Why interest rates are irrelevant

private lender interest ratesSecuring a business loan can be confusing and finding a transparent lender can be a difficult task. When choosing a lender there is a lot of jargon to sort through which is why it is easy for borrowers to focus only on getting the lowest interest rates. However, it’s far too common for borrowers to buy into a loan because the interest rate looks good only to discover a range of hidden costs and fees.

Interest rate vs total cost of the loan

The rate of interest is only one portion of the total cost of a loan. Trying to calculate the true cost over the life of a loan can be daunting but it makes good business sense to do so. This is why finding a lender that is entirely upfront and transparent about fees is incredibly important. One way to check is to see if they provide a proposed disbursement schedule or estimate of all upfront costs with any indicative offer.

Possible fees

Here is a list of fees a lender may require as part of the loan agreement, which can greatly increase the overall cost of the loan:

  • Establishment/Origination/Application Fees: Setting up the loan/account .
  • Documentation Fees: A fee to cover time spent preparing the loan documents.
  • Direct Debit Fees: When making a repayment some lenders charge for every transaction which add up over time.
  • Monthly Management Fees: Ongoing fees charged for the management of the loan.
  • Withdrawal Fees: Charged for every withdrawal, often seen in Line of Credit loans.
  • Late Fee: If the payment schedule is missed.
  • Early Repayment Fee: Charged if you pay the loan out before the due date.
  • Amendment Fees: Added by the lender if you request amendments to your loan/ repayments.

Educating borrowers

Helping borrowers to understand the difference between a good interest rate and the total cost of a loan is extremely important, particularly when dealing with short term lending. We have had clients come to us in the past who have been offered an interest half of what we offered, however when they took into account the other fees and charges they were required to pay they discovered that we were significantly cheaper than the other lender. When you look at the total cost of the loan, interest rates can become completely irrelevant.

Below is an example of a $435,000 two-month loan for a second mortgage we arranged for a client to help them complete a development project:

Interest for the two-month loan:                                         $16,530 (22.8% per annum)

Approval fee:                                                                               $15,206 ($2,871 to Referrer)

Legal fees:                                                                                     $2,735

Total cost of the loan:                                                               $34,471

This shows that, as the loan was only for two months, the interest was just less than 50% of the total cost, demonstrating how critical it is to know what all the other costs are.

The total benefit

When looking at whether to take this loan, the borrower also needed to consider how much money they would make out of the transaction.  They not only needed to look at the cost of the loan, but at the benefit that the loan was going to deliver.

This is where a rough feasibility study for the development was important.

Gross Realisation Value:                                                        $1,950,000

Land purchase:                                                                          $650,000

Stamp duty:                                                                                 $35,000

Build cost:                                                                                    $650,000

Other costs (agent, council, holding):                               $115,000

Total costs:                                                                                   $1,450,000

TOTAL GROSS PROFIT:                                                          $500,000

This means the project yields a gross profit of $500,000.

Therefore, the cost of the loan divided by the gross profit is approximately 7% of the total cost. The client was able to determine that it made business sense to give away 7% of their profit ($34,471) to get the deal done. As we can see from this example, the interest rate is less significant than the overall cost of the project.

Sound advice

When considering a loan, a borrower needs to gain perspective on the overall outcome of the loan rather than getting caught up just comparing interest rates. This is where sound advice from a broker and a transparent lender is critical.

For further information about private loans for business projects, give us a call on 1800 856 683 or contact us via our website: www.privatemortgagesaustralia.com.au/contact-us/

How property development finance works

Every homeowner understands the difference between their mortgage and the equity they have in their home but when it comes to commercial real estate transactions like property development finance, the difference between equity, preferred equity, mezzanine debt and senior debt can confuse even the savviest financial minds.

Let’s take a look at what’s called The Capital Stack to better understand where the different types of finance sit in a commercial property development.

The Capital Stack for property development finance

Senior Debt

Senior Debt is secured by a First Mortgage on the property itself, so if the borrower fails to pay the lender can sell the security property. This greatly reduces risk on the principal invested because, at worst, the lender can recoup its principal by selling the property.

Mezzanine Debt

Mezzanine Debt sits behind the senior debt in order of payment priority. Once the developer pays operating expenses and the senior debt payment all income must go to pay the mezzanine debt. If the developer is unable to pay (assuming they aren’t also in default under the senior debt), the lender typically has the ability to quickly take control of the property. The senior debt and mezzanine lenders will usually enter into an agreement, called a Priority Deed, where they spell out how their rights interact (i.e. what happens if a developer stops paying both of them).

Preferred Equity

Preferred Equity is perhaps the hardest portion of the capital stack to speak about generally because, for better and worse, it’s very flexible. Preferred equity holders have a preferred right to payments over regular (common) equity holders. “Pref” equity positions range from “hard” preferred equity, which function similarly to mezzanine debt and include a fixed coupon and maturity date to “soft” preferred equity, which is more likely to include some of the financial upside if the project performs well. While hard preferred equity holders may have the ability to make some decisions or kick out the developer if they fail to make payments, soft preferred equity holders typically have more limited rights.

