Part 2: Does this Model Create a House of Cards?
This is the second article in a three-part series of articles on Large Builder Developer Property Group (LBDPG) risks.
What are the risks faced in the Short-term?
Subject to individual circumstances, such as the level of gearing and access to capital, LBDPGs concentrate risk in the following areas:
- Finance risk: LBDPGs are often highly geared,
with short-term development specific funding from a large range of
banks, financiers and private funders. We believe heavy reliance on
private funders is a greater risk than reliance on banks and large
finance groups. This is because private funders, often:
- Are small illiquid funds;
- Have limited ability to meet cost overruns and loss provisions where new investor funds are not obtained or recycled; and
- Have thin balance sheets, unlike a traditional bank.
- Cost overruns and subcontractor failure risk:
LBDPGs assume full delivery and construction risk, unlike the
transfer of risk that occurs between an independent developer and a
contract builder. Should a key subcontractor fail, the LBDPG
absorbs the cost within the development. They must find the extra
funds needed to meet any cost overrun. If a key subcontractor
fails, chances are they're involved in the construction of a
number of other developments for the LBDPG. This could impact
multiple financiers across a number of developments;
- Market risk: The degree of market risk is
subject to market movements. This is multiplied within highly
leveraged balance sheets that are generally not diversified by
property class and location. In the current cycle, the focus has
been on metropolitan, high-density residential development in areas
where zoning has changed; and
- Tax risk: It is difficult to maintain the growth necessary to defer tax long-term. Leveraging residual stock leaves minimal cash flow to meet GST and income tax when these liabilities fall due. For LBDPGs the amounts payable can be substantial, and can cause immediate difficulties.
Failure of a LBDPG... is it contagious?
The fallout from the failure of a LBDPG could be catastrophic for stakeholders and the residential property market in general;
- Financiers:
-
- Banks: due to the large-scale funding of LBDPGs, banks could incur large losses. This might send shock waves through the banking community, and could result in a significant credit squeeze until banks digest the outcome;
- Private financiers and funds: small funds may not have the
capital base to absorb a substantial loss. This could result in the
collapse of the fund, or loss of investor confidence. Furthermore,
where the fund has other active borrowers and developments, such a
loss may affect these otherwise unrelated projects;
- Bond or security providers: often provide
bonding facilities on larger developments. The default of a LBDPG
could undermine the provider's confidence in issuing new
bonds;
- Other financially stable LBDPGs: The collapse
of a competitor could impact similar structured LBDPGs in a number
of ways:
-
- Loss of market confidence and access to finance, where they have similar banking relationships;\
- Collapse of common subcontractors;
- Reduction in site values and gross realisations of stock, where
the assets of the insolvent LBDPG are put to the market for sale by
financiers and insolvency practitioners;
- Subcontractors: This was previously mentioned
as a risk to a LBDPG, but conversely the failure of a LBDPG can
trigger the collapse of a subcontractor. LBDPGs have grown
exponentially over a short time-frame. They have in turn required
their subcontractors to grow with them, by size, complexity and in
the number of developments undertaken. From the subcontractor's
point of view, this is positive. They have a growing source of work
and an established relationship. This relationship allows them to
grow their business to match their customer's needs. Often
these subcontractors have also grown over a short time-frame. They
may lack the management expertise and capital to successfully
operate a business of a larger scale. Also, they rarely analyse the
risk associated with generating much of their revenue from one
customer. They overlook the impact on their business should this
customer either reduce its demand or fail due to insolvency. If
these subcontractors also work for other LBDPGs, their failure can
consequently flow-on to their developments.
- Consumers (purchasers of residential stock):
The effects on consumers include delays and the risk of contract
cancellation, securing and returning pre-sales deposits and
potential defect claims on completion; and
- Reputation: A LBDPG collapse not only impacts consumer confidence, it can also harm the reputation of the financiers involved.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.