Formulating a robust exit strategy is a critical part of the development process. When assessing an application for a development loan, the credibility of a clients’ proposed exit strategy will be reviewed and assessed in detail.
There are several ways a developer can exit a construction loan – the most common strategies being:
- to sell the development down, or
- to hold (and refinance any residual debt).
No matter the strategy, a lender’s comfort around this area of the transaction is paramount as this is how they expect to be repaid. Failure to clearly demonstrate how funds will be repaid and how you can execute on your strategy will likely result in the funding application being declined.
Learn how to create an exit strategy properly below.
Recycling Profits
Selling down completed stock (be it dwellings or sections) to realise profits is the most common exit strategy property developers adopt. This strategy enables profits to be recycled from one project into another upon completion. This “rinse and repeat” model enables developers to quickly scale their business and grow profits.
Many lenders will lend more aggressively against a ‘sales strategy’. This is because a ‘refinance’ (or ‘hold’) strategy requires the residual debt upon completion of the project to be refinanced. This means that any initial development funding provided by the initial lender cannot exceed an amount the developer will be able to borrower in the refinance market.
Refinancing requires the developer to meet servicing criteria (at a future point in time) which is largely unknown when they start construction. Because lending criteria (and interest rates) are constantly in flux, development lenders will be conservative when providing funding to clients to intend to hold their product.
As a result of the above, most lenders will lend more aggressively when the developer adopts a ‘sale strategy’. This means that selling down properties is a less capital-intensive compared to holding – not only because they can obtain greater leverage but also because the developer’s equity is not tied into the project over the long-term. Therefor, a developer’s return on equity tends to be higher over the short term.
Of course, there is an argument for both exit strategies as over the long term, holding can generate capital gain that can exceed any short-term gain generated through development.
Pre-selling & Lending Criteria
Mainstream lenders such as banks typically require a certain number of pre-sales as a pre-condition to funding construction. In today’s environment, most NZ banks require between 100-130% presale cover to ensure that their debt can be repaid in full upon completion of the project. One of the reasons that (some) banks insist upon a pre-sale cover greater than their debt facility (say 130%) is to ensure that their debt can still be repaid should some purchasers default.
In contrast non-bank lenders have more flexible terms and can fund projects with no (or a limited number of) presales. They also have greater flexibility when determining what constitutes a ‘qualifying presale’.
If you have decided to obtain pre-sales, our suggestion is to always seek ‘bank’ quality pre-sales where possible (regardless of the individual lender’s requirements). Bank quality presales can be typically defined as follows.
- Unconditional (subject only to the issuance of title and CCC)
- Independent contracts sold through an agent
- No related party sales
- Minimum 10% deposit paid (for NZ residents, 20% for non-NZ residents) and held in a solicitors trust account
- Terms consistent with the proposed plans for the project
- Appropriate sunset dates are usually +12 months after the expected completion date
- Sales to individuals (as opposed to a company or trust). If a sale is to a company or a trust then obtain a supporting guarantee from the Directors or Trustees.
- Avoid multiple sales to the same party (as they will typically not be accepted)
Following the above principles will put you in a good place to obtain funding from most lenders.
Should You Pre-sell?
Pre-selling has its perks when it comes to risk management however making such a decision will likely have broader implications for your project, particularly its profitability.
Below we look at some key points developers should consider when making this decision:
Risk mitigation
This one’s obvious – there is a reason that lenders insist on pre-sales. Pre-selling locks in revenue and protects your downside in the event of a decline in property prices. It also establishes a robust (often bankable) exit strategy via a watertight contractual arrangement. Selling at the end of a project will expose the developers to changes in market conditions leading us to our next point…the property cycle.
The property market is cyclical
A firm grasp on what stage of the property cycle we are in will enable us to make more informed decisions when it comes to risk management and risk mitigation. Pre-selling in the growth phase will likely result in you leaving money on the table. A good example is a client who was building two-bedroom townhouses in Epsom, Auckland in 2020. Feedback from real estate agents (and an RV) had suggested an end value of $1.0m per unit. However, our client could see that the market was taking off and was convinced that his product would present better on completion. He decided not to pre-sell, instead listing his properties when they were nearing completion. Between starting construction and completion, the market had moved substantially and our client sold all ten units for greater than $1,150k per unit, a +$1.5M gain in revenue for the project.
Cost Escalations
What is the likelihood of cost escalations during construction? In recent years, property prices have skyrocketed; however, so too have construction costs. This created an interesting predicament for some developers who had sold off-plan. By pre-selling, you are locking in your revenue. This means that any increase in cost (no matter how minor) will directly impact profitability. We all saw the news article in 2021 where developers were trying to renege or renegotiate on pre-sale contracts. This is because construction cost escalation during the build had eroded their profits. In the meantime, property prices were well above their initial presale prices, giving them the incentive to try cancel presales to recapture a project’s margin. In such circumstances, ensuring that construction costs are fixed before starting a project, and retaining/holding back some stock are just some ways to mitigate the impact of escalating construction costs.
Off-plan discount
It is commonly accepted that selling off-plan/before the project has been completed results in the developer selling at a slight discount to market (up to 5% of the purchase price). This can be for various reasons including uncertainty about what will be delivered, time delays, hesitancy on what direction the market may head and so on. However, this is not a blanket rule. Some developers take advantage of this using comprehensive marketing packs and high-quality renders to upsell their development.
Supply and demand: understanding what competing stock is planned for delivery (and when) should inform your sales exit strategy. You may decide to sell on completion if there is no competing stock. If there is lots of competing stock, then it will likely be harder to sell on completion and days on the market will increase. If you are fully drawn on a construction facility, holding costs will quickly erode your development margin. In this instance, pre-selling (at least some) will enable you to reduce debt and de-risk your project.
Price validation: while agents and valuer’s provide an incredibly valuable service, even they can be wrong. If you are building an unusual typology or intend on building a product that is new for the area, then pre-selling will enable to you to test the price point of your product. This will underline revenue assumptions in your project feasibility and allow you to move forward with your build with confidence.
Developing a Sales Strategy
There is no one size fits all approach when it comes to developing a sales strategy. For this reason, instead of detailing an effective sales strategy we have posed some questions which we encourage all our clients to consider before launching their sales campaign.
A good sales agent will help develop a comprehensive sales strategy, and thus we suggest obtaining multiple proposals from various agencies (similar to a tender process) before committing to any one agent.
- Who is the best sales agent to represent you – is there a particular person or agency who would be best suited to sell your product?
- What is the best fee proposal to incentivise your sales agent?
- When is the best time to commence marketing?
- Are you going to pre-sell off plan or sell closer to completion?
- How much stock do you want to release and when? Are you looking to sell 100% of your product before commencing construction or simply sell as many as you need to unlock funding.
- Will one typology be harder or easier to sell compared to another?
- Will selling one product first create a price floor or ceiling for unsold stock?
- How are you going to market your product i.e. what sales channels are you going to use?
Don’t get caught out
Undertaking a development without an exit strategy in place not only undermines your ability to obtain funding but can severely impact the viability of your project.
Pre-sales protect your downside; however, it can come at a cost. Deciding to sell on completion is still a viable strategy, so long as you clearly demonstrate how you will execute this and its rationale.
Being fully drawn on a construction loan facility with no exit in place will result in you incurring unnecessary holding costs which can quickly erode a project’s profit.
Be prepared on how to create and exit strategy; talk to ASAP Finance about funding your next project.