When applying for a construction loan, developers must present a comprehensive project feasibility study that clearly outlines the risks, financial structure, and overall viability of their development. Lenders rely heavily on this study to evaluate key factors such as market risk, construction risk, project location, presales, borrower and builder experience, and cash equity contributions.
Two essential components of this evaluation are the construction valuation and the Quantity Surveyor (QS) report, which together help lenders assess market risks, the cost to complete, and the project timeline.
In this guide, we will walk through how construction loan lenders assess project feasibility, focusing on the roles of construction valuations, QS reports, Project Site Related Value (PRSV), and soft equity.
Additionally, we will discuss how lenders evaluate individual and combined risks, conduct sensitivity analyses, and impose conditions to mitigate overall lending risk.
The Role of Project Feasibility in Lender Assessments
A well-prepared project feasibility study provides a comprehensive financial analysis, outlining the project's revenue potential, construction costs, and timelines. This document forms the foundation for a construction loan lender's decision-making process. It must demonstrate the financial viability of the project by addressing key areas:
Market Risk
Lenders assess market risk to determine if there is sufficient demand for the type of property being developed. A thorough market analysis should include comparable sales, absorption rates, and demand forecasts to show alignment with current market trends.
- Construction Valuation: A detailed construction valuation mitigates market risk by providing a thorough analysis of market prices, sales potential, and Gross Realisable Value (GRV). Lenders expect these projections to be supported by market research and comparable sales to ensure the developer’s pricing and revenue expectations are realistic.
Construction Risk
Construction risk encompasses potential cost overruns, delays, and builder insolvencies. Lenders mitigate these risks by conducting due diligence on the builder’s financial stability and experience.
- Quantity Surveyor (QS) Report: A QS report is critical in evaluating construction risk. It provides an independent verification of the project's total development costs, confirming that sufficient funds are in place to complete the project. Additionally, the report assesses the project's timeline feasibility and the adequacy of contingency budgets to handle unexpected delays.
Establishing PRSV and Soft Equity Through Feasibility
A critical aspect of a construction loan assessment is determining the Project Site Related Value (PRSV), which represents the adjusted land value necessary to achieve a target profit margin—usually around 20%. The PRSV often generates soft equity, which is the difference between the land's purchase price and the adjusted PRSV.
PRSV and Soft Equity in Feasibility Studies
The feasibility study plays a crucial role in justifying the PRSV and validating the soft equity generated. Developers must provide detailed market analysis, revenue projections, and comparable sales data to demonstrate that the PRSV is realistic and aligns with market conditions.
- Market Comparables and Revenue Projections: A strong feasibility study must include comparable property and land sales data to validate the PRSV. Accurate revenue projections based on market research reassure construction loan lenders that the development will meet its financial targets, justifying any adjustments to the land value that create soft equity.
- TDC and Contingency Budgets: The PRSV is typically calculated relative to the Total Development Costs (TDC) to ensure the developer secures a sufficient profit margin. The feasibility study must outline the TDC and contingency budgets to confirm the project’s financial feasibility, even if unexpected costs arise.
Assessing Cost to Complete and Timeline Risks
For a construction loan to be approved, lenders must have confidence in the cost to complete and the proposed project timeline. Any delays or cost overruns can undermine the profitability of the project and the lender’s ability to recover their loan.
QS Report for Cost to Complete
The QS report is an independent document outlining the remaining costs to complete the project. This report provides construction loan lenders with confidence that the project will not encounter funding shortfalls. It also verifies that the construction budget aligns with the feasibility study.
Timeline to Complete
Lenders depend on the QS report to establish a realistic timeline for project completion. Any delays in construction can erode profitability, so the QS ensures the timeline is achievable within the loan’s term.
Lenders Assess Individual and Combined Risks
Lenders break down individual risks, such as market risk, construction risk, presales, and borrower and builder experience before assessing their interaction. Evaluating these risks individually and collectively provides construction loan lenders with a comprehensive understanding of potential challenges.
For example, a project may have low market risk but high construction risk due to an inexperienced builder. Conversely, high presales may reduce market risk but still leave overall risk elevated if construction costs are underestimated. By combining these risk profiles, lenders gain a holistic view of the project’s overall feasibility.
Sensitivity Analysis: Stress Testing the Feasibility Study
Lenders use sensitivity analysis to stress test the project’s viability under different scenarios, such as cost overruns, delays, or reduced revenue.
Key Metrics Tested:
- Revenue Declines: Lenders evaluate how the project would perform if sales prices or rents are lower than expected. This analysis helps assess whether the project can meet debt obligations in less favourable market conditions.
- Cost Overruns: Lenders simulate scenarios where construction costs exceed projections. The feasibility study must include sufficient contingency funds to cover any unexpected increases in costs.
- Timeline Delays: Prolonged construction periods lead to increased financing costs, which can erode project profitability. Sensitivity analysis evaluates whether the project remains viable under potential delays.
Imposing Conditions to Mitigate Lending Risk
After evaluating the feasibility and conducting stress tests, construction loan lenders often impose specific conditions to protect their investment and mitigate risk. These conditions help ensure that the development stays on track and addresses identified risks.
Typical Lending Conditions:
- Presales Targets: Lenders may require a minimum level of presales to be achieved before disbursing the loan, managing market risk by ensuring demand.
- Cost Monitoring: Lenders impose regular reporting requirements, including QS reports, to track the project’s progress and ensure it stays within budget.
- Builder Due Diligence: Lenders demand a comprehensive assessment of the builder’s financial stability, capacity, and experience to reduce construction risk.
Conclusion
A well-prepared project feasibility study is the cornerstone of how construction loan lenders assess the viability of a development. By carefully evaluating market risk, construction risk, and the overall financial structure of the project and reinforcing this with a stress-tested sensitivity analysis lenders can mitigate risk and safeguard their investment. Developers must ensure that their feasibility study thoroughly addresses these concerns to secure favourable loan terms and ensure the project's success.
