Overview How does construction financing work, and why do P&L-based solutions fall short compared to Asset-based lending options? Find out in this article.
Construction finance in Australia: Construction finance loans and the importance of assets and looking beyond P&L. How private mortgage managers consistently outperform traditional construction finance companies to source cost-effective, custom-designed construction loan solutions for Australian builders and property developers.
Traditional construction finance companies and banks offer Australia a somewhat limited range of funding options. That can lead to a mismatch between how much revenue they generate and access to the funds required to get there for developers and builders.
The primary issue is that banks adhere to a broad set of qualification requirements that don’t apply equally when painting an accurate picture in different sectors with varying challenges. The concept of profit and loss is an excellent indicator of many things, but it’s not a reliable pointer in construction finance. A new breed of private construction financiers is taking a different approach.
What Is a Profit and Loss (P&L) Statement?
A profit and loss (P&L) statement is a financial document that summarises revenues, costs, and expenses that happen during a specific period. P&L statements are usually prepared for each quarter or an entire fiscal year.
The purpose of a profit and loss statement is to illustrate at a glance your business’s ability or inability to generate profit. From an internal point of view, a P&L statement can offer insights into how you could increase revenue by reducing operating costs, increasing sales, or combining both. These statements are an essential part of doing business and provide directors with an invaluable source of information. The trouble with P&L is that it doesn’t offer a complete picture for many companies. Whether that’s the case for you depends on how you trade and, often, on the sector you inhabit.
Construction firms often encounter problems when traditional lenders like banks rely too heavily on profit and loss to predict the outcome of a loan. That’s the result of several factors. Still, the long and the short of construction is that businesses experience a unique set of challenges, often spending considerable amounts of money on sites and contractors and waiting a significant time before projects get completed, and sales begin. In short, it’s not a traditional business where income is earned over relatively short cycles.
Looking at a construction or property development company over a quarter – or in many cases, even an entire year, is rarely a reliable indicator of its ability to cope with a construction loan. Projects can run for multiple fiscal periods. For that reason, many traditional construction loans lack the flexibility construction operators need. They come with many requirements and limitations – to the point where bank-based construction finance solutions can cause more problems than they solve, even impacting a business’s ability to generate revenue.
Construction Finance in Australia: How it Works
To identify the problems with traditional construction finance, it’s helpful to take a quick look at the unique challenges developers and builders face. Compared with many other businesses, construction requires a relatively long investment period with no chance of immediate sales.
Let’s consider a fairly typical scenario:
The Sydney Apartment Block
Prudential Custodians recently helped a Sydney-based property developer source cost-effective finance for an apartment block development in the Hornsby area just north of Sydney. The locale has excellent transport links to the CBD and is an up-and-coming neighbourhood for commuters, with property selling fast and investments earning a substantial return.
With that in mind, the developer, armed with a track record of delivering successful projects for over twenty years and specializing in apartment developments, didn’t anticipate too many issues in finding an adequate funding solution once a DA was in place and the project was ready to begin. However, a trip to the bank left the developer with more questions than answers.
The Project Specifics
The developer had purchased a site in 2017, planning to construct a twenty-apartment building. Each apartment would have three bedrooms and a terrace and feature high-quality fixtures and fittings as standard. That meant each should sell for an average price of $1.2 million. Market activity in the Hornsby area indicated apartments would sell relatively quickly. The developer had spent the previous year obtaining a suitable DA and had already secured the services of specialist contractors to complete the project.
Here’s what the traditional lender proposed:
The Bank Proposal
When the developer approached the bank, it looked at the project based on total development costs (TDC). That amounted to the following:
Land purchase cost: $4 million
Construction costs: $10 million
Additional costs: $1.5 million
Total TDC: $15.5 million
The bank also assessed the developer’s ability to repay any construction finance loan based partly on P&L during the two-year build and finance term. It was evaluating the situation that raised significant risks for the lender. Consequently, it proposed to fund 70% of the TDC and, based on a thorough assessment of the developer, set pre-sales at a hefty 50%, meaning ten of the apartments would need to be sold off-the-plan.
