Build-to-Rent (BTR) is set for significant growth this year as the property market explores alternative solutions for the growing pool of young Australians priced out of the Australian home ownership dream. This issue is exacerbated by the high number of international students and migrants moving to Australia, and low supply levels of rental properties in capital cities - caused by high construction costs and the slow progress in town planning regulations.
The last few years have been educational for BTR developers and funders alike as they begin to better understand the asset class in Australia and the potential risks and returns involved. Existing BTR operators such as Mirvac, Frasers, Oxford Properties, Greystar and Hines, have paved the way for the asset class as a compelling alternative to home ownership by offering spaces that are rich in amenities, with a focus on a higher quality of living andcustomer service. Historically, the main barrier to entry for other players has been the access to large balance sheets and equity funding.
Rising construction costs have restricted growth in the sector over the past two years - largely driven by COVID-19 related logistics and supply issues, interest rate hikes, and ongoing labour shortages. For example, construction projects in Brisbane continue to be at the mercy of labour availability, with large-scale infrastructure projects (i.e. Brisbane Casino, Gabba, Cross River Rail, Dexus Riverside) creating supply shortages in the market.
Despite this, there is growing appetite in the capital market for BTR investments. Market sentiment suggests that property valuations and the returns offered by BTR developments are stacking up as construction costs and valuations begin to subdue (marginally) in the first quarter of 2023. There is an expectation this will lead to increased acquisition activity from BTR developers and investment funds due to:
- BTR developers holding excess cash/capital (vs private developers)
- BTR holding a longer investment horizon (can look through the current ‘bad’ times).
- Build-To-Sell metrics do not easily stack up due to the low number of investors buying apartments as an investment and rising interest rates.
Funding Obstacles
There are several obstacles that BTR developers are currently facing when trying to secure debt funding including, but not limited to:
- New Asset Class - Since BTR is a relatively new concept in Australia, many lenders are hesitant to provide funding to developers without a proven track record of success in the market. There is also a lack of data for lenders to assess key risks and the return on investment for a BTR project and test assumptions such as BTR premium (representing the premium rate paid over and above an ordinary residential rental)
- Return hurdles - As BTR provides long exit timeframes and stable returns, this will limit some funds from being attracted to the asset class. Notwithstanding this, rising interest in BTR will occur when developers can no longer achieve 20 per cent plus returns on Build-To-Sell projects
- Operational requirements - Unlike traditional real estate markets, there is currently a lack of standardisation in the property and operational management of BTR assets, leasing, and financing in the BTR market. Given the reliance on strong operational management required in BTR, traditional Build-To-Sell operators may be hesitant to enter the BTR market without operational capability
- Valuations - When procuring finance for BTR projects, the loan-to-value ratio (LVR) will be determined by the valuation prior to construction, not once the asset is stabilised (over 80 per cent let). This results in a more capital-intensive project for the developer where banks lend against a lower valuation (pre-stabilisation).
Funding options
Despite these obstacles, BTR developers in Australia are finding ways to secure debt funding as Australian lenders become more familiar with the asset class. Some partner with established real estate developers or investors to bring their projects to fruition, while others turn to alternative financing options such as private equity.
A number of options are detailed below.
- Traditional bank financing - Historically, Australia’s largest banks have not demonstrated a lot of interest in the sector, however, this has changed over the last 12 months as the risks of this asset class are better understood. The key limitations of traditional bank financing are the funding hurdles (traditionally 50-55 per cent LVR and 1.5x interest coverage ratio (ICR)) which makes it difficult for BTR developers without flexibility in the terms. The forward rates used to determine the ICR are currently higher, and it impedes the developers’ borrowing capacity.
Despite this, banks are beginning to provide more flexible funding structures that can be explored for the right developers (strong credit history, track record and sufficient underlying capital). - Non-bank lenders - Provide an alternative to traditional bank financing, offering more flexible terms from an ICR and LVR perspective to support the project through the construction to stabilisation period. Non-bank lenders can also specialise in BTR financing, be well-positioned to understand the unique requirements of BTR projects and provide tailored financing solutions. The returns hurdle may be an issue given the cost of debt from these lenders.
- Private equity/debt - Given the limitations surrounding the flexibility of mainstream funding options in Australia and the contractionary risk setting of interest rates in the current market, funding BTR projects with private equity/debt is proving to be a viable option for developers and property funds. This has also been driven by the existing players in the market to date (i.e. Mirvac, Hines, Greystar). This trend may result in smaller private BTR developers partnering with private equity or debt funds to facilitate growth and mitigate complicated commercial construction projects.
BDO’s assistance
Navigating the extensive list of capital providers and partnering with the right provider can prove difficult. Our Debt Advisory team has experience finding funding solutions (both debt and equity) in the Build-To-Rent sector and can assist in navigating the extensive funding options available. For more information, please contact your local BDO adviser.