Constructing your construction loan
If you’re smart enough to have purchased a property with potential, there’s two key activities you will need to complete before the benefits really start to roll in.
Design and funding
It’s your choice as to which item you believe needs to be addressed first, but the truth is your design and your funding need to be juggled in tandem for optimum success.
While there’s usually a few tricky issues to handle, in most cases property owners have a relatively clear understanding of how to manage the design components of their project.
Funding, however, is a completely different issue. Many buyers curl up in a corner when it comes to sorting out the numbers, but it doesn’t have to be that way. Outlined below is a summary of how to construct – and manage – your construction loan.
But first . .a definition
A construction loan is a short term loan typically used for the purpose of constructing a structure and is finalised when the structure is completed. Home owners can use a construction loan to build or renovate their property. Slightly different versions of this type of loan are used for residential and commercial developments.
Construction loans most commonly have a progressive draw-down. That is, you draw down the loan (or increase your borrowing) as needed to pay for the construction progress payments. The amount available to borrow will be partly based on the value of the property upon completion of the construction.
For your home
When using a construction loan to build your home, the loan will usually be interest only over the first 12 months and then revert to a standard principal and interest loan. Once a construction loan has been approved and the construction of the property is underway, lenders will make progress payments throughout the stages of construction. Generally, the payments will be made at upon completion of the following five stages.
(1) Slab down or base: This is an amount to help you lay the foundation of your property. It covers the levelling of the ground, as well as the plumbing and waterproofing of your foundation.
(2) Frame stage: This is an amount to help you build the frame of your property. It covers partial brickwork, the roofing, trusses, and windows.
(3) Lockup: This is an amount to help you put up the external walls, and put in windows and doors (hence the term ‘lockup’, to make sure your house is lockable).
(4) Fitout or fixing: This is an amount to help you do the internal fittings and fixtures of your property. It covers plasterboards, the part-installation of cupboards and benches, plumbing, electricity, and gutters.
(5) Completion: This is an amount for the conclusion of contracted items (e.g. builders, equipment), as well as any finishing touches such as plumbing, electricity, and overall cleaning.
As the loan is being progressively drawn down, interest and repayments are calculated based only on the funds used so far. For example, if by the third progressive payment, only $150,000 has been drawn down on a $300,000 loan, interest would only be charged on $150,000. It is also important to note that most banks require you to use all of your equity before they release the next payment.
Additional work completed by contractors
In some cases, part of the work won’t be completed by your builder. Some common examples are:
- Swimming pool
- Power pole / power connection
- Site clearing
- Shed, dam or other hobby farm improvements
If you can provide a formal written quote for this work then a good broker can often organise the bank to extend the loan for these costs. It really depends on the nature of the work and the lender the broker chooses to work with as to whether this will be possible or not.
The key is to provide your broker with this information at the beginning of the process. If you tell your broker about the additional work later on there’s a good chance it won’t be financed. Note that some lenders will only release money for the additional work once the main house is completed. If this doesn’t suit your construction schedule, in some cases your broker may be able to help you fund these components in another way or through another lender.
Cost plus construction
A construction or building loan is usually based upon a fixed price contract. This can include land purchased with the intent to build, or property purchased with the intent to renovate or knock down and rebuild.
Cost plus contracts do not have a fixed price. This is normally because the builder cannot accurately determine the cost of construction so offering a fixed price would be a significant risk for them.
This is a problem for the bank as they cannot be sure you have the funds to complete the project. The last thing that the bank wants is to be left with a half finished house as security for a large home loan.
Why is the cost of construction difficult to determine?
The cost and scope of a project may not be able to be determined at the time of the mortgage contract. Whilst existing land and property have their own market value, a future building project can be difficult to price in advance.
Many builders will also not set a fixed price for a construction contract, as materials and labour costs can vary dramatically over time. This can be due to any of the following reasons:
- A construction project may take longer than estimated. For example, bad weather can delay work.
- Material costs such as commodities and other building materials change in price quite often.
- Labour costs may change per individual or labour requirements may change during the life of the project.
