Overview How does construction financing work, and why do P&L based solutions fall short compared to Asset-based lending options? Find out in this article.
How does construction finance in Australia work?
Traditional construction finance companies and banks often overlook the importance of assets and why solely P&L-based solutions don’t work for many builders and property developers.
Private mortgage managers consistently outperform traditional construction finance companies in sourcing more cost-effective, tailor-made construction loans for Australian builders and property developers. Traditional construction finance companies and banks have been offering limited funding options for too long now, and constructors and developers have suffered.
When lenders base construction finance loan decisions on P&L only, it leads to an assessment that’s out of step with the sector’s reality. The result is that traditional construction finance companies and banks are reluctant or unable to identify the revenue potential of construction projects, and borrowing becomes expensive and inconvenient.
The primary issue is that banks offer a limited set of products designed for a far too broad group of potential applicants – and none of them are specifically suitable for construction. Qualification requirements also don’t that don’t apply equally across the board. The needs and income cycle of a catering business are both a far cry from that of a builder Profit and loss are adequate indicators of many things. Still, it’s hardly a reliable indicator of financing in a sector where income and expenditure are often separated by multiple fiscal periods.
What is construction finance? The Profit and Loss (P&L) Statement
A profit and loss (P&L) statement summarize all costs, revenues, and expenses during a specific period. P&L statements are sometimes prepared to cover each trading quarter, but they may also cover an entire fiscal year.
A profit and loss statement illustrates a business’s ability to generate profit. From a company perspective, a P&L statement can offer insights into how you could increase revenue. That might be by increasing sales or reducing operating costs – if not by combining both.
Profit and loss statements provide directors with an invaluable source of information about the health of a business, and they are an essential part of trading. However, P&L alone can’t offer a complete picture for firms in some sectors. It’s a part of what is going on, but it doesn’t paint the entire picture. Whether that’s the case for your particular business could largely depend on the sector you inhabit.
Profit and loss are just one reason Australian construction firms have problems with traditional lenders like banks. The trouble begins because banks tend to rely too heavily on profit and loss to predict the outcome of taking on a loan. In reality, construction businesses experience a somewhat unique set of challenges and difficulties. They typically spend considerable amounts buying sites and paying contractors over a significant period before projects get completed, and sales bring money back in. For that reason, a profit and loss account can look decidedly unhealthy during an entire fiscal period, even when tens of millions of dollars worth of income is just around the next accounting corner.
That’s the case at the start of projects –when construction companies are looking to source investment and get sites underway. Looking at a construction or property development company over a quarter often gives an unrealistic account of its prospects. Doing so over an entire fiscal year is equally problematic and can’t be expected to offer insights into a business’s ability to cope with a construction loan.
Projects often run for two or three, or even more years in the construction sector. Because they rely heavily on profit and loss when assessing construction finance loan applications, traditional construction lenders and banks lack the versatility construction operators require. Consequently, banks and traditional construction finance loan providers bring too many different requirements and limitations. Beyond simply being expensive, frustrating, and inconvenient, bank-based construction finance solutions can cause operational problems during a build and even compromise schedules and profits.
Construction Finance in Australia: Banks Versus Private Financiers, Assets Versus P&L
If we’re to identify some of the common problems with traditional construction finance companies, it’s helpful to consider a typical lending experience. Here’s the story of one of Agility‘s recent clients, a Brisbane-based property developer embarking on an apartment block development in the city. The new product would happen in a neighbourhood with optimal transport links to the CBD, very popular with commuters and a range of demographics. As a result, property consistently sold fast, and investments in the area earned a substantial return.
The developer specialized in apartment developments and came with a highly desirable track record. The business had repeatedly delivered successful projects over ten years. A suitable DA had been obtained, and all the contractors were lined up by the time the developer approached the bank, expecting finance to be a formality.
The developer had bought the site in 2018 with plans to construct a six-apartment building eventually. Each apartment was expected to fetch $950,000, and market activity in the neighbourhood suggested all the flats would sell without a hitch.
