Qualitas On Demand CPD Series: Deep Dive: Land and Construction Loans

Mark Power, Commercial Real Estate Debt Specialist, and Nina Zhang, Director, Corporate Development, present on land and construction loans.

Nina Zhang: Welcome to the Qualitas On Demand CPD Series, which seeks to educate the adviser market on all things in the commercial real estate debt market.

Traditionally, income plays a big role in portfolios for Australian investors, and with interest rates rising, investors are searching for alternative investments to achieve consistent and reliable income as well as protection against rising inflation.

Qualitas is one of Australia’s leading alternative real estate investment management firms. We specialise in investing across the entire capital structure of real estate debt and equity.

Qualitas was established in 2008 during the GFC, where banks were pulling back their CRE lending and alternative financiers backed by growing investor capital identified a unique opportunity to fill the funding gap.

We have built up an extensive track record, and, in our 14 years of operation, we have invested $5.7bn of investor capital for real estate assets valued over $15.9Bn and have closed 172 debt deals.

Mark Power: Hi. I’m Mark Power, a Senior Director within the Real Estate Investment Team at Qualitas, and I am responsible for origination and execution of commercial real estate loans, otherwise known as “CRE loans”.

Nina Zhang: And, I’m Nina Zhang, Director within the Corporate Development team, responsible for managing our strategy and investor relations across QAL and QRI.

Today we’ll be going through land and construction CRE loans, covering the mechanics of these types of loans.

With recent media coverage around several builders experiencing financial difficulties, we thought it would be helpful to cover our approach to risk management and borrower/developer selection, in addition to some recent case studies.

We’ll now go into an overview of different CRE loan types.

The depth and breadth of CRE debt opportunities span across the entire life cycle of real estate.

The typical real estate life cycle starts with vacant land, and moves through planning and development milestones to eventually a completed building that can be occupied.

We ultimately refer to a completed building as carrying less risk and stabilised, as the asset is no longer exposed to risks of planning, development and construction, and has the potential to generate income.

Unzoned land is often the riskiest part of the real estate lifecycle as its ultimate use can be unknown or changed.

Loan types, you can see, relate to each stage of the real estate life cycle.

First one is land loans, used to fund land that is ultimately intended to be developed.

Construction loans are used to finance property development and construction costs.

Investment loans are used to finance completed buildings that can be occupied or to generate income from tenancy. This also includes residual stock loans, which are secured against completed unsold stock from construction projects.

Qualitas is a “through-the-cycle” investor. We are sector agnostic and always seek to invest in the best risk-adjusted return opportunities having regard to the timing within the cycle of the market.

Credit risk is essentially the determination through assessment of the creditworthiness and serviceability of the borrower and valuation of security property to service the loan.

Credit risk is inherently important for identifying all known risks to a transaction so that it can be accurately priced as per what we covered in Module 1.

The credit risk assessment process involves:

  • assessing the borrower quality. For example, what is their financial standing and track record. This also includes other transaction parties, such as the builder and the guarantor.
  • assessing the property quality, such as where it is located, specific features, functionality and desirability, as well as tenancy, for example.
  • assessing the market conditions, such as the macro and micro economic conditions that may impact the borrower’s creditworthiness and security property performance.

Once these key areas are assessed, the financier can then structure the loan — for example, determine the appropriate loan terms and any financial covenants for their risk appetite. An important financial covenant, for example, is the loan-to-value ratio, ie how much to lend against the value of the property. Other financial covenants can be the level of property cash flow that covers interest (for example, the interest cover ratio) or the minimum pre-sales to be achieved before construction funding can commence.

Each loan type will have its own key areas of credit risk.

Land loans are generally not income-generating, so closer attention to other interest-servicing sources, which include borrower or guarantor cash flow, is required. Land loans also have the greatest planning risks as each milestone achievement or failure of the development approval can impact property value significantly.

The key risk of construction loans is the delivery and completion of the project. A half-completed building is usually only worth its cost value, so it is important to ensure the delivery risks are well understood. The borrower and builder track record and expertise are extremely important for mitigating these risks. Also, whether pre-sales are achieved to start construction and the actual settlement within 1-2 years time can be impacted by market conditions.

Key risks of investment loans are specific to the property’s current tenancy, occupancy, rental rates, which can all be affected by market conditions.

