Why would developers commence construction with minimal presales?

However, changing market conditions, including rising labour and material costs are seeing construction prices continually escalate resulting in costing uncertainty and apartment projects commencing in the absence of presales. Subsequently, in the current environment developers are seeking alternative and bespoke sources of capital to facilitate construction commencement.

Here Monark analyses the reasons why developers should consider commencing construction of a project with minimal presales.

1. Increased construction prices– Construction costs have risen and are expected to continue to rise by up to 20%.  As a result, there is an inherent risk that developers successful in pre-selling a project prior to locking in a fixed price construction contract could be eroding profit margins by selling at too low a price. In some instances, particularly in Queensland where legislation does not ensure sunset clauses are for the benefit of purchasers only, developers are counteracting this by terminating presales in order to resell at a higher price, once construction costs are known. The better and more prudent option is to hold off on preselling until a construction contract is signed. Once construction pricing is ascertained, it is possible to attribute a price per square metre for each apartment thus ensuring the project remains profitable.

2. Buyer requirements– The increase of owner-occupier purchasers (in particular downsizers who sell a family home before downsizing) has meant that more buyers are looking for certainty around construction completion and settlement date. This results in hesitancy to enter into sales contracts pre-construction.  These purchasers are more particular about “what the finished product” will look like and reticent to have their deposits sit in a trust account earning minimal interest whilst a developer secures presales. In addition, they want certainty to align the purchasing of furniture with a move in date. This is particularly an issue with long supply lead times from overseas.

3. Display suite expense– A benefit of selling during construction is eliminating the need to outlay money on expensive display suites. The increased number of purchasers desiring to walk-through the ‘end product’ before purchasing is challenging the notion of a traditional display suite on site.  This outlay may be better directed towards purchaser incentives, such as furniture packages.

Amongst this background, the viability of presales as a requirement to obtaining construction funding is being challenged.  Whilst major Australian banks continue to require high levels of pre-commitments, non-bank financiers such as Monark Property Partners are providing developers with certainty and flexibility by funding projects with minimal or even no presales. In some instances, step down pricing provisions may be appropriate, allowing rates to reduce once certain presales hurdles are met.

Without presales, non-bank lenders are looking to several factors to gain comfort that risk is adequately mitigated before approving finance.  Some of these factors include:

1. Cash equity contributions– Greater cash equity provides lenders with confidence that the developer has genuine “skin in the game”.  Whilst developers have recently been able to increase equity through value uplift in the site, lenders are more likely to look at true cash equity indicating the developer has more to lose and is less likely to walk-away if development issues arise.

2. Viable exit strategy– Without presales a clear exit is trickier to demonstrate. Funders are more likely to lend against boutique, high end projects in inner urban locations, where property values are underpinned by a robust, established housing market. Experienced agents are successfully selling these projects during or post construction using the requisite expertise and knowledge of the market.  Moreover, with the weight of capital seeking to be deployed, residual apartment loans are becoming common practice and are a reliable source of repayment for the incumbent financier.

3. An experienced team – The more experienced a developer the more likely a lender will view the project as less risky, even with no presales. In situations where the developer has little experience the appointment of a strong team, including a highly experienced Project Marketing team and seasoned consultants is imperative. An experienced development team is likely to provide a financier with comfort the project will complete within budget and projected timeframes and be sold during and/or post construction.

4. Due diligence on builder – Appointing an experienced builder with a track record of completing similar projects in size and quality has never been more critical.  Lenders are carrying out detailed due diligence on proposed builders before approving finance. A builder with a strong track record who is financially sound and able to work through any movements in price is critical.

There is no doubting that obtaining presales is advantageous where construction costs are known, however present market conditions are challenging developers and financiers.  The uncertainty around building costs and property prices, coupled with decreased offshore/investor purchasers and changes to purchaser sentiment are factors likely to persist for some time. Nimble non-bank lenders such as Monark, are well placed with a strong understanding of the market, to identify risks and gain the necessary comfort to provide construction funding without presales.

At Monark we subscribe to the theory that well designed, boutique residential and commercial projects located in inner city fringe locations will continue to perform strongly in a post COVID environment.

Article was written by – Adam Slade-Jacobson, CIO and Executive Director and Ashley Hartman, Head of Legal and Operations.