Construction Mortgages – Turn-Key vs Progress Payment

While the Reserve Bank has tried to make finance more difficult in the past 6 months, they have also 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.

So, if you’ve made the decision to purchase a new home, you will likely be faced with two choices of contract.  A “Turn Key” Contract and 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 it’s Code of Compliance Certificate (CCC).  The contract is (as the name suggests) simple enough that you can 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 does not require any cash (apart from your deposit) until the house is completely ready to go
• You know exactly what you the cost of the build will be.  You don’t need to pay interest costs during the course of the build

Cons:

• Likely to be slightly more expensive contract than Progress Payment.  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.  In this case you would need to try to exit the contract (get your deposit back) or sell it on before it is ready.

A Turn Key contract that is due to settle in under a year holds less risk and if you have good income and good deposit, this should be a fairly low risk for you.  It is easy on your cashflow (no payments are required after the initial deposit).

What is a Progress Payment Construction Contract?

A bit more work is involved with these.  The first payment you’re likely to make is for the Section.  You will be able to get a mortgage for 80% of this (you can use equity in your current property to get the other 20% though).

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.

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 as the holding costs are not included.  However, you’ll be paying interest on any outstanding mortgage so this is often negated.
• Banks typically prefer these over the Turn Key Contracts as they have a security early on in the contract.

Cons:

• Slightly more work with the bank.  It’s not a set-and-forget contract like Turn Key
• It is harder on cashflow if your income is a little lower.

Final payment upon “Practical Completion”

Some construction contracts – both Turn Key and Progress Payment – require the final payment to be made upon Practical Completion.  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 a 2 or 3 months before a CCC is issued which can put a lot of strain on the builder’s cashflow.  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 bank knows it can easily sell a house and retrieve their money.  It is therefore up to the bank 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 be 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 to do when a Builder wishes to be paid upon practical completion?

As mentioned above, 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 (hint: 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 were because the building firm was being malicious or sneaky.  The clauses are 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 is a lot of differences between 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 is not lending at all on Turn Key contracts for Investment Properties.

As with all property purchases, the first step should be to speak to your Adviser.