Residual stock loan risks are whether completed stock is selling and at what value and what rate as proceeds are applied to amortise the loan. They are also not generally income-producing, so servicing is supplemented by borrower cash flow. The builder reputation and quality are also important to consider.

An appropriate tenor is an important part of managing credit risk. At Qualitas, we keep our average maturity profile at just over a year to provide ourselves with flexibility to re-assess and re-price the investments.

The primary repayment and exit strategy of the loan is also important as typically this will determine the initial LVR the financier is comfortable with, having regard to the valuation risks during the loan term. For example, if refinance is the primary repayment, then a financier will consider what LVR an incoming lender will reasonably refinance the loan and whether any amortisation should apply.

Not only is the initial credit assessment and loan structuring important for managing credit risk, it is crucial for financiers to undertake ongoing management of each loan to anticipate issues earlier and to ensure loan performance is not impacted, hence preserving investor capital and investor return.

At Qualitas, we lend to highly capable sponsors with proven track record in the scale of target projects.

Capability, capacity and execution are the three key attributes that we look for when assessing new investment opportunities.

We conduct detailed due diligence on their track record, reputation and the brand. We look at their balance sheet, especially for construction loans.

If something doesn’t meet our criteria, we will pass on the opportunity. This approach is evident through our total 172 debt investments over 14 years of operating history.

The majority of our loans have personal guarantees from the developers, and we target mid-market developers with the ability to top up equity if things go wrong.

We see significant opportunities in the land and construction debt sector driven by long-term housing supply shortage in Australia and continued funding gaps in the market as the banks apply rigid blanket lending metrics.

The lending environment for land and construction debt has materially evolved in the last few years as the residual stock loan market has matured and has been recognised as a method of exit. Financiers are also getting comfort from pre-sale coverage.

As one of the leading alternative construction financiers in Australia, Qualitas has substantial first mover advantage and has extensive experience at managing these types of investments through multiple real estate cycles.

Mark Power: So, what are land loans? Land loans are used at the very beginning of the development cycle.

They are provided to fund a site purchase or to refinance a development site with the expectation that development work will commence within 18 months.

These loans are secured against infill vacant land. This includes undeveloped land that can be subdivided, land approved for development and land yet to be approved for development.

Sites held for speculative purposes or without any acceptable development execution strategy evidence would simply not be considered.

Qualitas will generally target medium- and high-density sites

So, what are the key risks of land loans? When assessing land loan investments, we focus on development feasibility, exit strategy, developer capability and market conditions.

We require a third-party valuer to provide an independent view on these key aspects and also apply our internal view on their assessment.

At Qualitas, we focus on sites with DA approval and high probability to convert to a construction facility and/or a site with deep buyer pool that could be readily re-sold.

For land loans, we set a very high standard for developers’ experience and financial capacity to execute and manage the development.

So, what are the typical terms of a land loan? Land loans generally have a term of 6 to 18 months with loan-to-value ranges between 40 per cent to 70 per cent. We require full recourse with personal guarantee from our counterparties.

Interest may be either capitalised or paid periodically in arrears. However, any capitalisation of interest cannot exceed LVR.

As shown on previous slides, these loans will be usually be converted to construction loans once development commences.

We will now present two of our land loan case studies.

The first one is a $17 million senior land loan, secured against the development site located at Avenue Road, Mosman, New South Wales.

This facility will be converted to a $42m construction loan, sourced from our Construction Debt Fund, with DA approval held for demolition of the existing dwelling and development of 11 high-end units with retail and car space.

There is a shortage of modern, well-appointed apartments and fit-for-purpose retail or commercial accommodation in Mosman, and hence the subject development is expected to be well received by wealthy downsizers and owner-occupiers who are seeking to be close to retail amenities.

The second project is at Newcastle, New South Wales, one of our land residual stock loans, whereby 10 vacant industrial lots have been sub-divided, close to the Port of Newcastle, and are currently on the market for sale.

The site presented on the slide is a subdivided property with underground services installed and a wide bitumen-paved roadway with direct frontage to Greenleaf Road.

Now, moving on to our deep dive into construction loans.

So, what are construction loans? With recent media coverage around several developers or builders experiencing financial difficulties, we thought it would be helpful to cover the risks and our approach for borrower and developer selection.

