Navigating financial shortfalls in construction: case study

May 10 2024 by Andy Wong

Introduction

With Melbourne property prices in a surprise fall for the first three months of 2024, understanding the impact that price fluctuations can have on an ongoing project can save time and money but also potentially save the feasibility of the overall project. This case study looks at a hypothetical scenario, exploring the ramifications of a fall in property value and possible solutions to keep the project running.

Background

A high-profile commercial development project in the suburb of Sorrento, Victoria is under assessment for finance with a non-bank lender. Originally, stakeholders projected a Gross Realisable Value (GRV) net of GST of $42,000,000 for this ambitious project. The development will be for the construction of 50 luxury residential apartments with two commercial and retail spaces on the ground floor of the building. The initial financial blueprint supports a loan of $31,500,000, based on a 75% loan-to-value ratio (LVR) of the GRV net of GST ($42,000,000), a common practice in commercial real estate lending used to mitigate risk while providing ample funding. The initial projected equity required by the developer is $4,775,000 and the breakdown of the funding table drafted by the developer is as below:

Problem

As the finance application goes through with the non-bank lender, an independent valuation firm is contracted to assess the project. The GRV net of GST is estimated at $40,000,000, $2,000,000 lower than the initial estimates. This adjustment may appear minor in the context of a multi-million dollar project, but it has significant financial implications.

Impact

As the valuer estimates the property value to be lower, the primary concern for the developer may be a $2,000,000 reduction in sales when the completed properties are sold. However, it is important to consider that the valuation is a projected amount that may or may not eventuate. If the property market outlook improves during the construction phase of the project, the developer may end up with more than $40,000,000 in sales, meaning the lower valuation has no impact on the project. It also depends on any presales for the properties, which provides strong guidance for the estimated sales revenue.

However, the immediate consequence with the non-bank lender is a reduction in the available loan amount to $30,000,000 to maintain the LVR at 75%. Non-bank lenders typically request any shortfall required by the developer to be provided from the start of the project; in other words, when the land is acquired. As such, the decrease in loan available reduces the funding from $3,800,000 (from the funding table above) to $2,300,000 (per the revised funding table below). This reduction creates a potential challenge to fund the additional $1,500,000 to keep the project on track without compromising its intended scope and quality.

Solutions

For stakeholders, primarily the developers and financial backers, the change in valuation necessitates a swift and strategic response. The developers face the daunting task of either injecting more capital, scaling down the project or finding cost efficiencies.

To address the funding gap, the project may team consider several strategies:

• Equity Financing: Seeking additional equity contributions from existing or new investors, offering a stake in the project in return for immediate capital injection.

• Cost Reengineering: Working closely with architects and contractors to identify possible reductions in construction costs without significantly affecting the aesthetics or functionality of the building.

• Scope Adjustment: Reducing the scale of the project, such as decreasing the number of floors or opting for less expensive building materials.

• Leveraging Equity From Other Properties: Providing other security properties to leverage and fund the $1,500,000 gap. As an example, adding a few security properties such as apartments, houses or commercial units worth $2,000,000 might satisfy the requirement to close the funding gap. The non-bank lender would then register a mortgage on the additional properties to increase the loan amount to $31,500,000 (back to the initial estimates).

Each option carries its own risks and benefits, requiring careful consideration to strike the right balance between financial viability and project integrity.

Conclusion

This case study serves as a reminder of the importance of accurate property valuations in construction finance. The unexpected drop in the GRV of the project, from an anticipated $42,000,000 to $40,000,000, reveals the delicate balance required in project financing and the significant effects that even minor fluctuations in property valuation can have on funding strategies.

Ultimately, this case study highlights the critical importance of adaptability in the real estate development sector. Developers must be prepared to adjust their plans in response to changing market conditions to ensure the success of their projects. By planning for contingencies and engaging in creative financial problem solving, developers can navigate the uncertainties of the market and maintain the integrity and financial viability of their projects. This proactive stance not only safeguards the project but also enhances investor confidence and secures the long-term sustainability of their business operations.

Image credit: Pixabay