Capitalised Interest Loans
In the dynamic realm of development finance, capitalised interest loans serve as a strategic option for lenders and developers alike, offering flexibility to the client and risk mitigation for the lender. Let’s delve into the core features of capitalised interest loans and understand why it is the preferred repayment type in the world of development finance.
Understanding Capitalised Interest Loans
Monthly Interest, Capitalised: Capitalised interest loans break away from the
traditional repayment model. Instead of developers managing monthly interest expenses, the interest is ‘capitalised’ onto the principal amount each month. The entire repayment, covering both principal and accumulated interest, happens when the loan matures.
Assessment of exit strategy: When a capitalised interest repayment structure is adopted, the lender relies on th
e client’s ability to “exit” or repay the loan in full upon maturity to earn their interest (and recover
the principal sum). In this sense, development funders place a greater emphasis on “exit strategy” as opposed to “cash flow” when a cap interest structure is adopted. In most instances, this will be the eventual sale of the properties upon the projects completion. However it could also be by way of refinance to another lender.
Risk Mitigation: A loan facility is comprised of a principal sum, and capitalised interest provision. If a capitalised interest repayment structure is being used:
The lender retains the capitalised interest within their facility. Doing so means that the lender knows what their total exposure (LVR) will be upon maturity of the loan.
A loan facility is made up of multiple components. Assuming that the Facility Limit of a loan is fixed, allowing for capitalised interest within the loan facility will reduce the principal sum available to the client.
The Dynamics of Development Loans in New Zealand
Cost-to-Complete Basis: In New Zealand, property developments are predominantly funded on a cost-to-complete basis. This means that the lenders structure loans to ensure that they always have sufficient funds in their loan facility to complete the project. As a project progresses, the property value is enhanced and the “cost to complete” the project decreases. This creates a surplus within the loan facility, allowing lenders to release funds to the client, recognising the value contributed to the site.
Capitalised Interest as a Project Cost: Finance costs, an integral part of any project budget; thus “interest” needs to be retained by the lender within their loan facility. Strict adoption of funding on a cost-to-complete basis will see most lenders insist on interest being capitalised for property developments. Lenders will forecast what they expect the likely interest cost will be for the term of the loan and include a provision within the loan facility.
Loan term and final LVR position: Lenders providing a capitalised interest loan do so for a specific term and based on a forecast facility limit. When the end of the term is reached, the loan will reach the facility limit. If a loan extension is required, further capitalised interest (and fees) will need to be provided. This means that the facility limit will need to increase. However, doing so will increase the LVR. If the lender is unwilling to take on further risk, the borrower will need to pre-pay interest and fees for the extended term. This is one of the reasons why lenders pay very careful attention to the development program when setting up the loan facility and during the construction phase. Potential delays can ultimately increase finance costs and increase the LVR for the loan.
Tailored Solutions for Property Developers
Development Income: Property developers, often without traditional income streams, rely on project completion and sale. Capitalised interest loans align with this income structure, allowing developers to defer interest payments until the project is sold, simplifying their financial commitments, and alleviating the financial burdens during critical construction and development phases.
Minimising Capitalised Interest Expense: Unlike lender fees, which apply to the facility limit, interest is only charged on the drawn balance of the loan. To reduce interest expenses, consider minimising the initial cash advance. This may involve paying off existing mortgages or restructuring debt away from the development asset, ensuring an unencumbered property before setting up the loan. However, it’s essential to acknowledge the trade-off – reducing debt may cut costs but could impact the return on equity for the project.
Capitalised Interest Loans: A Win-Win for Property Developers and Lenders
In the diverse landscape of development finance, capitalised interest loans emerge as the preferred repayment method for lenders and property developers. These development loans empower developers to prioritize cash flows toward projects while concurrently serving as an effective risk management tool for lenders.