Is a ‘Return on Cost’ of 20%, a thing of 2020?
Over the past month, we have seen a common theme emerge among our clients with respect to project returns on residential build form product. Where you would previously expect to see a return on return on cost close to the 20% mark, the norm has now dropped to around 15% (sometimes less). This trend of diminishing returns has had a direct impact on the viability of a project, in terms of both project funding and site values.
In a market currently defined by the strength of sales, you would expect a developer to be making their best profit in years. A combination of factors including rising construction costs, particularly materials & labour, coupled with a competitive site acquisition market, has however seen pressure fall on returns. If you bought your site early this year and time to go back to the drawing board. In times like these costs will inevitably be passed down to the end buyer, but this takes time. It has been well documented that recently there have been substantial short-term gains achieved in the SEQ housing market. With the exception of the Gold Coast Market however, we have not seen the equivalent level of gains on townhouses or apartments (or should I say Residences 😊). It appears therefore, that there is presently a disconnect between the escalation in the cost to produce stock and the growth in the sale prices of Residences in SEQ. Sure, the level of sales and enquiry has notably improved, but it will take some time before we see increases in pricing enough to offset heightened building costs. The price rise in these asset classes will ultimately come when buyers are priced out of the housing market and see value in a shiny new apartment located in the suburb they want to live in. This has prompted developers to ask themselves several questions… Can the project wait for sale price escalation? Or do I take the sales while they are there and accept a lower return? If I choose to plough on ahead how does a financier look at this and why do financiers want to see minimum returns?
Ultimately, financiers want to see that there is an adequate return over their debt position. If this return is not where they expect it, they want to gain an understanding why you are doing it. In years gone by a typical financier would expect to see a project return of around 20%, but it was not uncommon to accept anywhere between 15% & 20%. This was dependant on various factors aligned to risk such as size of the project, type of product (investor/luxury), sales status & delivery. Often you can mitigate a lesser return based on group strategy or other factors not priced into a developer’s ROC shown through a feasibility.
management fees or a team of carpenters on wages that you need to keep moving. With the major banks, policy is often balanced by commercial judgement and the right financier will decide based on a combination of factors as detailed above. Private funders will likely accept a lesser ROC than a major bank, however this can at times be counterintuitive as the additional cost of funds can diminish the returns further.
The most integral part of obtaining funding is being able to communicate correctly with your financier. Through succinctly conveying the underlying reasons why your project is showing a lesser return, you can clearly articulate your strategy. We often find that once a financier has a perception of a particular project it is very hard to reverse that opinion. As ex bankers we understand the inner workings of a bank & can provide reliable advice to our clients as to what viable finance options are available in the market so they can make an informed decision. Our value lies in taking the time to understand a project and our client’s drivers early on and translating that in a way the bank understands & assesses risk. Get it right the first time, get in touch.