General borrowing points for a baseline construction loan
- You can borrow a maximum of 80% of the value of the land plus the cost of construction.
- It’s possible to borrow 100% of the land and construction costs with a guarantor.
- Large scale renovations of existing properties are also acceptable.
- You must have contingency funds in case you go over your budget.
- Most banks do not lend to cost plus building contracts.
If you’re in the fabulous position of planning to convert a house on a large block into multiple dwellings, you will need a construction loan . . .albeit with a bit more VOLUME.
Small developments (up to 4 dwellings)
- For 2 dwellings: Borrow up to 95% of the land and construction costs (hard costs).
- For 4 dwellings: Borrow up to 80% of the land and construction costs (hard costs).
- Borrow up to 100% of the market value of the property plus any costs associated with completing the purchase with the help of a guarantor.
Medium developments (over 5 dwellings)
- Borrow up to 70% of the land and construction costs (hard costs).
- Borrowing more than 70% is possible with a private lender but they will charge a higher interest rate than general commercial rates.
- You need to meet 70% of the GRV (gross realisation or on completion valuation).
- A profit margin of at least 20% of costs is the minimum bank feasibility requirement.
- Loan term: Up to 3 years.
- Minimum loan size: $1,000,000.
- Maximum loan size: Anything over $20 million considered on a case by case basis.
- Residual stock loans are available to help maximise your return on investment.
Do you need contingency funds?
Some banks require you to have contingency funds but some don’t. Work with your broker to find a flexible lender, negotiate higher Loan to Value Ratios (LVRs) and lower interest rates than you would normally be able to qualify for if you were to go to your own bank.
Is this a residential or commercial loan?
A residential development loan is for the purposes of building a maximum of 4 units on one title for residential purposes. This could either be a duplex, triplex, townhouse or a small unit block. Anything more than 4 units will need to be assessed by the commercial department of a lender and fall under commercial development loan requirements.
With a residential development loan, your interest rates are a lot lower than getting a commercial loan. A commercial development loan is very similar to a residential construction loan except banks are a little tighter with the Loan to Value Ratio (LVR).
Generally speaking, the following is available.
- Standard commercial property: Borrow up to 75% of the land and construction costs or Land to Development Cost Ratio (LDCR) or 65% of the on completion value. With a guarantor, you can borrow up to 100%.
- Specialised commercial property: 50-60% LDCR for specialised commercial properties including landfill or waste management facilities.
Do lenders require a personal guarantee from shareholders?
If you wanted to purchase and develop land in a joint venture structure, typically the project manager and the service partner would be appointed as directors (and guarantors). The money partners in the trust structure would appointed as shareholders/unit holders.
Generally speaking, all shareholders are required to provide a guarantee by default but this is negotiable depending on the strength of your case. In particular, if your Loan to Value (LVR) is low, you may negotiate to just have directors and shareholders of significance to provide guarantees.
Do I always need to set up a trust structure?
Some banks require you to set up your loan in the name of a company or trust because the residential development loans are unregulated. For most lenders, this isn’t a requirement of approval.
How does a residential development loan work?
Like a normal residential construction loan, the bank will release funds at the end of each stage of development. These stages are typically as follows.
- The deposit.
- Base stage.
- Frame stage.
- Lock-up stage.
- Fixing stage.
To receive each progress payment, it’s simply a matter of signing a progress payment request and sending it off to the bank along with an invoice from the builder. For the first progress payment, you’ll have to provide a copy of the receipt from the builder showing that you’ve sent them the funds you’re required to contribute.
Getting progress payments can be delayed due to bank mistakes like losing your files, but it helps if you have a specialist mortgage broker on your side who can manage all of this for you. In this way, the progress payments can be smooth and you won’t be left in cash flow limbo with builders and tradesmen down your throat asking for payment.
How will the bank assess your development plans?
Think of a residential development loan application like pitching a business opportunity: the bank wants to know that the development you have planned is going to be viable and profitable.