The Bank’s Construction Finance Package
This is where the problems began for the developer. The bank evaluated the project based on total development costs (TDC):
Land purchase cost: $1 million
Construction costs: $2 million
Additional costs: $200,000
Total TDC: $3,200,000
The bank also used the development company’s P&L statements to assess its ability to repay any construction finance loan over the two-year project period and finance term. In doing so, the lender created a risky environment on paper. Bound by rigid lending criteria and a limited approach to assessing construction projects, it consequently proposed to fund only 70% of the TDC. In addition, influenced by the P&L-based evaluation, the bank specified pre-sales of 50%, meaning three apartments would be sold off-the-plan. The bank also imposed stringent requirements for inspections during the loan term, releasing funds gradually only after the builder had passed each one.
The Problems with the Bank
The developer was unsatisfied with the bank’s proposal because it had a rich history of turning around profitable apartment developments. The market for apartments in the area was healthy. Still, the developer also considered the requirement for pre-sales to be a significant roadblock – and a threat to the project’s profitability. Through extensive experience, it knew higher sale prices could be achieved after completion.
There was also the matter of the DA and the fact land value had increased substantially after the developer put a DA in place. In short, the developer considered the bank’s proposal to be entirely unsuitable and approached Agility for a consultation.
Construction Finance in Australia: The Benefits of a Sector-specific Solution
Agility is a private mortgage manager with access to specialist financiers who concentrate on the construction sector. For that reason, we can arrange custom funding solutions for developers and construction firms of all sizes. A flexible, sector-specific approach allows us to look beyond total development costs and profit and loss. We evaluate projects based on their unique potential to generate profit.
In the case of the Brisbane development, we assessed the developer, the project, and the financial pressures during construction, exactly as a bank would. However, we went further than TDC and P&L, examining gross realization value (GRV) too:
Total TDC: $3,200,000
Return from 6 apartments: $5,700,000
Total ROI: $2,500,000
After the delays with the bank, getting the project underway was the developer’s primary objective, so Agility didn’t stop there. As construction specialists, we know that a significant upturn in land value results from putting a suitable DA in place. In the case of the Brisbane project, the land was purchased for $1 million but was now worth $1.9 million. That allowed us to advance the difference in value to get the project started.
As the project progressed, Agility continued to assess end value and arranged further funding with zero pre-sales requirements, allowing the developer to achieve projected ROI projections ahead of time.
What is construction finance? Why assets and GRV are so important
The construction sector can be an extremely challenging environment, and while cash flow is a vital part of making projects successful, the way it happens in construction is almost unique. That’s why it’s so crucial that construction finance companies and private mortgage managers consider the bigger picture when it comes to construction finance loans. Assets like machinery and vehicles are valuable and can substantially reduce borrowing costs. Likewise, the value in construction projects and the sizeable returns from building work can offer a far more cost-effective alternative to traditional P&L-based evaluations.
In the construction industry, GRV represents a valuable asset. If a developer is consistently profitable, successful, and brings experience to the table, that’s an asset too. Once a project is deemed viable, end value must be factored into any lending equation, and the developer gets a fair deal from construction finance companies.
It’s not rocket science, and there are no longer any reasonable excuses for the banks. TDC is relatively easy to calculate. With any well-planned construction project, profits are also simple to predict. At the same time, frequently occurring issues within the industry like DA-based equity need to be considered, and lending solutions have to be realistic, equity-based options that developers and builders can use.
Why do property developers and builders get so frustrated with banks and other traditional construction finance companies?
Profits are based on acquiring potentially good sites, obtaining all necessary permissions and permits, and adding significant value by transforming little or nothing into something homebuyers will pay large sums of money to own.
Construction Finance in Australia: Better Funding, More Profitable Outcomes
Here at Agility, we think the solution to ineffective construction finance loans is pretty straightforward. Options need to be based on the requirements of builders and developers. When construction finance is custom-made for the sector, projects turn into profits more quickly.
The construction sector isn’t like hospitality, retail, or farming. It thoroughly deserves funding solutions that are designed around its particular features. Whether you’re building an office extension in central Melbourne or a multi-hectare housing project in Canberra, having access to the right finance option at an appropriate time can be the difference between turning a healthy profit and turning down a profitable opportunity.
Therefore, the construction industry’s rise in private funding solutions is easy to explain. Traditional construction finance companies and banks with ill-fitting products have often let developers and builders down. At Agility, we think it’s high time there were fairer, sector-specific solutions, and we work hard to make applications faster too.