Construction loans are provided to fund real estate development and construction costs in respect of land on which the construction is soon to commence.

The security provided is the development land site and the improvements constructed upon it, which upon completion will incorporate the completed building.

Construction loans are typically drawn on a monthly basis as the project progresses.

All construction loans are provided on a cost-to-complete basis, with the borrower required to inject their equity contribution prior to the construction loan being drawn.

Interest on construction loans is capitalising.

Due diligence is very extensive on a construction loan at Qualitas. Some might even call the process invasive. For a construction loan, we scrutinise every aspect of the development, including borrower capability and experience, design of the project, suitability of the project in the market in which it is being delivered, builder due diligence. We also conduct builder replacement sensitivity, cost escalation sensitivity, market value diminution sensitivity and the impact of project delay on costs. We need to be comfortable that the borrower or guarantor has the balance sheet to provide additional equity during the course of construction if required.

So, what are the key risks associated with construction loans? There is an array of different risk items to consider when funding a construction loan. A key risk is the capacity of the builder to complete the project in accordance with the fixed price, fixed time contract. Qualitas undertakes extensive analysis on information provided for each builder including their financial standing, their track record of performance their current project work in progress, sub-contractor relationships, defects history and construction contract terms.

Although we cannot prevent builders going into administration, there are a number of factors worthy of highlight.

Qualitas doesn’t lend to the construction business. We lend directly to the developers.

And there are multiple layers of profit and equity buffers before a debt financier suffers any loss.

Firstly, you have cost contingency built in by developers within the project feasibility, which is usually around 5 per cent.

Secondly, you’ve got forecast profit inherent in the project, usually around 20 per cent of project costs.

And thirdly there’s also the developer equity in the project, which is usually around 20 per cent of project costs.

We’ve experienced a couple of incidents over our 14-year history where the builder has gone into insolvency. In each of these cases, we’ve managed to identify the issue and act very quickly. We’ve replaced the builder within a period of no greater than six months, and projects have been completed without any capital loss to Qualitas.

This simplified senior loan structure diagram demonstrates the relationships between key parties.

A guarantee can either be granted by a corporate entity or individual, which is respectively referred to as a corporate guarantee and a personal guarantee.

Guarantees enhance the creditworthiness of the loan because the financier has recourse back to another entity to support repayment and servicing of the loan.

If there is no guarantee, then the loan is referred to as “non-recourse”, as ultimate repayment and servicing of the loan is dependent on just the borrower and the value of the property and income generation of the underlying security property.

The tripartite agreement between the builder, financier and borrower gives the financier the right to step into the shoes of the borrower when things don’t go according to plan.

Here are the typical terms.

One important factor to highlight is that construction loans are sized off the lesser of a percentage of total cost, typically 75 to 85 per cent, and the forecast as if complete valuation, typically 65 to 75 per cent.

The source of repayment of the loan is critically evaluated, and in the case of a residential development is usually a combination of sales of completed dwellings and refinance into a residual stock loan. In terms of a commercial development, repayment is often refinance of the construction debt into a longer-dated term investment facility.

I will go through two construction loans we’ve recently settled.

The first one is a senior construction loan facility provided to fund the development of 18 high-end townhouses in Newport, Sydney.

The project is currently fully sold, and three months away from completion.

The sponsor group is a highly experienced private developer, who has a five-year relationship with Qualitas.

The second example is one of our mezzanine construction loans, provided to assist in the construction of 324 residential units in Alphington.

A mezzanine loan is a subordinated second ranking, or second mortgage, facility which increases a debt stack over and above a traditional senior loan. It earns a materially higher interest rate than a traditional loan to reflect the heightened risk position.

Notwithstanding the nature of this loan, our loan-to-value ratio does not exceed 78 per cent of the end value of the project.

At Qualitas, we are passionate about educating our investors on the CRE debt asset class.

To summarise the three key takeaways of the modules:

  • CRE debt is a highly specialised asset class and requires a specialised manager.
  • We are one of the only specialist CRE managers in the country, which is all we do, commercial real estate.
  • We are finding more and more investors seeking CRE debt, as it aims to deliver risk-adjusted returns at attractive premiums in a rising interest rate environment whilst providing comfort through the security of profit that capital can be preserved.

Thank you for your time, and we hope you have enjoyed our presentation