The pros and cons of co-financing a development
A lot of people are attracted to cohousing because they like the idea of cutting the developer out and financing the project by themselves. Why not have the home buyers play the role of developers and cut out the developer's fees and profits?
When we first started working on Kaenga, we thought this way too. Our plan was to help groups to put together enough equity with their deposits so that they could approach a bank for the rest of the funding they needed to fund their homes.
However, we’ve found that things are not that simple. Because the way the New Zealand finance works, this approach imposes difficult hurdles and high risks on homebuyers. The rest of this article looks at what these hurdles are and offers some thoughts on how to address them.
A high initial price
In order to fund a project, banks want to see a 20% profit baked into the project. That’s because this return offers them a level of safety - even if a project costs 20% more to build, than expected, there is still enough money to pay the bank.
To prove to the bank that you are able to make this profit, you will need to show them that you have signed sales agreements that in total are worth 20% more than the cost of the build (as estimated by their QS).
Let me illustrate this with an example. Take a 70 sqm apartment that costs $560k to build ($8k/square metre). The bank will want to see the unit sold for at least $700k. Now if the homebuyers finance this project, they be the beneficiaries of this profit. All going to plan, the ultimate price they will pay is $700k-$140k=$560k.
The fact that people have to sign up for the higher price might seem academic. However, it means that people must ultimately have the ability to pay the $700k price. Many people can’t do this, particularly those most in need of an affordable home.
Being on the hook if everything goes wrong
Even worse, banks also generally require a personal guarantee from the developer. That means that if things go badly wrong and the project fails, the bank can call on the developer to pay them back in full.
If homebuyers choose to fund a project themselves, banks will require at least some (and possibly all) of home buyers to give them a personal guarantee. This means that if the homebuyers do not have the means to cover any losses that occur, they will face bankruptcy if the project fails. Although this really is a worst case scenario, many people are understandably unwilling to face this risk.
Finding equity for the project
Although the banks will provide funding for a project, they require the developers to provide a proportion of the funds as well. At a minimum, home buyers going it alone have to find 20%-30% of the cost of the build, and in fact they might be required to provide even more funding.
It might be possible to cover some of this by using people’s deposits they would usually have to pay to buy a home, but this means that people risk losing these deposits. What’s more, homebuyers usually need these deposits to get a mortgage once the building is complete, so they can be left in a very difficult position if they put their deposits at risk.
Alternatives to self-funding
Although there are certainly a number of downsides that cohousers who decide to cofinance a development must face, there are some interesting options that might address these issues.
The first is to bring in outside investors. This is the approach that the successful Nightingale Model from Australia uses. While these investors will probably require a high return (14%-20% on the funds they lend) to compensate for the significant risk they are taking, they will also significantly reduce the risk of the project. And since they’re only lend a portion of the money, they will be cheaper than relying on a developer.
Finding outside investors who are willing to do this may be tricky, but if you are able to establish the social and sustainable creditials of your project, there are social impact investors who might be interested in investing.
Another interesting source of funding is crowd funding. Crowd funding platforms like pledgeme.co.nz allow regular people to invest in your project. You can raise up to $2m through crowd funding and it has significantly smaller cost than traditional fund raising. While the cost of this funding varies, it is to be a relatively cheap source of finance provide you can convince enough people to invest.
Finally, there is always the option of working with a developer. Although you won’t get the savings you might achieve through self-funding, you will save yourself a lot of risk and stress. And cohousing opens up opportunities to save money through codesign and coliving that don't come with the same level of risks.
So in summary, cofinance does present an opportunity to save some money, but it means that homebuyers have to take on some significant risks. So what do you think? Are the 15%-20% savings worth taking on the risks of offering a personal guarantee. Or is it better to rely on other ways to save money? Is there a better approach that we've missed out?
We'd love to hear your thoughts on these matters, so go ahead and comment below.