A fund announces a challenged loan position and there emerges a phrase that stops investors cold: potentially nil recovery. This is the risk that comes alongside the attractive headline returns offered by subordinated loans in the property development sector.
We refer to this risk as the closing vice. Once it starts moving, the subordinated lender in a property development is unlikely to escape without crystallising a capital loss.
To explain how the vice operates, we first consider three things:
- How a development is valued
- How a development is funded
- What occurs when a borrower defaults
How a development is valued
Unlike a trading business or a tenanted building, a development site has no income nor operating history. So how do you value it?
The standard approach is the as-if-complete method. A valuer estimates the gross realisable value (“GRV”) or what the finished product would sell for based upon a set of assumptions, factoring forecast market conditions. Note that the inputs of the forecast are based upon current information yet need to anchor a valuation that will only be realised in two to three years.
A development valuation is a point-in-time estimate of a future outcome, built on assumptions that can – and do – move against you.
The entire capital structure of the project is sized against this number; a number that is only as reliable as the market conditions underpinning it.
How a development is funded
Development projects are funded through a combination of debt and equity, with each tier in the capital structure carrying a different risk profile.
Senior debt typically comprises 60–65% of the as-if-complete GRV. It benefits from first-ranking security and is first to be repaid. Consequently, it bears the lowest cost of capital and the lowest relative risk. Senior lenders have the right to enforce their rights independent of other stakeholders in the capital stack.
Subordinated or mezzanine debt typically comprises the next 15–20% of the GRV (or up to 75-85% LVR). It sits behind the senior and is normally subject to intercreditor agreements that restrict its ability to act. Its higher risk profile in turn attracts (or should attract) a meaningfully higher return.
Equity, normally the developer’s own capital makes up the remaining 15–20%. This capital has the highest risk and is the first-loss buffer and offers a cushion for debt funders.
The subordinated lender sits in the first layer of debt above the equity — the first debt position to be impaired when a project moves against them.
When a borrower defaults
Development defaults rarely arrive as a single event. A pre-sales target is missed. Construction costs overrun. A subcontractor fails.
The senior lender will begin to accrue default interest as the borrower works to resolve the default.
The subordinated lender has few options. The intercreditor agreement prevents enforcement while the senior is in place. So, it waits while the senior debt grows above them.
The closing jaws of the vice
The vice is what happens when both of these forces (each a “jaw” of the vice) move at the same time.
Jaw one: the valuation or GRV contracts. Construction has stalled. Comparable sales have softened. The forecast as-if-complete value no longer stacks up. Market commentators are currently talking about 7-8% price falls in the property market over the next 12-months. That is approximately 50% of the 15-20% equity buffer, making the subordinated lender’s headroom wafer thin.
Jaw two: the senior debt expands. Accruing default interest will grow the size of the senior debt, and correspondingly its claim to the final GRV. Market default interest rates range from 2-4% per month. This means a development in default for 4-months may see senior debt expand by 8-16%. This combined with falling GRV would see subordinated lenders wear a capital loss.
Conclusion
Subordinated property development lending can offer investors an attractive return profile, for the given risk profile.
The challenge for subordinated investors in the current market is their exposure to loans written over 6-months ago. Rapidly changing market conditions have seen the risk profiles of these loans skyrocket – without a compensatory increase in returns.
Investors should consider their current exposure to legacy loan positions and be aware of the risk of the closing jaws of the vice.
For Australian investors seeking predictable income and portfolio balance, private credit is a sophisticated and increasingly essential component of their portfolios.
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