Development
7 Critical Factors to Nail Property Development Funding
TL;DR: The number one factor that can kill even the most profitable development is a lack of appropriate property development funding. Lenders assess seven criteria: IRR (25%+), return on cost (20%+), percentage of cost (75-80%), percentage of GRV (~65%), assets and liabilities, experience and serviceability. Understand them before you take on a project, or before you invest with a developer.
Q: What is the number one factor that can kill even the most profitable property development project?
A: Lack of appropriate property development funding!
Yes… Getting the all important property development funding that is appropriate for the project… is, well, make or break!
So, if you are considering investing in a development project then you need to know this…
The 7 critical factors to successful property development funding
Get these right and you will have banks, JV partners and gap funders kicking down your door. Without adequate property development funding on appropriate terms, even the best property development projects are doomed from the outset. With the tightening of lending criteria over recent years, understanding exactly what lenders are looking for is crucial before taking on a development (or investing your hard earned cash with a developer, an alternative investment path that is becoming increasingly common today).
Most developers cannot fund their projects purely out of their own capital and the more prudent would not do so anyway. As you become more experienced and take on more projects, you will quickly realise why it’s important to spread your financial risk across numerous projects… even if it means sharing some of the development profits.
Let’s assume you have found a site that is economically viable, and your due diligence analysis is favourable. Perhaps you control the site by way of a contract or an option agreement.
The next step is to raise capital
Soft costs vs. hard costs
Generally, development finance is lent as a percentage of the overall costs of a project. These costs are split into hard costs and soft costs.
Hard costs often refers to the costs of actual physical construction of a real estate development project but can include the land and acquisition costs, local council approval costs and professional fees.
Soft costs are less obvious than hard costs as they encompass anything and everything which is not directly related to the physical development of a building, e.g. loan establishment fees, interest, mortgage duty, valuation fees, legal and accounting costs, and marketing costs.
Although some lenders will provide for some of the marketing costs, in most cases the developer has to fund this cost by obtaining sufficient pre-sales to support their application.
Debt vs. equity funding
Funding packages generally comprise of debt funding and equity funding. Both are key to getting sufficient property development funding… but come with very different terms and levels of risk to the lender.
Debt funding requires the developer to pay interest and certain fees, but the developer keeps all the profit after all costs are paid.
Sources of debt funding are banks and non-banks and comprise of senior debt (where the developer offers the lenders a 1st mortgage) and mezzanine debt which sits behind the senior lender (2nd mortgage) in order of payout.
Equity funding is where the lender elects to take on some of the risk by sharing in the profit. Usually this form of funding is more expensive as it reflects the higher risk including lack of mortgage security.
Equity financing is only offered by a small number of banks and non-bank lenders and, more recently, from crowdfunding and co-development providers, where everyday investors provide the funds from their SMSF or other savings vehicles. That is the model our own projects use: investor capital ranks ahead of developer profit, with investors sharing in the growth the build creates. (For the investor’s view of how those layers rank and pay out, see how to compare property development crowdfunding opportunities.)
The biggest challenge for the developer is to get as much money together to cover most of the total development costs. Unfortunately, the difference between the hard costs and soft costs available and the total costs can result in a funding ‘gap’ or a shortfall after all funding sources have been exhausted.
Plugging this funding gap with private money has become a lucrative opportunity for investors in recent times, particularly when the project is already quite advanced at the time of making the investment, i.e. post DA approved, with significant pre-sales and strong valuations, and when the debt funding is already approved.
7 key lending criteria
Lenders ultimately ‘sell’ money to developers and compete with other lenders depending on their unique lending criteria. Development managers often engage brokers to introduce funders, and brokers may charge upfront fees, sometimes $20,000 or more, for introductions that may never produce an acceptable funding offer. It pays to understand the criteria yourself first: the same seven tests sit behind bank facilities, non-bank property development loans and private funding lines alike. (Chapter 6 of our guide, the funding gatekeeper, walks these tests from the developer’s seat.)
| # | Criterion | What lenders typically want |
|---|---|---|
| 1 | Internal rate of return (IRR) | 25%+ |
| 2 | Return on cost | 20%+ |
| 3 | Percentage of cost | They fund 75-80% of costs |
| 4 | Percentage of GRV | Debt up to ~65% of sales revenue |
| 5 | Assets and liabilities | Net assets beyond your equity |
| 6 | Developer’s experience | Both project AND developer matter |
| 7 | Serviceability | You can carry the loan if sales slow |
1. Internal Rate of Return. This is the interest rate at which the net present value of an asset is zero. Financiers typically won’t lend on projects showing less than a 25% IRR unless substantial additional equity is provided.