The bank arrived at this proposal based on perceived risks. The developer would essentially be operating at a considerable loss for the project’s duration, and its ability to service the loan – on paper – presented challenges. For the project to return the profit required to repay construction finance, the bank needed to be sure it had enough security, and so it imposed significant pre-sales requirements.
In addition to this, and perceiving success as dependent on the developer’s ability to deliver, the bank wanted to ensure that construction went without a hitch so the loan could be fully repaid. Ignoring the developer’s track record also imposed strict inspection requirements during the build. These would happen on multiple occasions between construction phases. Every time the builder passed an examination, funds for the next stage would be released.
The Potential Problems with the Bank Proposal
The developer was unhappy with the proposal for several reasons. Firstly, the business had an excellent record of turning around textbook apartment developments in the Sydney area. For that reason, the company felt it represented a minimal risk to the bank.
Secondly, the business considered the market for apartments in the area to be particularly buoyant, with this specific development representing an excellent prospect for any investor. It had conducted extensive research and concluded that a significant ROI was well within reach with a concerted sales and marketing effort.
Thirdly, the developer considered pre-sales to be a significant roadblock. As an experienced apartment builder, the business knew selling luxury apartments off-the-plan wasn’t the most profitable way to do business. Directors felt a return up to 10% higher could be achieved with a sales effort after apartments were completed and ready to view.
Lastly, there was the matter of the DA. Since the developer purchased the land, its value had risen considerably by 60%. The bank’s reliance on a rigid definition of TDC didn’t allow it to revalue the ground at its current worth, which could have helped the builder reduce borrowing costs.
The developer considered the bank’s proposal wholly inadequate, so it approached Prudential Custodians for advice.
Construction Finance in Australia: The Private Construction Finance loan
Prudential Custodians manages a pool of private investor funds specializing in construction and property development. For that reason, we can look beyond total development costs and profit and loss and evaluate project potential in a way that allows more tailored construction finance loans.
In the case of the Hornsby apartment development, we looked at the developer and all the other factors that would dictate whether or not the project would return a profit and the financial pressures on the business during construction, just like the bank.
However, we also looked beyond TDC and P&L to the project’s gross realization value (GRV):
Total TDC: $15.5 million
Return from 20 apartments: $24 million
Total ROI: $ 8.5 million
And that’s not where Prudential Custodians stopped. We’re construction specialists, and we know that a significant upturn in land value results from putting a suitable DA in place. In the case of this particular builder, that amounted to an increase of $2.4 million – making the current land value $6.4 million by far an insignificant sum. We considered the developer to be an excellent prospect in any case, but that existing equity further reduced the funding risks associated with the project.
Based on GRV and all the other aspects of the apartment development, Prudential Custodians was able to source a private construction finance loan with no pre-sales requirements. Not only that, but there would be no need for time-consuming inspections in between construction phases. As a result, the developer got the project underway without delay, completed it ahead of schedule, and achieved the projected return.
Why are assets and GRV so crucial in construction?
Construction is a challenging industry, and cash flow happens over a relatively long cycle compared to other sectors. Along with a construction firm’s other assets – such as machinery and vehicles, for instance, which often amount to millions of dollars – it’s essential to look beyond P&L at the value tied up within current projects.
In construction, end value equates to an asset. If a project and developer both check out, then once TDC is deducted and factors like DA-based equity, also known as sweat equity, are accounted for, GRV should play a significant part in assessing the viability of both the project and any construction finance loan. Ignoring GRV is akin to missing the whole point of the property development and construction industry: acquiring profitable sites and adding value by undertaking construction works.
Construction Finance in Australia: A&L Versus P&L
Effective construction finance loans should be based on the needs of developers. When that happens, viable projects turn into profits, and there are far fewer barriers for investors and constructors.
The construction sector is unique. Whether it’s a sky-scraping office building in the CBD or a fast subdivision in the suburbs, ineffective construction finance loans are profit sapping. Delays can kill any property development, and failing to acknowledge assets and the natural construction P&L cycle makes construction finance expensive.
Traditional construction finance companies and banks fall short of developers’ and builders’ needs. Inflexible products designed for too broad a range of businesses just can’t cut it in the construction sector. At Prudential Custodians, we believe it’s time for fairer, sector-specific finance solutions for construction. Construction finance loans require a specialized approach and business knowledge to solve developers’ challenges and problems.
