Alternative Funding

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The big four banks’ increased capital requirements will heighten the need for alternative funding sources for property development, according to a real estate investment firm Qualitas.
The company, which provides equity and debt financing to residential, commercial and retail property developers, discussed the issue in a briefing in Sydney.  
The Australian market is unusually dependent on big banks for commercial real estate lending, said group managing director Andrew Schwartz.
“Australia’s four major banks dominate the $230 billion commercial real estate debt market, with a market share of over 90%. In comparison, commercial banks in the United Kingdom and United States control between 40%-60% of the market, with non-banks, such as institutional debt funds, controlling the remainder. But real estate debt funds haven’t had a big presence in Australia to date,” he said.
This is set to change in the coming years, with the Australian Prudential Regulation Authority’s decision to increase the big banks’ required capital levels. When coupled with banks’ internal requirements that limit commercial real estate Loan to Valuation Ratios (LVRs) to around 55-65%, Qualitas says the market will need more options.
“The banks have their hands tied when it comes to making loans to property developers. As a result, there is a need for additional funding sources, which is where Qualitas fills the gap. Sometimes we provide this alongside the banks, through mezzanine debt, and other times we provide senior debt or equity,” Schwartz said.
While co-investing from its own balance sheet, Qualitas also invests discretionary capital on behalf of institutional and high-net-worth investors. It is seeing strong interest from offshore investors keen to access the Australian property market, which continues to demonstrate relative value compared to North American and European markets. 
“The depth of capital in foreign markets is huge - relative to Australia – and the weight of this money has compressed returns offshore, while they remain higher here. Some investors are also attracted by the fall in the AUD. As a result, we expect 2016 will see increased momentum of foreign capital coming to Australia. This is good news for the market, as it will increase the options available to those who need capital from alternative sources,” said Schwartz.
However, accessing quality deals in the local market can be challenging for overseas investors, according to Schwartz.
“Some of the biggest managers providing commercial real estate debt and equity capital globally aren’t seriously competing down here – they operate on more of a fly in/fly out basis. As a result, they don’t have the networks of contacts or on-the-ground access to deals before they hit the market.
“We deliver superior returns on a risk adjusted basis. Returns are attractive, so people assume it must be very risky. However, there are reasons they are high. Access is key: we are providing capital that our clients can’t source from the banks, while the market we operate in is very closed, built on networks, trust and long term relationships; so there is an information arbitrage at work,” Schwartz said to emphasise that Qualitas delivers above-market returns.
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Bank funding gap for property development set to widen: Qualitas

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The rise of alternate funding may be the next big thing in developer financing following APRA's tightening oversight of banks, if we are to interpret recent commentary by Daniel Holden, director of construction finance group Holden Capital.
The pressure on major banks to meet capital adequacy levels under the Basil III accord has reduced their appetite for construction lending, says Holden in one of his posts. To achieve their objectives, banks have raised the bar for developers in terms of their pre-conditions, cut gearing levels and increased their pricing on debt, effectively implementing a flight to quality and leaving many of the their traditional but more marginal clients in terms of credit strength, looking for alternative funding sources, he says.
Record low interest rates have come as a boon then, encouraging developers to shift to alternate funding.
In FY15, Holden Capital settled 64% of its deals with the major banks but this quickly changed with 62% of the $300 million of project debt settling before Christmas likely to be set with alternative funding sources, a pre-Christmas post said.
While alternative funding sources may have some additional costs, they also come with distinct benefits to developers who do not want to be restricted in their ability to look for market opportunities due to constraints placed by traditional banks.
As an example, non-bank money can cost as low as 9-10% per annum, which when compared to the traditional bank cost on a medium sized projects of say 30 products, would add as little as $170,000 or 10% variance on normal finance costs to a project with a total cost of $6 million.
Alternative funding also offers a developer the potential for significant savings in other areas such as the chance to start the project without the need for pre-sales, unlike when approaching banks. The developer can lock in a construction price and reduce escalation risk as well as sell houses with a more certain delivery date, rather than the more speculative off the plan route required to meet banks' pre-sale criteria, Holden adds.
According to a case study by Holden Capital, bank and non-bank lenders have different requirements regarding loan ratios. Most non-bank lenders are so called gross realisation (GR) lenders and the main criterion for them is a loan to value ratio (LVR) of no more than 65%. Banks also require a maximum LVR of 65%, but in addition they impose a limit of no more than 80% of the total development cost (TDC).
The bank option benefits from a significantly lower total interest cost, but the non-bank alternative does not require the delay of between 3-6 months associated with the pre-sales requirement and benefits from a lower requirement on developer equity with the potential for a significantly increased return on investment.
Holden has also summarised the kind of developers best placed to succeed in this environment.
The 'Phoenix' developer, who were successful pre-GFC but rapidly declined during the GFC due to unfortunate dealings with their creditors but are now rising again Phoenix-like. Typically this type of developer is very experienced, but misjudged the state of the market and their level of exposure to it during the GFC, he says. Now they are back out there, wiser from experience and unlikely to make the same mistakes. They are more conservative with their own limited capital and looking for equity partners to leverage their position. Holden predicts that the 'Phoenix' developers will most likely be successful in the coming years.
The other is the cautious developer, who identifies risk upfront and finds ways to mitigate these as much as possible. They also realise that they don’t know everything, and won’t hesitate to utilise the skills of others, where there is a gap in their knowledge and skills base. In reality, they are the 'Smart Developer', he concludes.
According to Holden, Australia has a deep market of passive investors willing to take equity positions on development projects. In conclusion, developers could achieve much more if they use the right consultants and redirect their energy and time into enhancing their core skill sets, which would reflect in long-term success.
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