Construction Loans – Key Considerations for Property Developers (Part 1 of 2)

This is Part 1 of a two-part series on the key legal and commercial considerations for property developers negotiating and entering into a construction loan facility in Australia.

Construction loans are an integral part of the Australian property development landscape.  They can involve significant risk for a property developer, particularly where the developer provides a personal guarantee meaning that the developer’s personal assets are on the line.

What is the loan structure?

Australian construction facilities are commonly structured as multi-tranche, revolving limit loans.  Interest is typically serviced from an interest reserve or capitalised, and drawdowns are advanced progressively based on certification by the lender’s appointed quantity surveyor of the project costs to be paid from each drawdown.

What are the conditions precedent?

Conditions precedent are the requirements that must be satisfied before the lender is obliged to advance funds.  They typically include the execution of a building contract, evidence that the required insurances are in place and a report from the lender appointed quantity surveyor confirming the budget, the works program, and the adequacy of the contingency allowance.  If the borrower does not satisfy the conditions precedent, the lender has no obligation to advance the loan.

Can the borrower complete the project by the “latest completion date”?

Most lenders require practical completion of the project to occur by a specified date, known as the “latest completion date”.  Borrowers should ensure that the “latest completion date” provides adequate buffer for potential project delays, as a failure to achieve practical completion by this date will typically constitute an event of default.

Can the borrower fund any cost overruns?

Construction loans usually require the borrower to fund all cost overruns – that is the amount by which the actual project costs exceed the approved budget.  Construction projects frequently exceed the approved budget owing to factors such as unexpected site conditions, changes to building materials or specifications, and fluctuations in property-related expenses.  Some construction loans give the lender an option to fund cost overruns, however, this is usually at a significantly higher interest rate.

Is the interest rate fixed or variable?

Whether the interest rate is fixed or variable can have a significant impact on total borrowing costs.  If the interest rate is variable, then interest rate movements may materially affect the cost of the loan over its term.  Conversely, if the interest rate is fixed, the borrower should be alert to any clauses that allow the lender to increase the rate – for example, by reference to any upward movements in the RBA target cash rate.

What is the default interest rate?

Default interest and additional margin uplifts commonly apply upon events of default or covenant breaches.  Borrowers should ensure that any default rate is a genuine pre-estimate of the lender’s loss and not penal.

What security is the lender requiring?

Lenders will typically require, at a minimum, mortgage security over the development property, personal guarantees from the directors and key stakeholders, and a charge over the assets of the borrower company and any corporate guarantors.  The lender may also require security over other projects or entities outside the project structure.  Where this is the case, the borrower should carefully consider whether it is able and willing to provide that additional security.

Does the agreement contain a charging clause?

The borrower should also be aware of any charging clauses or provisions that prevent guarantors from granting guarantees to other financiers, as these may limit a guarantor’s ability to obtain funding for future developments.

Look out for Part 2, where I’ll cover pre-sales requirements, lender fees, minimum interest periods, warranties, lender oversight and reporting, and default provisions.