Nobel Laureate Joseph Stiglitz defined credit risk as arising from the simple fact that there are an infinite number of people who wish to borrow money, but only a finite number of people capable of paying it back. For any credit department of a lending institution determining the who and when of the group that cannot pay is of vital importance.

A rising market covers a plethora of mistakes. Rising rents and capital values will cover costing blow outs, delays in approvals and other items. However when the market slows or levels, these mistakes become more evident, therefore avoiding them in the fist place is the main issue.

Credit risk has the potential to become a major problem; while parts of the property market have headed south, there are many property types and localities that are showing strong resilience.

Property developers make their returns by selling at a profit to their costs, consequently getting those profits is most important. Financiers make a return on funds invested so getting their return and avoiding capital losses is most important. This requires both Initial Analysis and Ongoing Management.

Initial Analysis

An investment/transaction has two main components: the personal or business component and the property component.

The personal component relates to the developer/investor and their background. In any market, the main issues are.

• Financial strength: the ability to contribute equity to a project. A rising market means pre-sales are almost assured. However in any market pre-sales are no substitute for equity. Equity in a project underpins a developer’s commitment to completing the project.
• Expertise: especially with regard to managing the property development/investment process and the technical ability to deliver.
• Track record: particularly in relation to this type of property activity. In many instances where a developer is caught out by a change in the marketplace the developer will seek an alternate property use to cover their costs, for example a residential development site becomes a bulky goods site. In effect the developer is extending their reach.
• Workload: in a falling market bargains become available and opportunistic developers look to take advantage of any prospect that comes their way. However a developer that has too many projects may have difficulty servicing (financially and time-wise) all projects. Furthermore the developer may enter a market that they lack expertise in.

The property component is the project/property and its market. This component may be the only recourse for the financier to get their money back if a developer goes bankrupt and the financier has to step in to take control
The initial analysis will look at the property within the context of today’s market. Whilst many niches are experiencing problems there are a number of property types and localities which are showing solid performance. These variations can be attributed to two main factors:-

• Geography – locations, the demand for this product and their underlying economies within the location
• Demography – buyer profile and financial status

There are a variety of economic drivers in Australia, which affect the property market. Anyone from the west will currently tell you that the Perth market is going full steam ahead on the back of strong resources prices; however the Sydney market has pockets of falling demand and prices. Furthermore the impact of the rising petrol prices is yet to be fully felt in many markets.

While the demographically driven “sea change” phenomenon is well documented other demographic drivers are also apparent. These include the up-sizing rather than down-sizing 55+ group and the difference between the investor market and the owner occupier market in terms of both pocket depth and product demanded.

Any financier needs to Know the Market in order to establish the level of risk regarding the property that they are advancing funds on.

The property market has numerous sub-markets. Residential can be divided into city, region and suburb locations, then into apartments, town houses and houses and finally into the level of accommodation. A two bedroom apartment is in a completely different market to a four bedroom house in terms of pricing and buyer profile, even though they may be situated next to each other. Investors for cheaper apartments have all but completely disappeared in the current market while owner occupiers (in specific locations) will climb over each other for well priced appropriate product.

Purchasers are notoriously fickle, if the market is for owner occupiers then the accommodation and finish needs to cater for this group not for investors which have different requirements.

Ongoing Management

The ongoing management of a loan portfolio is labour intensive, particularly with regard to professional labour. Notwithstanding this, working out problem loans is even more labour intensive requiring one professional for 2 – 3 loans. This necessitates the following:-

• Monitor the project
• Monitor the market

Project monitoring requires keeping in touch with the development, this includes the following:-

• Pre-sales and sales: This is where the developer and financier differ in a falling market. The developer makes their return on development profit; therefore they want to retain pre-sale prices at the expense of speed of pre-sales. The financier wants their money back in the allocated time; hence speed of pre-sales is more important than getting that additional $50,000 per property (providing their loan amount is covered).
• Slow sales may indicate a slowing market however they may also indicate a marketing team that should be revitalised. While there is little that a financier can do to change the former, there is a lot they can do to change the latter.
• Is the work actually being done and is that amount of work matching the drawdowns? This requires site inspections by someone that knows the difference between plate height and lock up stages. Furthermore this is not a weekend activity, an ability to speak to the workers on site will also establish any potential cash flow difficulties; checking to see if and how the subcontractors are being paid will indicate any potential cash flow issues before they appear on financial statements.

Market monitoring requires understanding property and economic dynamics for that project’s market.

• Any region will have overall trends in price movements; however there is no substitute for an understanding of price and sales movements in the individual project’s market. This will indicate if pricing needs to be changed, marketing retargeted or, if it is early enough, changes in design details.
• This will also cover purchaser’s/tenant’s incentives. In a slow market developers will often offer inducements to purchasers/tenants in the form of cash or free overseas holidays. If these are prevalent in the market they need to be factored into the bottom line analysis in an understanding of market levels. In the current market there are a number of residential projects that are being sold with purchaser’s incentives.
• This is just as true for non-residential property. Understanding the catchment area for a retail property will indicate if the centre needs to be reconfigured or alternate tenants sourced. This needs to be done before tenants start experiencing trading difficulties.

Financiers are ultimately concerned with mitigating risk and in this current economic climate there is no substitute for understanding and knowing the property market relevant to their lending portfolio.