Offering guarantees to private developers probably carries less risk

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Offering guarantees to private developers probably carries less risk
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By Greg Ninness

The Government’s KiwiBuild scheme is designed to increase the supply of affordable homes for first home buyers but it may also prove a boon for residential property developers, particularly in the Auckland market.

Developers can tender to have their projects included in the Government’s Buying Off The Plans initiative, under which they would undertake to produce a certain number of homes in a development for a maximum specified price, which would then be sold to qualifying first home buyers through the KiwiBuild scheme.

If for any reason the homes could not be sold at the specified price, the Government would guarantee to buy the homes itself at the specified price, or refund the developers the difference between the specified price and the price the homes actually sell for.

Where that happened, it would be the Government rather than the developer that would take the loss.

With that guarantee in hand, developers should also find it easier to raise the money to get their projects off the ground, because their financiers will take comfort from the fact that the ultimate sale of a certain number of units in a project at a certain price is government guaranteed.

The payback for the government is that this should increase the supply of new homes being built at the affordable end of the market where the need is greatest.

But there may be another reason developers would want to get involved in KiwiBuild – a potential lack of interest from property investors.

Until very recently investors have made up a big proportion of the buyers in many new developments, particularly in Auckland.

However much, if not most of that investment activity, whether the investors were based locally or overseas, has been speculative, as buyers chased capital gains rather than rental yields.

And there are increasing signs that capital gains in Auckland have now largely dried up.

The Real Estate Institute of New Zealand’s lower quartile selling price between August 2016 and May 2018 has mostly remained within a very tight range between $650,000 and $668,000.

In the last 22 months the lower quartile price has only moved outside that range three times, and even then not by much.

In May this year it was $665,000 which was below where it was in October 2016.

That suggests that In Auckland, the market is going nowhere at the affordable end there’s unlikely to have been much in the way of capital gains for nearly two years.

A similar trend is evident in the middle of the market.

The accompanying graph (below) shows the monthly movements in the REINZ’s Auckland median price between March 2016 and May 2018.

This shows more volatility than the lower quartile price, but it doesn’t show a particular direction either up or down.

If you were to run a line through it to plot a trend you would have to say it was flat at around $850,000, so there’s probably not much in the way of capital gains to be had in the middle of the market either.

Which could leave investors that are willing to sign up for new projects being a bit thin on the ground, and that could see more developers turning to KiwiBuild to get their projects up and running.

But should the Government be exposing itself to financial risks by offering guarantees to private developers?

On balance it probably should, because the risks it is taking on with KiwiBuild’s Buying Off The Plans scheme are probably less than it would face if it developed the same properties itself.

The Government could acquire land and hire architects and builders to develop a certain number of homes to sell at an affordable price, or it could offer guarantees to private developers to do the same job.

In both cases, the main financial risk is that there could be a downturn in the market between the time construction on the project started and when the homes were completed, which could mean the homes might have to be sold for less than expected, potentially causing a loss.

The risk of that happening is the same regardless of whether the Government developed the homes itself, or engaged with a private developer to do it.

So there is no difference in the potential financial risk to the Government whichever way it goes.

But using a private developer also has an advantage for the Government.

One of the biggest challenges facing property developers is controlling their costs.

If the Government was to develop the homes itself, it would carry all of the risks of a cost blow out.

But if it contracts with a private developer, the developer carries all of that risk, because it is contractually obliged to supply the homes at a certain price, regardless of how well it controls its costs.

So provided the Government is careful to partner with developers who have a good knowledge of the market and a successful track record, there can be substantial advantages for both parties in utilising KiwiBuild’s Buying Off The Plans scheme to increase the supply of affordable homes.

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