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Get Ready For Tighter Capital

Tighter capital constraints are on their way in the wake of the Reserve Bank’s new requirements, writes Ben Pauley.

By: Ben Pauley

31 January 2020

There has been a lot of dialogue in the press lately around the new capital requirements for banks and what that will mean for interest rates. What isn’t often spoken about is what it might mean for access to capital.

In simple terms, banks have two ways of addressing their required returns; increasing price (interest rates) and reducing risk. Increasing price is very simple to understand; what cost you 5% yesterday might cost you five and a half percent tomorrow.

Reducing risk is one that is a little more nuanced, but something the banks are engaged in at the moment. I expect it to also ramp up a little further over the next two or three years. Banks are required to carry capital (hold money) against each loan that they make, and the amount of capital they are required to keep is relative to the risk of the loan.

The riskier the loan, the more capital the bank is required to hold, and the more capital held the harder it is to get a good return.

Why The Change?

The Reserve Bank recently brought in new standards that require each bank to hold almost double the capital and therefore will impact on their returns (and their pricing). To minimise the impact on both pricing and returns, I expect the banks to adjust their risk appetites over the next few years. This will make access to (first tier) capital harder to obtain, particularly for riskier projects.

‘I expect the banks to adjust their risk appetites over the next few years - this will make access to (first tier) capital harder to obtain’

All banks have risk models that dictate their capital requirements and these models attract some key things. For property investment these include the level of gearing (banks targets are less than 50%), interest cover (banks seek at least two times interest cover on loans), strength of the tenant(s) and strength of the sponsor.

For developments, some of these remain (strength of sponsor, gearing) but there are some others. Banks typically target the developer to provide 30% of capital to the project, have a clear and defined exit (namely pre-sales or pre-leases) and place a lot of weight on the professional team involved in the project (head contractor, quantity surveyor, project manager, architects).

Some of these metrics (for both transactions) may stretch out a little further in the future. Banks may seek interest cover of at least two and a half times rather than two, and they may seek a 35-40% percent capital injection from a developer, or much higher profit margins.

Banks will never be closed for business, but navigating their requirements and preparing a transaction for finance will become more important and difficult. Banks are also not the only answer to finance - with at least thirty other lenders available in the market to provide capital for development or investment. What is particularly important is engaging professionals and advice early in the process to ensure that you start on the right path and have time to work through those processes.

If you are looking at a complex property or business transaction, give Squirrel a call and ask to speak to one of our commercial specialists – we can navigate the jungle with you and help with finding the right path.

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