Getting the Numbers Right with Home Loan Refinancing
By Michael Langhammer and Andrew Clugston
Whilst Australia continues to defy the global economic downturn, constrained credit conditions have hampered the property industry’s attempts to finance new projects as well as refinance existing assets. Now more than ever, presenting a professional, complete and accurate finance proposal has become crucial in securing finance.
Pitcher Partners has regularly worked closely with our property developers and property investor clients to procure finance. Our recent experiences combined with open and frank discussions with senior bankers have taught us a great deal about presenting a property finance proposal to maximise the chances of success in the current economic environment.
Property developers, get the numbers right
It might sound strange but the inability of developers to accurately forecast cash flow requirements, in particular peak debt, continues to frustrate many bankers with the risk that the success of finance proposals may be jeopardised.Bankers have confirmed that property developers regularly approach banks without preparing a detailed monthly cash flow forecast. Such forecasts should take into account the impacts of staged settlements, GST facilities and realistic finance costs based on the monthly loan balance.
Critical to any financial modelling is the ability to undertake some sensitivity analysis and consider some what if scenarios. For example what if:
- Construction is delayed by 3 months?
- 5% of pre-sales fail to settle?
- Unsold lots do not sell?
- Impact of rental guarantees
Too often this analysis is left up to the banker to model which is less than ideal for the developer on two counts.
Firstly, banks are currently inundated with new applications for property projects to finance whilst being faced with limited capital to lend. Any proposal requiring significant work to be undertaken by the banker risks being placed in the too hard basket.
Secondly, providing no cash flow or sensitivity analysis leaves the bank to draw their own conclusions as to the risk profile of the project. The developer will have little opportunity to review the analysis presented for credit approval. In our experience this is why some credit approved offers come in at substantially lower than expected LCRs (Loan to Cost Ratio) or higher margins.
Evidence of risk mitigation
Developers spend much of their time and effort de-risking their projects. This often results in several strategies available to mitigate most major risks. However, these strategies are rarely communicated to the bank in a clear and concise format.Bankers have commented that this area of the finance application receives considerable attention from their credit committees but too often the bank receives little input from the developer. Any banker with sound property experience will be able to identify most of the major risks but will rarely be aware of all the work undertaken to mitigate these.
A finance proposal should always include a section devoted to risk assessment. This assessment involves the identification of risks, attributes a probability of the risk occurring (high, medium, low) and assesses the magnitude of the financial impact. In addition, the analysis should detail the various mitigating circumstances and actions that have been undertaken to help address each risk.
Property investors, don’t get left behind in the rush
Property investors unfortunate enough to have gone through the refinancing of a property post 2008 can confirm that pre Global Financial Crisis GFC gearing levels are a thing of the past. Banks have reduced Loan to Value Ratios LVRs by around 10% across all property classes. With stagnant or declining commercial property values, investors are faced with the task of bridging the gap between their previous debt facility and the reduced level of gearing currently offered by the banks.
Some of our clients have recently succeeded in bridging this gap via mezzanine finance and private equity from private investors and superannuation funds. However, obtaining such finance can take time and obtaining the approval of the senior lender is not always guaranteed. As such, this process should not be left to the last minute. Adding to the difficulty facing investors is the waive of property debt set to expire within the next two years. The graph below, prepared by JP Morgan and reported in the Australian Financial Review on 8 July, illustrates the increase in debt due to expire over the next five years. In particular, 2012 and 2015 look set to see refinancing activity among Real Estate Investment Trusts peak at 7 to 8 times the current levels. No doubt this refinancing activity will be replicated in the private sector.
(Source: Australian Financial Review, 8 July, 2010)
Such refinancing activity will place additional strain on your bank’s property division. This may result in delays in processing applications and less time spent structuring the finance to best suit your needs.Just as concerning is the impact this level of refinancing may have on available funds for mezzanine finance and private equity. Developers and investors seeking to refinance a property within the next couple of years would be well advised to start the process now.
As with developers, a detailed finance proposal should be prepared by investors seeking to refinance an asset. The proposal can be provided to the bank as well as potential mezzanine financiers and private equity participants. In addition to the normal contents of a finance proposal, the document should focus on:
- Quality of the tenants
- Weighted Average Lease Term Duration (WALD)
- A funding term aligned with WALD
- Forecast Interest Cover Ratio (including mezzanine interest)
- Demonstrate that the mezzanine financier is protected even with a possible drop in the future value of the asset
- Sensitivity analysis focused on varying interest rates, rental reviews and valuations
Whilst mezzanine finance or private equity may not ultimately be required, given the uncertainty surrounding credit markets it is prudent to explore the options available well before your current facility expires. Considerable time may be required to ensure the bank is comfortable with the mezzanine financier and any possible second mortgage arrangement. In the event that mezzanine finance is not a viable option, introducing an equity partner may be the only alternative to selling the asset. Introducing an equity partner brings about several taxation issues including Stamp Duty and Capital Gains Tax. This is yet further evidence of the need to start planning early.
A strategy of deferring the refinancing process until the last minute, in the hope that things will improve, is fraught with danger. A little time now can avoid many sleepless nights in the future.
Pitcher Partnerswould be pleased to talk to you about how we can assist in providing cash flow budgets and framing finance proposals that will address the key issues that will be considered by a financier.