Debt funders the forgotten creditors of construction industry collapses

When property developers collapse, debt funders rarely get a mention among those losing substantial amounts.

Rising interest rates combined with labour and material shortages have caused chaos in the building and construction sector.

The numbers are clear: a 75 per cent increase in construction industry insolvencies with over 2000 external administrations were recorded since mid 2021.

When a property group collapses, attention is usually focused on the staff, subcontractors and customers who are left out of pocket and owed money, but alas, there is another group of creditors who do not get a mention – the debt funders.

And this group does not just consist of big banks; it also contains mum-and-dad investors who invested in mortgage funds trying to get higher than term deposit returns on their cash.

Building company failures have been so frequent over the past 12 months that people hardly raise an eyebrow when we hear about large building companies going into administration. Dyldam Group, which was once Australia’s third-largest apartment builder, went into administration on New Year’s Eve 2020 owing $500m to creditors, and parent company Dyldam Developments went into administration last year with debts of more than $180m.

Perth-based Clough, which had been operating since 1919 and had been one of the main construction contractors for the Snowy Hydro 2.0 project, went into administration in December, and for Melbourne-based home builder Porter Davis, liquidators were appointed in March, at which time it had 466 staff and debts of about $150m.

How property developments work

To understand why some mum-and-dad investors in mortgage funds have lost money while others have not, we must first understand how the development process works and what risk you can take.

When a developer undertakes an apartment project, the first step is to secure the intended land for the new apartment block. This is typically an older-style house on a larger block, and in larger developments, several homes in a row are purchased.

Once the land is secured, it can take between 12 and 24 months to get the required approvals, which may involve a state government rezoning request and development application to council.

The collapse of builder Porter Davis left partly built homes in its wake. Picture: Jason Edwards

After the approval process is complete but before construction begins, the developer will produce a marketing brochure and may be found in your local shopping centre kiosk trying to pre-sell as many apartments as possible.

The purchasers pay a 10 per cent deposit and the balance is payable on completion. This is known as purchasing a property “off the plan”.

When construction starts, it typically takes 20 months to demolish the existing structure and build the apartment complex. At completion, off-the-plan buyers take possession of their apartments and any unsold properties are put on the market and sold by the developer.

Financing arrangements

In the background, the developer will usually try to minimise their cash outlay by borrowing as much money as possible to fund the land purchase and subsequent development process.

For the initial land purchase, one and sometimes two loans totalling up to 80 per cent of the land value is taken out by the developer.

The first ranking loan, known as the senior debt, represents 40 to 60 per cent of the land value and is typically issued by a bank or large private credit provider who places a first registered mortgage over the title of the property. The second loan, known as mezzanine finance, provides an extra 20 to 40 per cent debt at a higher interest rate.

If the developer defaults on the loan, the senior lender will have first right to recoup their debt via sale of the property and if there is anything left over, the mezzanine lender will then have access to the residual funds to try and recoup their loan.

Known as “holding finance”, the initial loans to purchase the proposed development site are usually held for between six and 24 months, giving the developer enough time to get approvals in place. The market interest rate on the senior loan is currently between 7 per cent and 10 per cent, and the riskier second loan attracts an interest rate of between 10 and 13 per cent.

Once the developer is ready to build, they refinance the holding loan into a construction loan and this is where we see a sharp increase in risk. The construction loan is based on the estimated completion value of the property.

In other words, if the development fails part way through and the half-complete site is sold, there is a chance that not all of the construction loan will be able to be paid back as the loan was based on the higher completed value which does not exist. As such, the interest rate on construction loans varies from 8 per cent to 18 per cent.

How mum-and-dad investors are exposed

While it is obvious that construction loans are riskier than holding loans and mezzanine loans are riskier than first ranking loans, it can be very confusing for the average mum-and-dad investor to decipher the complex information memorandums (IMs) and product disclosure statements (PDSs) provided by property debt investment companies, which offer rates of regular interests in exchange for investment in their mortgage funds.

In fact, surveillance activities from ASIC last year led to 18 funds, including some of the largest in the country, amending their marketing material as the corporate regulator had concerns over inadequate warnings and downplaying risks.

ASIC deputy chair Karen Chester said: “Our primary concern here is retail investors and potentially unsophisticated whole­sale investors, especially retirees, making important investment decisions based on marketing that does not accurately represent fund performance.”

One of the problems is that the fund manager can have a multitude of names for their fund which makes it almost impossible to figure out what the fund does without reading the disclosure documents – which are usually 50 to 100 pages long.

Names used include feeder funds, warehouse funds, Class A or Class B funds, high yield funds and opportunities funds.

To compound the problem, many mum-and-dad investors make the mistake of placing emphasis on the wrong things, and instead of reading the PDS or IM, focus on the one-page fund summary, which highlights the strong historical interest returns and flashes images of elegant completed buildings.

Just as there has been a spike in building company collapses, there have been several property lending funds that have been wound up or shut down by the regulator in recent times.

What to look out for

There is no such thing as a free lunch, and if an investor is going to move away from the safety of a bank term deposit, which returns 5 per cent interest, to a property loan fund that returns 7 to 20 per cent, the investor needs to go into it with their eyes wide open.

Otherwise they risk losing 100 per cent of their money.

Key things to assess when thinking about investing in a mortgage fund are:

● Understanding how their money will be used. Is it for holding finance, construction finance, first ranking loans or mezzanine finance?

● What is the average loan to value ratio of the fund?

● Is an independent third-party custodian used, or does the investment manager handle the money themselves?

● What fees does the fund manager charge?

● How many loan defaults have there been in the fund and why did they occur?

● How many loans are currently in arrears?

● What is the probability of a capital loss in the fund or suspension of interest payments and/or redemptions?

● Are there any conflicts of interest, such as the loan manager also being the borrower of the money via a separate development company?

● How can you determine that the fund has legitimate loan investments and is not a Ponzi scheme?

● How much of the loan manager’s own money do they invest in their loan funds?

● Is there regular liquidity or is the money locked away for a period of time?

James Gerrard is principal
and director of Sydney
financial planning firm www.financialadvisor.com.au