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It goes without saying that the current circumstances are unlike anything anyone has experienced. Such exceptional times require thoughtful and considered responses. The Global Financial Crisis was characterised by a collapse of liquidity in debt markets. This impacted banks and, in particular, led to a consequent absence of credit and lending capacity on the part of those affected banks.

The current situation is markedly different. The good news is:

  • banks are better capitalised than they have ever been, and
  • the Commonwealth Government and the Reserve Bank have both acted quickly with support measures for bank customers, albeit with an emphasis on retail and SME customers.

The bad news:

  • if we are honest—nobody knows where this is going or where it will end up, and
  • in the case of the property market, valuations (assuming valuers are open for business) may be difficult to rely on—what is “market” in such times?

Banks have moved quickly to reassure borrowers, large and small, that they will be supportive of their customers. In the case of corporate and commercial borrowers, that support is likely to take the form of:

  • restructuring of facilities
  • amendment to existing facility terms
  • forbearance, and
  • waivers (conditional or unconditional).

With this context in mind, the following represents some practical considerations for those who have an exposure to the property market, with a focus on the specific issues confronting property lenders to the Construction Development sector.

Construction Development sector

For simplicity, we have assumed a committed existing bilateral facility agreement with an initial drawdown.

What are the likely issues?

  • Project delays and/or cessation of business (e.g. due to builder solvency issues, lack of availability of materials and labour, site shut down)
  • Financial covenant compliance issues
  • Breach of project specific undertakings
  • Interest and/or principal repayment issues, and
  • Solvency of Borrowers or Guarantors.

What should you do?

Most importantly, review the facility agreement for:

  • Covenant breaches: A typical construction development facility will incorporate, in addition to general corporate status style covenants, the following:
    • A Loan to Development Cost Ratio (LDCR), and/
    • A Loan to Value Ratio (LVR)
  • Project specific undertakings: A typical construction development facility will often contain specific undertakings such as requirements or obligations for:
    • The borrower to achieve practical completion by a specific sunset date and not to agree to any extension of that date without financier consent
    • Certifications to be provided regarding
      •  cost to complete a project, or
      •  funding cost overruns from agreed contingencies or equity
    • Rights of the lender to attend Project Control Group meetings
    • The building works to be undertaken in a “good and workmanlike manner’’
    • The Borrower to notify of any builder breach under the building contract
    • The Borrower to enforce the building contract if there is a builder default, and
    • Progress payments due to the builder to be paid on time and in accordance with the building contract.
  • Residential developments: A facility agreement for a residential development will usually contain requirements or obligations for:
    • The Borrower to keep the lender advised of any changes to the building works that will impact on qualifying pre-sale contracts
    • The Borrower to advise the lender of sales of all units that are not subject to qualifying pre-sales requirements
    • The Borrower to advise of any termination of a qualifying pre-sale contract, and
    • The Borrower to perform its obligations under qualifying pre-sale contracts and, in particular, to ensure that the project is proceeding so that the pre-sale contract sunset date is not missed, and purchasers are not otherwise entitled to terminate pre-sale contracts.
  • Events of default: A breach of any of the obligations referred to above will (subject to any cure period) constitute an event of default. In addition, there will typically be some or all of the following events of default:
    • Cessation of business
    • Failure of the builder to perform under the building contract
    • The building works not being undertaken in accordance with either the building contract or, in some instances the project plan
    • Builder insolvency, and
    • Construction delays or abandonment.

So, what should you do next?  

It is a cliché to say we are in unchartered waters. Lenders will have their rights and powers of enforcement, which we explore further below.

Practically though, given market conditions, there are limitations as to what steps a lender can take. Here are some suggestions of practical steps that can be considered:

Contract audits

  • Undertake an audit of pre-sale contracts and building contracts
  • Ask the Borrower for verification of the status of qualifying pre-sale contracts, and
  • Ask the Borrower for an update on the status of works, delays and costs.

In the current market, settlement risk is real. Lenders need to try and determine the extent of that settlement risk and whether there is a sufficient value to qualifying pre-sale contracts to pay down the lender’s exposure. Undertaking such audits early, taking into account any changed circumstances, will assist the lender to determine if any project undertakings or pre-sale contract requirements are likely to be breached.

Covenant testing

  • To test the LDCR, you will probably need to involve the existing quantity surveyor (QS). As at the date of this article, construction sites are still open and so the QS should be able to go on site (subject to social distancing and other requirements).
  • To test the LVR test under current market circumstances, you will need to get an updated valuation. It is possible that there will be push back from valuers on the basis that in such unusual times “what constitutes market”. Nevertheless, some indication of both valuation “as is” as well as “on completion” will give the lender guidance on where the market may be.

If the covenant testing discloses a breach, then there are a number of options to consider:

  • Check the cure regime under the facility agreement, both as to timing and the right of the Borrower to undertake an equity and/or security top up
  • Agree to forbear/reserve rights regarding the breaches, subject to the Borrower’s compliance by a certain date
  • Waive the breach, possibly subject to conditions such as an equity injection by the Borrower or security top up
  • Re-set the covenant, and
  • Issue a default notice and impose the default rate of interest.

Builder solvency issues

If there are concerns about builder solvency and/or performance, then you may consider:

  • Reviewing the builder side deed (if relevant) for step in and other lender rights
  • Check what security the Borrower has from the builder—retentions or bank guarantees or surety bonds. Also check on what basis they can be called and whether the lender’s security captures the related proceeds of a claim  and provides the lender with recourse to these funds.

 

In the next articles in this series, we will address challenges for lenders to the Commercial Investment and Hospitality sectors.

Further information

These are indeed challenging times and call for a considered approach with a response taken from a base of sound advice. Please contact our Banking & Finance team to discuss any of the issues and approaches outlined in this article.

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