Common Equity

Common Equity is the riskiest and most profitable portion of the real estate capital stack. Typically the developer (or sponsor) will be required – by the lender and/or by other equity investors – to invest their own money as some portion of the equity to have skin in the game. Equity investments carry the greatest risk, because investment agreements entitle every other tranche of capital to be repaid before common equity holders. However, if the property development does well equity investors usually receive an exceptional rate of return. This is because they receive a portion of profit which can easily outstrip the return paid to debt holders usually expressed as an interest rate.

For example, a sponsor may have sourced senior finance at 6% per annum, mezzanine finance at 22% per annum but the sponsor and common equity holders return on investment is 50% per annum. Another way to think about it is that common equity is very expensive when compared to debt within the capital stack.

Understanding the stack is incredibly important as certain lenders will only become involved in particular types of property development finance and interest rates will vary depending on the risk. Currently, Private Mortgages Australia provides Senior Debt and Mezzanine Debt, and have aspirations to offer Preferred Equity in the future.

If you’d like to discuss finance for your next property development project then please get in touch.

How to obtain development finance

Development FinanceIt is well known that to secure development finance from a major bank is getting much more difficult. Like the GFC days when it was virtually impossible to obtain finance, tighter controls continue to be implemented. Banks generally require 100% of debt coverage from pre-sales and they have pulled back on the percentage of hard costs that they will fund.

However, there are non-bank lenders and private lenders that will look at a project from a different angle to the major banks. Developer finance lenders will work off the gross realisation value (GRV) of the project rather than the traditional hard cost or total development cost (TDC) method when working out how much they will lend.

The main things non-traditional development finance lenders will look at are:

  • The project – does it make sense?
  • The profit – is there a big enough profit in the project?
  • The people – are the people behind the development experienced?

GRV development finance method explained

Gross realisation value (GRV) based first mortgage facilities look at the projected end value of the project and will extend funding to a percentage of that. In general, the maximum GRV is 65%, or 70% in some cases.

Advantages of GRV development finance

  • No pre-sale requirements can mean a higher realisation price especially in a rising market.
  • No pre-sale requirements can mean the project holding costs are less and the development can commence more quickly.
  • Less developer equity required.
  • Taxable income figures for the borrowers are not generally required.
  • All fees and interest can be capitalised

GRV development finance general guidelines

With non-bank lenders and private funders, each project is looked at on an individual basis. However, below are some guidelines that, if met, will help you secure developer finance.

  • Projects should be in desirable locations with high demand for the product being built.
  • Profit margins should be between 15% and 25% depending on the type of project.
  • The borrower should be an experienced developer.
  • The borrower, while not generally required to prove serviceability, will need to have some tangible assets behind them and not be credit impaired.
  • While the funding may typically be available up to 65% of the GRV or end value, this ratio cannot be exceeded at the land stage or any stage of the development. If the land has increased significantly from when it was purchased there is no restriction on using the increased value. This means that 100% of hard costs can be funded in some circumstances.

Have a read of a case study for a development finance deal we recently undertook and you can also hear more about how PMA can help developers with finance in this video.

A word from our referrers – Lee Spyda

Lee SpydaLee Spyda from Investor Loans Network Gold Coast is a valued PMA referrer. He is committed to empowering clients through education, supporting them to reach their goals and providing exceptional service. We decided to have a chat with him and find a bit more about why he loves being a commercial finance broker.

  1. Tell us about your career history? I’m celebrating 10 years as a mortgage broker this year which is an important milestone for me as I really enjoy this work. I’ve also worked in sales and prior to moving to Australia in 2000 I undertook an apprenticeship in Pattern Making with Rolls Royce Industrial Power Group which was incredibly interesting.
  2. What do you find interesting about commercial finance? The most interesting thing about commercial finance is that every deal is different, there’s never a one-size fits all. For me, it’s really straight-forward. It’s about applying common sense and assessing each deal on the individual merits and circumstances and getting the best result for your client.
  3. What’s the most interesting commercial finance deal you’ve worked on? I’m currently involved in a property development consisting of over 140 townhouses which is really interesting. Over-purchasing blocks of units or other property with no deposit is a favourite scenario – solving the problems and making it work.
  4. What’s one piece of advice you always give to commercial clients? I always tell my clients that it’s not just about the interest rate, it’s the cost of the money in the long-run. We look at all the costs and make sure that the deal has the best chance of making a profit. In the end a percentage of something is better than a percentage of nothing!
  5. What are the benefits of working with a non-bank lender like PMA? Non-bank lenders like PMA have extremely quick approval times, a straight-forward loan process and, best of all, common sense is applied to each deal.
  6. What do you like about working with PMA? I’ve always enjoyed working with PMA because they have a great team, a simple approach and they look at things for what they are when making decisions.

 

Lee Spyda talks about commercial lending Lee Spyda is the Director & Finance Strategist at Investor Loans Network Gold Coast where he helps his clients to build their passive income property portfolio through asset protected structures to secure their financial future.

Lee has a Diploma in Finance and Mortgage Broker Management.

To get in touch with Lee contact [email protected]