De-risking the Investment
22 December 2020
For Commercial Real Estate debt secured by development projects, strategies to de-risk the investment are critical. For first mortgage loans which have been subject to thorough due diligence by the investment manager, mitigation strategies such as Loan to Value Ratio (LVR), Loan to Cost Ratios (LCR) and pre-sales conditions are useful risk mitigation tools. Here are the key de-risking strategies applied by Banner to ease risk of the investment.
De-risking the Investment (LVR)
Lending into the CRE market has several qualitative elements that necessarily requires a skilled manager to thoroughly understand, assess and manage. Most investments will be secured by a mortgage over real estate. The amount lent is usually restricted to a percentage of the value of the asset, which is usually determined by an independent third-party valuation expert. To ensure the integrity of the valuation process, most well managed funds will have a formal panel of independent valuers, who are appointed due to their expertise and experience.
The percentage of the assets value that is extended to the borrower is described as the Loan to Value Ratio (“LVR”). This essentially means that in the event of a default situation the borrower assumes the first loss position in the event the asset is sold at a price less than the valuation. For an LVR of say 65% (broadly accepted conservative LVR position), the asset’s underlying value would need to sell at a discount of 30-35% of the valued sum (after allowance for costs) for there to be a capital loss to the CRE debt holder. In this way LVR can operate to protect the lender against property market price cycles.
De-risking the Investment (LCR)
For development loans the assessment of risk must also include an analysis of the ‘Loan to Cost Ratio’. This is calculated by reference to the amount of the proposed loan against the total costs of the project. This includes cost of the land, construction costs and interest capitalisation to give a comprehensive statement of the project’s leverage. The higher the ratio, the higher the leverage and the riskier the project is considered (all else being equal).
In the management of construction projects, the manager should be analysing and forming a view on acceptable LCR for each transaction.
De-risking the Investment (pre-sales)
For Commercial Real Estate debt secured by development projects, a key risk mitigation requirement of funders, is to require a certain proportion of the stock to be pre-sold prior to settlement or the commencement of construction funding. There are several reasons for a pre-sale requirement, including:
1. Demonstration that the project has a market.
2. Upon the completion of the project, the pre-sold stock (being residential dwellings (units/townhouses, industrial lots, land lots, etc) provides for an immediate repayment of all or part of the loan from the net sale proceeds, which are paid directly to the lender.
3. Pre-sales provide a validation of the projects pricing and the valuation assessment.
4. For purchasers who acquire a stock (unit, townhouse, etc) item prior to commencement of construction, they are required to lodge a deposit (usually 10% of the purchase price), usually with the developer’s or funder’s solicitor that is held in the firm’s trust account. The 10% deposit is non-refundable at completion of the project, and as such provides an element of surety that the purchase will complete the purchase upon completion of the building works. Failing to complete the purchase can lead to forfeiture of the 10% deposit to the lender.
5. Lenders will review the pre-sale contracts and require that they are in approved form and contain clauses which ensure the contract is not conditional or able to be avoided.
These represent some of the key de-risking strategies applied by Banner to loans that otherwise meet strict credit criteria.