Along with your personal financials, most lenders will also want to see a property development business plan or a feasibility plan showing the costs of construction versus potential profit. It should look really neat and professional because it shows that you’ve done your due diligence on the project.
What you’ll generally want to provide in a business plan is the following information.
- What funds you have to put towards completion (not including your security for finance).
- Contingency funds in case things go wrong (some lenders like to see 10-20% in contingency funds if you’re an owner builder).
- Your experience as a developer in the construction of similar-sized projects.
- The experience of the building team (including their certifications).
- A description of the site, its location and zoning.
- A design concept.
- The costs including landing, construction and soft costs.
- Construction timeline.
- How you plan to sell the properties or whether you have tenants lined up.
There are firms and companies that can help you draft a professional property development plan. By doing so, you have a much stronger chance of getting approved.
Is this your first residential development?
Although you’ll generally need previous development experience in either a developer, builder or project manager capacity, your broker should be able identify a lender to help you if this is your first time.
- You can borrow up to 70% of the Gross Realisation Value (GRV) or 80% of the hard costs.
- Available for up to four dwellings up to $1,500,000.
- Some lenders don’t need proof of income if you plan to sell the properties on completion.
- No presales are required for small duplex, townhouse and unit developments.
You need to present a feasibility study
The bank wants to know that you’ve accurately calculated the costs of construction versus your return on investment or profitability margin at the end of the project.
Project costs include the following.
- Development Application (DA): These costs can vary from council to council.
- Construction costs: This includes hard costs for material, paying builders and contractors, overruns such as where excavation machines are needed to cut into rock or when you’ve already pre-sold a unit but the customer wants to upgrade building materials or finishes.
- Selling the property: There’s stamp duty and professional fees for real estate agents and solicitors that can amount to roughly 6.5% of construction costs.
- Unpredictable overruns: Costs can quickly blowout as projects get delayed – you can’t control this but you need to factor a certain buffer based on your own feasibility study and market research.
This is not an exhaustive list of costs but it gives you some idea of what you’re up against. In the end, you need to work out that at the end of the project and pre-sales, you’re 20-30% ahead in profit. If so, you’ll have a good chance of getting approved.
Will the bank accept proposed rental income?
Usually, the bank will accept proposed rental income. The lender will either ask for a letter from the real estate agent to confirm the market rent income or they’ll use the rental figure estimated by the bank valuer.
They can accept up to 80% of this projected rental income which can seriously increase your borrowing power.
Note: Rental income on vacant land will not be accepted but it may be accepted if there is a construction contract in place.
Will I need pre-sales?
Unlike a commercial development loan, you don’t need to pre-sell any of the properties or units in the development in order to get approved for a loan.
There may be exceptions to this rule if you’re planning to build in an area outside of a metro or inner city or particularly in a rural location, which is seen as a higher risk. Use the bank sites for their postcode location calculators to find out whether your development is in a high risk postcode.
In any case, having some pre-sales does add a lot of strength to your application – that’s if you’re planning to sell as the optimum situation would be to retain the properties long term.
Many lenders require pre-sales to equal the amount of debt but some can take less. For example, with a four-townhouse development in a high demand area, the bank will still consider your application if you have anywhere between 0-4 pre-sales.
What about pre-sales for larger developments?
For commercial developments, some lenders require 100% pre-sales (genuine, unrelated parties) before they will approve your loan. However, if GRV is less than $5 million, they can accept 50% pre-sales debt cover, albeit, this will generally be at a higher interest rate over a 15-year term.
Debt cover or Debt Service Coverage Ratio (DSCR) is used by commercial lenders to work out the Net Operating Income (NOI) to the debt service. Put simply, the bank wants to know that the pre-sales will cover the whole debt or at least percentage of it.
For example, if the entire project is set to cost $2 million, you may be required to pre-sell at least $1 million (50%) before the bank will consider your application.
Does the development cover soft costs?
Depending on your investment strategy, you may actually need two to three loans throughout the entire development process, specifically:
- A ‘land loan’ to cover the cost of buying the block of land.
- The construction loan, to cover the building costs.
