dwellings) development will either be done under Residential Finance products and rules or under Commercial Finance.  Usually the distinguishing factor between which type of finance is used is the number of units being built.

As a general rule:

• <4 dwellings being constructed: Residential Finance options are available.
• >4 dwellings being constructed: Commercial Finance options.

In most cases, property developers would prefer to obtain Residential Finance as it is far cheaper and less onerous in its requirements than Commercial Finance.

Residential finance is relatively simple & the process is similar to any house & land construction.  Commercial finance options are usually more complicated.  Below we explain the different finance process between residential and commercial loans for developments.

1. Costs

Commercial finance usually entails an:

• Application Fee: approximately 0.50% of the total loan amount.

• Valuation Fee: long form valuation required. This costs approximately $3k for smaller projects and much more for larger projects.

• Quantity Surveyor reports: These are independent reports that comment on the build progress. They usually cost $3k, and may be required multiple times for an individual development. May be requested under Residential Finance as well.

• Interest rates are higher for Commercial loans. They are approximately 1.0-2.0% higher than standard residential rates.  If a private funder is required for a specific purpose, the rate may be more than double standard residential finance.

2. Presales

Commercial finance usually require presales on the project.

Only a small number of lenders accept no presales, but borrowers will usually need to demonstrate the ability to meet repayments on the end debt without the use of proposed rental income.  This is typically very difficult to do, unless income position is very strong. Under residential finance you do not require presales and you can use the proposed rental income of the dwellings.  This makes the qualifying criteria for residential finance easier.

3. Valuations, LVR & Capital required

Normally residential lending is 80% of the “as is” or “in one line” valuation.  This means that the valuer will value the construction as if you are building 3-4 dwellings on one title, rather than separately titled dwellings.

These valuations are usually 15-20% below the actual value of the project.

Therefore, the actual LVR based on the ‘end value’ of the completed development on residential finance is somewhere between 65-70% of the end value.

Commercial finance is up to 70% of the ‘end value’ of the project. Commercial lending allows developers to capitalise the interest but this is factored into the LVR.

Despite there being a lower LVR being provided under Commercial Finance arrangements, the amount of money lenders are willing to provide is usually higher with Commercial Finance arrangements, meaning less capital is required by property developers.

Here is an example of the total funds that a lender will allow on a total project cost of $2million with an end value of $2.4million.

In this example, the property developer requires $144,000 less capital to complete the project under Commercial Finance relative to Residential Finance.  This is usually one of the key benefits of going down the Commercial Finance route, and why some investors seek this path, even if they meet residential finance requirements.

4. Character & application details:

When it comes to commercial finance lenders take a more stringent approach to the application. As a minimum they will require the following information:

• Customer background and experience – resume/CV of the sponsors, specific to their development experience. The lender will need to see the last few projects (i.e. address, description, gross realization, profit, cost/time to build, if there were overruns and how they were managed).

• Builder background – depending on the scale of the project the lender will require information on the builder used. If the project is high scale, i.e. 50 plus units then most lenders will require the builder to be on the lender’s panel. If the builder is not on the panel, then they would need to do a presentation to the lender to come on board.

• Full details of the project – the lender (and the valuer) will require plans, DA approval, project feasibility (lenders will need to see a minimum of 15%-20% profit – this includes total project costings, including land, construction contingency, capitalization of interest, council fees, stamp duty, etc), Building Contract/Tender, marketing plans (if available), copy of the Pre Sale contracts (if available/applicable), copy of pre lease agreements (for commercial/retail developments) and QS report.

5. Lending options:

• Under Commercial finance, lenders take a ‘commercial’ business view of the project. This means that there are many funders that may be able to finance the project, albeit at vastly different costs.

• If a standard lender says no, there are likely to be private lender solutions who have capital specifically allocated to these types of investments. This usually comes at a significant interest rate premium, but may be necessary to complete the development.

Under residential finance, the rules are more ‘black or white’.  You either meet the eligibility criteria or you don’t.  The same rules for approving applications that we have unpacked apply.