Construction Mortgages – Turn-Key vs Progress Payment Contracts

For some time now the Reserve Bank has tried to encourage mortgage lending on newly constructed properties. In other words, getting finance is slightly easier if you are purchasing a construction contract than it is for an existing property.

While as kiwis we love our image as number 8 wire DIYers, gone are the days where we get the family and neighbours around to lay the concrete or put up the framing. At least that’s what grandma says used to happen and who’s going to argue with grandma, except grandad on Christmas day after a few egg nogs? These days with council consents and building standards to be met you are almost certainly going to be looking for a contractor to manage your build.

Having made the decision to build a new home with a contractor, you will likely be faced with two choices of contract.  A “turn-key” contract or a “progress payment” contract.

What is a turn-key construction contract?

Turn key-contracts are quite simple in their structure. You pay an initial deposit to indicate your interest in purchasing. This is usually around 10% of the total price. You pay the remaining 90% once the house has received its code of compliance certificate (CCC). As the name suggests, the contract is simple enough that you can just turn the key and walk in the door. Everything should be ready for you.

Hot Tip: Always check that the money for your deposit is held in a trust (your lawyer should do this for you). If the builder goes bust during the build, your deposit will be protected. If it is not in a trust, then it will be difficult to retrieve your deposit.

Pros

• Very simple and easy on your cash flow, with no payments required after the initial deposit until the house is completely ready to go.
• You know exactly what the cost of the build will be. You don’t need to pay interest costs during the course of the build.

• Likely to be slightly more expensive than a progress payment contract. The developers must wear the cost of all labour and materials during the build and they pass this on.
• Your offer of finance typically lasts a maximum of 1 year. If the construction takes longer than this – and it easily can – you may need to reapply and run the risk that you cannot meet the finance criteria for a further offer of finance. In this case, you would need to try to exit the contract (get your deposit back) or sell it on before it is ready.

Cons

• A turn-key contract that is due to settle in under a year holds less risk and if you have a good income and a good deposit, this could be a good option for you.

What are progress payment construction contracts?

A bit more work is involved with these. You get mortgage approval for the cost of the whole project upfront, then the funds get released in stages as payments become due. Your full deposit gets paid at the first payment. The first payment you’re likely to make is for the purchase of the section. So for a $500,000 project with an 80% mortgage, you would pay your 20% ($100,000) when purchasing the $150,000 section and the bank would pay the remaining $50,000. You can use the equity in your current property for the deposit.

Once construction has started, you will be required to make payments at certain stages (ie; when the foundations have been completed, when the framing is up, when the roof is on etc). The payments are relatively easy to organise; it requires sending the invoices to the bank. You pay interest on any funds released by the bank so your mortgage payments increase at each stage.

Pros

• From the moment you settle on the section, your finance is locked in. If the construction takes longer than a year, your finance won’t expire.
• Slightly cheaper contract than a turn-key contract as the holding costs are not included. However, you’ll be increasingly paying interest on your mortgage as funds get released at each stage so this is often negated.
• Banks typically prefer these over the turn-key contracts as they have security early on in the contract.

Cons

• Slightly more work with the bank. It’s not a set-and-forget contract like turn-keys are.
• Depending on your income, cash flow can be a problem.

Final payment upon “practical completion”

Some turn-key and progress payment contracts require the final payment to be made upon ”practical completion”, this is often prior to CCC being issued. It is good to point this out to your adviser and the bank at the beginning. Some banks are completely fine with this if all paperwork is completed and ticked off. Other banks are hesitant to release all the funds until they can be sure the CCC is completed.

Why do builders want their final payment upon practical completion?

From the builder’s point of view, once a practical completion certificate has been done, they have completed all of the work required and fulfilled the contract. It might be 2 or 3 months before a CCC is issued which can put a lot of strain on the builder’s cash flow. Most builders would prefer to be paid once they have finished work rather than once CCC is issued.

Why do banks prefer to release funds upon CCC rather than practical completion?

Banks give low-interest rates because they lend against good quality securities. Unsecured loans can be up to 20% p.a. but mortgage rates are ~4% because the banks know they can easily sell a house and retrieve their money. It is therefore up to the banks to always know that the securities they hold are easily sellable.

There is a very small chance that a CCC may not be issued, even though a practical completion certificate has been completed. A bank therefore typically tries to hold back the last of the lending until the CCC is issued to make sure they have a high-quality security.

What do I do when a builder wishes to be paid upon practical completion?

The easiest strategy is to let the bank know prior to the first drawdown that the contract requires payment upon practical completion. The bank can bring up any issues they have at the time. Most banks will simply release the funds and set a calendar reminder to follow up on the CCC.

Should I get a lawyer to check my construction contract?

The short answer is "yes, always". If you're going through a major building brand, there's little chance of you getting ripped off, however, a lawyer will be able to point out any unusual clauses in the contract. Some of the ones we've had with our clients are:

• A requirement to pay 95% of the contract when only 67% of the building was done (the bank was a little unhappy with this!)
• The cost of a fence to be paid before work could be started. This cost was outside the contract quote.
• Paving of the driveway was not included in the total cost of the contract.

None of these clauses was because the building firm was being malicious or sneaky. The clauses were to cover cashflow costs, OSH requirements or simply to reduce the cost of building. But all needed to be at least acknowledged before the contract could be signed.

Summary

In general, the banks (and the Reserve Bank) want to encourage lending against new homes but there are a lot of differences between the types of construction contracts and how the banks view each contract. 
One bank may require you to be able to pay for both your own property and the new property without rental income. Another bank may not be lending at all on turn-key contracts for investment properties. As with all property purchases, the first step should be to speak to your mortgage adviser.