2. Return on Cost. The return on cost is calculated by dividing the development profit by the total development cost and multiplying by 100%. Generally lenders require at least a 20% return on cost unless additional equity is available.
3. Percentage of Cost. The percentage of funds advanced as a percentage of the total development costs. Current lenders may advance 75-80% of costs depending on additional factors.
4. Percentage of Gross Realisable Value. GRV is the total value of all sales in the project. Lenders today typically lend up to 65% of total expected sales revenue.
5. Assets and Liabilities. Financiers evaluate the developer’s assets (e.g. shares, cash, property) and liabilities (debts) to determine net wealth. Lenders consider worst-case scenarios and typically require some net assets beyond the developer’s equity contribution.
6. Developer’s Experience. I’m often asked which is more important: the developer’s experience or the feasibility of the project. In my experience the answer is BOTH. Experience matters significantly, and inexperienced developers risk delays and cost blowouts that a seasoned team would avoid.
7. Serviceability. This refers to the developer’s ability to make regular loan repayments should the project not achieve the forecasted level of sales. Interest is typically capitalised during the project and repaid from sales revenue upon completion.
Three key risk mitigation factors
1. Loan to Value Ratio. The loan to value ratio (LVR) is the loan amount divided by the value of the asset offered as security. For example, an asset value of $10,000,000 with an $8,000,000 loan equals an 80% LVR. Lower LVRs indicate reduced lender risk and signal greater borrower commitment.
2. Pre-sales. Most lenders will want to see a number of pre-sales (sales of the properties prior to construction) to prove there is a market for the end product. Current lenders typically require pre-sales covering 100% of the debt. Without pre-sales, debt costs and interest rates increase.
3. Builder’s Contract. Often the lender will need to approve the chosen builder and ensure they are contracted on a full turnkey construction basis. The builder must maintain strong finances to fund construction costs until payment from settlements, though most builders draw down on debt facilities as progress warrants.
But… what if you don’t meet these lending criteria?
If you do not have much experience, I’d suggest you partner with an experienced developer or engage a professional project manager recommended by the lender.
And success breeds success: a strong track record attracts multiple funding sources, and puts you in the position where banks, private lenders and joint venture partners are all competing for your business.
If you are on the investor side of that equation, funding a developer rather than being one, this is the armchair developer path. You can see what the cost-price maths looks like in our Manufactured Equity Calculator, and when is the best time to develop property answers the timing question that usually comes next.
General information only. Nothing here is financial, credit or tax advice, and lending criteria vary between lenders and change over time. Speak with your licensed finance professional before committing to a project.
Frequently asked questions
How much equity do I need for property development finance?
Lenders typically advance 75 to 80 per cent of total development cost, so plan to contribute 20 to 25 per cent yourself, plus a buffer for overruns. That contribution can come from cash, equity in other property, or investor capital, though every lender will want to see you carrying meaningful skin in the game.
What is a good return on cost for a property development?
Most lenders want to see a forecast return on cost of at least 20 per cent, meaning the project's profit is at least a fifth of everything it costs to deliver. Below that, the margin may not survive a cost overrun or a soft sales market, and funding becomes much harder to obtain.
Do banks still fund small property developments in Australia?
Yes, but selectively. The major banks have tightened development lending over the past decade, and non-bank and private credit lenders have filled much of the gap. Non-banks generally move faster and require fewer pre-sales, in exchange for higher rates and fees. Many small developers now run bank and non-bank quotes side by side.
How many pre-sales do I need for development funding?
Banks have traditionally wanted pre-sale contracts covering 100 per cent of the debt, though requirements vary with the project and the market. Non-bank lenders often accept lower pre-sale cover, sometimes none, priced accordingly. Every pre-sale you bring reduces the lender's risk and strengthens your negotiating position.
Can a first-time developer get development finance?
It is harder, not impossible. Lenders weight developer experience heavily, so first-timers improve their chances by partnering with an experienced developer, engaging a respected project manager recommended by the lender, keeping the project simple, and bringing a stronger equity contribution. The team's track record can substitute for the borrower's.