A critical part of a developer being able to undertake and complete a property development is having the financial wherewithal to obtain 100% of the funds that are necessary for it.
Financing a development involves: the injection of equity (via the developer’s internal cash funds and/or real estate assets used a security); and/or debt funding (external debt finance). In Australia, commercial lenders, such as banks and finance companies, almost always require a small- or medium-size developer to inject a certain level of equity (risk capital) into a property development, relative to the amount of debt finance that they provide. For example, they may require a minimum of 25% equity to be willing to provide debt funding for 75% of development costs.
A situation commonly arises where a developer may be able obtain development finance from a primary debt lender, such as a bank, for most of the cost of a development, say 65%, if that developer provides the rest of that cost from his or her equity, however that developer may have only 20% of the cost of that project to offer the bank as part of his or her risk capital (security offering) for the loan. In such a case, the developer may want to and be able to obtain further debt funding from a different lender to bridge the gap between his or her equity level and the primary debt lender’s offering, to secure 100% funding of the development. This type of ‘gap’ finance is called “secondary debt” funding, which includes “mezzanine” funding, and the interest cost that lenders charge for it can be a few or many percentage points higher than the interest rate that the developer pays for primary debt finance. The reason for the higher interest rate is that more risk is attached to secondary debt funding, relative to primary debt funds, because secondary debt funds (such as 2nd mortgage or mezzanine funds) are subordinate to primary debt funds in order of priority of repayment in the case of the borrower’s bankruptcy. The main benefit of a developer obtaining secondary debt finance is that, if the development proposal is a highly profitable one, the developer does not miss out on an opportunity to make a substantial return if primary debt funding, plus the developer’s available equity, cannot completely fund the development. On the other hand, the terms of the secondary debt funding contract, including a higher interest rate on borrowed funds and, in the case of mezzanine finance, the potential for a mezzanine funder to take an equity position in the developer’s company for further security, should be weighed against the risk of missing out on the expected financial benefit from undertaking the development.
The property feasibility software, Feastudy Professional, which enables the efficient and comprehensive financial feasibility study of developing a piece of real estate for profit and is produced by Devfeas Pty Ltd, can model equity and debt funding and their related costs for a development with respect to:
The “Equity Amount”, as reported in the Profit and Loss reports of the program, is the total of all equity actually injected into the cashflow, not what is provisionally injected from entries in the Equity and Joint Venture window.
Another way for a developer to obtain a substantial amount of the funds that are required to pay for a development is to joint venture (JV) with a partner, such as a development site’s owner. A JV development enables a reduction in interest costs and sharing of the financial risk for the venture. Feastudy Professional facilitates joint venture analyses for various combinations of equity from two JV partners.
In a Development file in the software, whatever costs are not funded by income and/or GST input tax credits are funded, in accord with certain rules, by Equity, Secondary Debt Funds and Primary Debt Funds – in that order. If a cost or part of it is not funded by income, input tax credits, Equity nor Secondary Debt Funds, then Primary Debt Funds are used to fund that cost or part cost.
Feastudy Professional only allows for a “fluctuating overdraft” type of loan facility with respect to draw downs from a lender and any actual draw down of debt is completely used to fund, or partly fund, new net Development costs for the month.
At Devfeas Pty Ltd, we have taken the view, based on professional accountants’ advice, that a fully drawn debt facility from day one, with the interest capitalised monthly, is more like corporate lending rather than ‘tailored’ or specific development finance. Thus, we have adopted the principle that the development’s feasibility, for the purposes of Feastudy Professional, should not be burdened with interest costs on funds that are drawn down from a lender if they are not used immediately to directly fund specific new development costs for the month.
A Line Fee, which is a charge that is payable by a borrower to a financial institution to keep a loan facility, e.g. a Line of Credit (LOC) or an overdraft, available to the borrower, can apply to primary debt funds for a Development file in Feastudy Professional. When relevant data entries are made for a Line Fee, the program calculates the monthly amount of the fee by: multiplying the annual percentage rate for the Line Fee by the Maximum Limit of Loan (the maximum monetary limit for the loan facility) for Primary Debt Funds; and then dividing the resulting product by twelve (12). The monthly amount of the Line Fee is then paid in each month of the specified period for the Line Fee.
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