Elevated stakes: assessing the risk premium of construction finance

With Australia’s population forecasted to reach over 29 million by 2030, driven by net migration of around 500,000 per year, the demand for new housing is at record highs. The Australian Government announced in August 2023 a target of 60,000 new dwellings per quarter for the next 5 years, well above the long run average of 39,000 per quarter. It is unsurprising that we are seeing an increase in demand for construction finance and an increasing concentration of construction loans within private credit fund portfolios. What is less understood, is how much risk is this adding to an investor’s portfolio? And what amount of additional return justifies this risk? To answer this, we need to understand the nature of construction finance and consider the risks of this type of lending in the context of the Australian market.

 

Understanding Construction Loan Dynamics

Put simply, a construction loan is a type of financing used for the purpose of building new residential / commercial structures or extensive renovations. These loans cover various costs associated with construction, including land purchase, materials, labour costs and other project-related expenses. The terms of construction loans can vary but terms are typically less than 24 months. The amount advanced by the lender is typically based on the expected completed valuation of the project. For example, a residential property may be purchased for $1,000,000 in its current state by a developer who has plans to knock down and replace the existing property with townhouses with a total completed valuation of $2,000,000. If a lender advances 70% against the final valuation, i.e. $1,400,000, there may be a period through the construction phase where the value of the loan is greater than the value of the property it its current form. Should a borrower default occur in this stage, the lender, and hence the credit investor, may experience a loss of capital.

The Risk of Uncontrolled Variables

We see several key risks that contribute to the possibility of a loss investor capital:

1. Uncertainty of Economic Conditions: The economic environment at the start of the project is different from the environment in which the completed project may be sold. This increases the likelihood that the true completed value deviates from the original valuation.

2. Material and Labour Costs: We have seen rising interest rates, increasing labour and raw material costs, all of which can significantly reduce the profitability of a project, eroding the borrower’s equity and increasing the potential loss of investor capital. Additionally, there is the risk of defects either during or after the construction period that result in costly remediation before an Occupancy Certificate can be issued.

3. Delays: Construction delays can occur for several reasons, including material availability, skilled staff shortages, builder solvency, weather and disputes between the developer and builder or the builder and sub-contractor. Delays can materially increase the cost (e.g. labour and interest on the construction loan) and reduce the economic viability of the project.

4. Financing Risk: If the construction project is not finished within the loan term or fails to achieve the specified milestones, there is a possibility that financing expenses will rise or lines of credit may be revoked, affecting the project’s completion.

5. Regulatory Change: Projects may be modified or cancelled because of changes to building requirements or zoning rules. This can significantly impact the final project valuation and expose credit investors to capital losses.

Whilst the lender has the protection of the loan to value ratio and progressively drawdown funds as the construction project moves through the various stages, there is no getting around the fact that these risks exist and are beyond the control of the lender and credit investors.

This poses the questions, ‘if construction lending is riskier, why aren’t we seeing more issues in Australian credit portfolios?’ For the better part of the last decade (with the exclusion of COVID, where banks provided mortgage payment holidays and the Government released unprecedented stimulus into the economy), the Australian property market has largely experienced what would be considered “good times”. Borrowers have experienced extended periods of record low interest rates; we have seen arrears rates at all-time lows and a surge in asset values. When times are good and assets are performing well, it is easy to lose sight of the risk-adjusted return of a fixed income portfolio, with the primary focus turning towards the headline return figure.

A Histroical Perspective

With the last financial crisis over a decade in the rear-view mirror, and the ‘fading affect bias’ enabling us to forget the “bad times”, it is important to remind ourselves where pockets of pain were felt in recent Australian history, reflect on the risk within our credit portfolios, and evaluate if we are being compensated for this risk. In the wake of the GFC, whilst Australia got through better than most developed nations, Suncorp Metway provides a great insight into a credit ‘pain pocket’. In June 2012, 53.9% of the loans within Suncorp Metway’s $2.35bn Construction & Development Loan Advances book were impaired, i.e. assets that are no longer worth what they are listed at on the balance sheet and expected to incur some loss of capital. This increased from 2.3% 5 years prior. In 2012 the Construction & Development Loan Advances book comprised only 4.7% of the total Gross Credit Risk exposure but accounted for 60.5% of total impaired assets. For context, the Real Estate Mortgage Loan Advances book impaired assets peaked at 0.1% in 2009 and Total Gross Assets saw an impaired asset peak of 4.8% in June 2011.

More recently, an eye watering 2,400+ construction companies in Australia entered administration between since July 2021. To put this in perspective, this means that construction company defaults comprise nearly 27% of all company defaults in Australia since July 2021. This data, sourced from ASIC in March 2024, paints a vivid picture of the challenges faced by the construction industry.

What Risk Premium is Fair?

All of this is not to suggest there is no place for construction finance in the Australian market. In fact, government policy and population forecasts dictate that it is necessary. The question we need to ask ourselves is, what extra rate of return should we be expecting in a credit portfolio for taking on construction risk? Based on history in the Australian market and the current headwinds in the construction industry, we would argue an extra 1-2% (versus returns of diversified credit funds, such as the Manning Monthly Income Fund) does not hit the mark on a risk adjusted basis.

Co-authored by Samuel Evans – Senior Investment Analyst at Manning Asset Management