A shortage of funding has been blamed as a major reason why new home construction in New Zealand has fallen so far behind demand. At the end of 2016, many New Zealand banks followed their Australian parent banks in tightening lending to the property sector. From early 2017, banks gradually became more receptive to development lending.
However, another change in the market at that point meant banks still struggled to advance loans for new projects. New Zealand’s property market was particularly quiet in the six months before the September election in 2017.
In particular, since the Labour-led coalition government proposed a ban on overseas buyers in November 2017, some banks have required that the presale contracts developers submit involve buyers who are not overseas persons.
A lending manager who asked to remain anonymous told YIJU New Zealand that, since mid-2017, few projects brought to him for loan applications had met banks’ presale requirements.
He remarked: “Actually, over the past year, I feel banks’ requirements for development loans have barely changed. Changes in market conditions simply mean that many projects cannot meet banks’ requirements for project profit margins and presales.”
Understanding presales: cost calculations must come first
Presales determine whether developers can obtain bank loans and how much they can borrow. In banks’ internal assessment systems for development loans, different criteria carry different weightings. Presales account for the largest share of the score.
The lending professional quoted above explained that, for any loan, a key consideration for banks is the source of repayment. For salaried homebuyers taking out a mortgage, that source is their salary.
For business loans, banks focus on income from business operations. For individuals borrowing to buy investment properties, rental income is the source of repayment.
For development loans, presales are the source of repayment. Without presales, or if presales fall short of requirements, there is effectively a problem with the repayment source. Banks will naturally decline the application.
Generally, when assessing a project’s feasibility, banks want lending to be no more than 7 tenths of the total project budget. The lending professional said developers must presell homes to a value equivalent to the amount they wish to borrow. Developers only need to meet banks’ presale requirements before the loan is advanced.
However, some developers rush to launch presales to catch favourable market conditions. This can backfire when their initial cost calculations are too hasty and rough. Only once construction begins do they discover that presale prices cannot cover building costs.
The lending manager said investment in property development, like any investment, requires a clear understanding of the costs involved.
Yet many developers, after buying land, do not prepare a detailed feasibility report on subsequent development costs, or base their feasibility analysis on preliminary drawings, or concept designs. Once the final design is complete, they discover that actual market quotes are higher than anticipated.
Quantity surveyors, or QSs, play an important role in controlling project costs. The earlier a professional QS becomes involved, the sooner developers can obtain a budget that closely reflects actual costs, improving their chances of securing bank finance.
New Zealand registered quantity surveyor Red Zhou, registration number 237, said that, where land costs and design fees are fixed, labour and materials costs are the most susceptible to fluctuations caused by changes during construction. Contracts with different subcontractors can also lead to additional charges.
In practice, some developers rely entirely on experience for their initial cost estimates because they do not want to incur additional fees. If bank pre-approval is based on a rough estimate and actual costs later exceed that basis, the bank may withdraw the pre-approved facility. Obtaining additional lending then becomes even more difficult.
Red Zhou therefore said that the closer a developer’s initial budget is to actual costs, the more likely the project is to succeed from a funding perspective.
The lending manager also advised developers to seek help from an independent quantity surveyor when preparing their initial budget, and to increase their contingency allowance as much as possible to give themselves greater room to adjust.
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Launching presales without a carefully prepared cost budget is something that often happens with inexperienced developers. The lending professional stressed that the timing of presales is important.
Generally, developers are best advised to wait until the project design is complete, the relevant building consent has been obtained and the project QS has reviewed the budget before launching presales.
However, because QS services involve a fee, some smaller projects that depend on low prices to secure presales may be unwilling to spend money on a QS.
An industry professional said projects worth less than NZ$5,000,000 typically do not engage a QS. For projects worth NZ$5,000,000 to NZ$10,000,000, around half use a QS. Large projects worth more than ten million dollars usually involve a QS. The larger the project, the smaller the proportion of its costs accounted for by QS fees.
High initial land costs can leave profit margins below banks’ requirements
Another reason banks turn developers away is low project profitability. This often occurs where land acquisition costs were high.
If the development land was bought in 2016, high land costs are an immediate reality. The lending professional said that, with the overall property market declining and construction costs remaining high, expensive land can further reduce a project’s profit.
If the market were still rising, developers might be able to set higher selling prices to absorb those costs. But market conditions are now completely different.
“No investor wants to invest in a project with very low profits. If costs later exceed the budget, the profit margin falls further. If developers cannot make money, they may walk away. That is something banks do not want to see.
” The lending professional said that, to avoid this, banks explicitly stipulate gross profit requirements in their development lending conditions, with requirements varying between banks.
According to the lending manager, more experienced developers generally use their own funds to buy land. They then obtain the relevant resource consent and building consent, and establish a reasonable grasp of costs and market selling prices before approaching banks about development finance.
If market conditions are poor, sales cannot be lifted, costs cannot be reduced and profit margins cannot meet banks’ requirements, preventing lending, developers can hold the land until the next cycle.
Alongside the total value of presales and the project’s profit margin, banks also assess whether developers have the financial capacity to cover subsequent cost overruns.
For local developers, banks will usually also use their networks to investigate their industry experience. Any unfinished projects in their track record may affect the bank’s view of them.
Chinese developers are now arriving in New Zealand with substantial funds of their own, considerable experience delivering successful projects and established reputations. For these developers, local banks’ concern is their experience in New Zealand.
The lending professional advised that banks would want these Chinese-owned companies to have a local project management team in New Zealand to coordinate the work, and to engage an independent QS to calculate budget costs.
Because Chinese-owned companies are unfamiliar with local conditions, banks would also want those applying for finance to select their main contractor through an independent QS. As part of the loan application, the developer’s chosen main contractor must also be acceptable to the bank.
The current market is highly complex, and the unexpectedly rapid rise in construction costs has left the industry at a loss. The lending professional said that, ultimately, developers need to take a more conservative approach: estimate costs higher and lower their expected selling prices. Together, these adjustments can improve their resilience to market risks.
Thanks to Prostone Consulting Ltd for providing technical support for this article.
Interview and words: Chen Xiuyue
Photography: Ricardo Gomez Angel