- An investment loan if you’re planning to hold on to one of the properties.
What about the cost of the development application (DA) and other soft costs?
Soft costs are generally considered as costs that aren’t labour and materials. These ‘extra’ development costs relate to:
- DA approval from the local council
- Clearing the block of land
- Driveway and landscaping
- Legal fees
Many first-time residential property developers are often surprised that the development loan only covers the land and construction costs. Make sure you take into account these extra costs when calculating the total cost of development.
The way around it is if you bought the block of land a few years ago and have paid off a good part of the land loan. If you have the equity, you can cash out and use these funds to cover some of the extra costs.
In this situation, you can work with a broker to refinance your existing mortgage to transfer to a residential development loan. Alternatively, if you can provide formal written quotes for soft costs some banks will extend the loan for these costs.
It really depends on the nature of the work and the lender as to whether this will be possible or not.
Can I switch to a residential loan?
You should speak to your mortgage broker to find out whether you qualify. When the project is complete and you have been given an Occupation Certificate, you can potentially refinance to a residential home loan and save thousands by paying home or investment property rates.
Depending on how your loan was established, there will be a range of options as to how the loan could work after the construction is complete. Your strategy should be discussed prior to your project commencing as you could be charged break costs if you need to shut down the lending facility to swap to a different type of loan.
For example in some cases, you need to have been paying a development loan for at least 12 months before you can refinance so as to avoid break costs. This option is typically only available to developers that have sold one or two units to meet the standard 100% debt cover requirement.
By planning out your approach, you can save thousands in mortgage repayments and have the option to hold your properties for a longer time period and potentially sell at a higher price in the future.
Residential development loan FAQs
A residential development can potentially return higher dividends than simply investing in an existing residential property. However, there is a lot more risk involved constructing a duplex or townhouse for investment purposes.
Apart from choosing the right location and researching the local market, sometimes things can go wrong with the construction process so you have to be prepared.
Where do I start?
Before even applying for a residential development loan, you should consider why you’re developing in the first place. The most fundamental question to consider is whether you plan to sell all of the properties, keep one to live in and rent it out or rent out all three as investment properties you will keep for a long time.
Answering this question should determine where you want to purchase and what kind of multi-dwelling property would best suit that location and market.
Your exit strategy
Are you planning on keeping one of the properties? Once the development is complete, you may decide that you want to hold on to one of the premises as an investment property.
If there is enough profit from selling the other one or two properties, you may be able to buy the property without the need for a loan. If there aren’t enough funds, your mortgage broker can help you refinance the property to an investment loan so you can pay out the development loan.
One more IMPORTANT note
Ensure you check out the ‘Building and construction – residential premises’ page on the Australian Taxation Office (ATO) website for information regarding tax implications when selling a property in a multi-dwelling development.
For example, you’re liable for the Goods and Services Tax (GST) when selling one of your units and dwelling but you calculate the GST owed using the margin scheme and save on this tax cost.
You should seek tax advice from your accountant and financial advice from a specialist in development funding to ensure you’re making an investment decision that works best for your financial situation.
Buy smarter = limitless ways to build lifetime income
Crave Property Advisory is a unique property strategy and buyers agent service. As the only independent and unbiased advisory that can help you use any property strategy Australia-wide, Crave’s services extend to home, investment and commercial property. A highly client focused organization, Crave developed the Modular Investing System (MI System) to provide clients with the ability to use a tailored mix of strategies and efficiently build profitable portfolios that create lifetime income.
Debra Beck-Mewing is the CEO of Crave Property Advisory, and has more than 20 years’ experience in property investing, Australia-wide. She has used a range of strategies to build her property portfolio including renovating, granny flats, sub-division and development. Debra is skilled in identifying development opportunities, and sourcing properties that have multiple uses and multiple exit strategies. She is a Qualified Property Investment Advisor, licensed real estate agent and also holds a Bachelor of Commerce and Master of Business.
Disclaimer – This information is of a general nature only and does not constitute professional advice. We strongly recommend you seek your own professional advice in relation to your particular circumstances.
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