8 risks to successful property development financing

May 15 2024 by Andy Wong

With an increasing number of construction projects being put on hold over the past year, lenders are actively monitoring and managing risks to protect their investments. This article explores the type of risks lenders consider when they look at funding a property project and how developers can help mitigate them, leading to enhanced viability and profitability.

Assessment and Management of Risks by Lenders

Lenders, whether banks or non-banks, employ a set of generally accepted guidelines to evaluate the risks associated when funding development projects. These guidelines help determine the viability of lending on a project and how transactions should be priced. Below is a list of risks a lender may consider when lending for a property project.

Market Risk

Market risk pertains to the potential for units not to sell at the projected prices by the project's conclusion, which is crucial for repaying the incurred debt. Factors such as location, property type and the developer's marketing strategy significantly influence this risk. Banks often mitigate this risk by requiring strong presale levels before approving financing, ensuring sufficient funds to cover debts upon project completion. Conversely, private lenders may accept higher market risks, occasionally funding projects without presales at a premium rate.

Developer Risk

Another crucial aspect lenders may evaluate is the developer's capability to manage potential issues during the development process. This includes the developer's experience, ability to address problems swiftly, financial resilience to cover cost overruns and historical reliability. Strategies to mitigate developer risk include partnering inexperienced developers with seasoned ones or hiring skilled project managers.

Construction Risk

The construction of a property project presents significant risks and requires meticulous assessment, similar to developer risk, focusing on the builder’s financial stability, experience and reputation. More complex constructions, such as those that feature basements, also introduce additional risks. The preparation of the construction contracts, to include clauses for liquidated damages, retention sums and the requirement for a tripartite deed, also needs to be considered. Ensuring that the builder is adequately insured is also crucial. Employing an experienced project manager can effectively mitigate construction risks by maintaining strict oversight and early identification of potential issues.

Legal Risk

This involves the potential legal complications that could undermine the lender's position, based on the borrowing and legal structure set up for the property project. All parties, especially guarantors, are generally required to be well informed about the implications of their financial commitments.

Regulatory Risk

Changes in legislation can impact the ability to sell units, such as restrictions affecting foreign buyers, which could increase market risk. Keeping an eye on proposed legislations changes and timing projects ahead from potential changes in government, both local and federal, can help manage regulatory risks.

Site Risk

Factors like ground conditions, contamination and zoning affect the site risk. Difficult build environments, such as sloped sites, can also elevate risk levels. Some lenders may require a preliminary risk screen assessment from the Environment Protection Authority Victoria (EPA Victoria) to be provided to further understand the development site and the issues that may arise during the development project. Should the assessment determine that an environmental audit is required, the lender may request it prior to funding the project.

Reputational Risk

Lenders may avoid financing projects that could harm their reputation, such as those associated with controversial industries. They can also decline to take on clients who are negatively viewed by the public.

Project Risk

Projects with robust profit margins are better positioned to absorb cost overruns and delays. Conversely, projects with minimal margins face greater challenges in managing unforeseen issues, and highly leveraged projects have significantly higher risk. Lenders consider the all the risks mentioned above and how they can impact the profit margins, the overall feasibility and likely returns when they consider financing a project.

Conclusion

Navigating the myriad of risks in property development requires thorough assessment and strategic mitigation strategies. PropertySensor specialises in evaluating and addressing these risks, providing tailored solutions to maximise financing outcomes for developers. Our expertise in mezzanine finance, preferred equity finance and other property development financing options make us a trusted partner for developers aiming to achieve successful outcomes in their projects. Contact us today to learn how we can help with your projects.