The credit crunch has affected most areas of the mortgage market over the last year but one area where the impact has been less severe is the self build and renovation market. This may come as a surprise as many still regard self build as being rather niche. However intermediaries may find that this specialist area could prove to be somewhat of a ruby in the dust in the current climate.
There are a number of reasons for the current popularity of self build and renovating. Building your own house usually adds 25 per cent – 35 per cent equity so self builders are protected to a large extent from drops in property values; land has become more available and cheaper as developers offload parts of their landbanks; and self builders are good quality borrowers with very low arrears rates and with low LTVs once the house is finished.
As a result, mortgage intermediaries are paying more attention to this market so it is important that they have a clear understanding of how self build finance works and the pitfalls which can occur if the wrong type of mortgage is recommended. Self build mortgages need to be thought of in more complex terms than a normal house purchase mortgage because with a self build project you have the development phase to fund and if the money is not there to pay the bills, the project can grind to a halt.
Concerns
The fundamental concerns of a self builder or renovator during the development phase are:
• How can they raise enough money for their project?
• How can they stay in their current home during the build?
• How can they ensure they have the funds when they need to pay for materials and labour?
• How can they make sure the project runs smoothly and to time?
Intermediaries, therefore, need to ensure that they recommend a self build mortgage which provides the client with reassurance and a satisfactory answer to all these questions.
The key to a successful project is preparation and cashflow. The self builder needs to have the project fully planned and costed and also allow for a contingency fund of about 10 per cent to cover changes and unforeseen events. They also need to plan out when they will need cash during the project and make sure that their self build mortgage provides the cash they need when they need it.
Different types
There are basically two types of self build mortgage: the arrears stage payment mortgage and the advance stage payment mortgage.
With the arrears stage payment mortgage, money is released at the end of each stage of the build after the work has been completed and an interim valuation carried out. These interim valuations cost about £65 and up to five are carried out during the course of the build. An arrears stage payment mortgage protects the lender because they are not releasing money until there is sufficient value in the building on site to support the borrowing so that in the case of repossession, the lender can get their money back.
Typically lending will be between 75 per cent – 85 per cent of the cost of the build and some - but not all - will lend in advance to purchase the land on which the house will be built.
It is not difficult then to see why an arrears mortgage does not suit everyone and that with this type of mortgage the client can suffer from cashflow problems as they have to complete and pay for large parts of the build before getting money from the lender. As a result, many self builders with this type of mortgage sell their current house to release equity and move into rented accommodation or a caravan on site.
An alternative approach to self build mortgages is the advance stage payment mortgage. Here the cost of the build and land is worked out and split into the various stages but rather than waiting until the work has been completed, the money – up to 95 per cent of the cost of land and build - is released at the start of each stage giving the self builder positive cashflow and making the build process easier and quicker as they have money to pay for labour and materials as they fall due, and there is no need for interim valuations as lending is based on cost and not value.
Obviously the lender needs to ensure that their money is protected so advance payment mortgages include a short term indemnity policy to protect the lender for the amount of money they have lent above their normal terms.
Case study
The following example illustrates the different cash requirements during a project between an advance and arrears stage payment mortgage.
The Reeves family are building a timber frame five bedroom house on an infill plot which currently has outline planning. The plot is costing them £280,000 and the house will cost a further £165,000 to build. They are borrowing on a full status basis and want 95 per cent of the costs as they have limited cash available to them, in this instance £22,500, making their borrowing £422,750.
There are a number of issues to consider here:
· Cashflow during the project because they are using a timber frame kit which has to be paid for before it leaves the factory.
· Going over budget due to unforeseen problems when work starts, particularly at first stage when foundations are being done.
The following table shows the cash position at each stage of the build and highlights that the way an arrears stage payment releases the money to the client means that the £22,500 cash they have is not sufficient during construction and they will need to find other short term funding to get them over the cash shortfall. However, with the advance stage payment mortgage, the high borrowing percentage of 95 per cent and money released at the start of each stage means that the clients can feed their £22,500 into the project over its duration and not have a need for any additional funding.
With the arrears self build mortgage, the client has an immediate need for £70,000 for the purchase of the plot as the lender will only lend 75 per cent. Given they only have £22,500 this gives them an immediate cashflow problem and a need to find an additional £47,500. The issue compounds at the foundation stage when the arrears based lender will release nothing until the foundations have been completed and an interim valuation done. This is made worse by the fact that for a timber frame build the kit normally has to be paid for before the foundations are completed. The result is that the full cost of that stage (£50,000) has to be found before any further money is released. This is in addition to the extra £70,000 the client needed for the purchase of the plot. This means that by the time the foundations are finished, the client who has £22,500 cash actually needs to find £120,000 ie £97,500 more than they have available. This is a huge issue and one which, if not identified at the planning stage, can cause a project to fail.
Contrast this with the advance stage payment mortgage. The borrowing on the land is £266,000 so the client only needs to allocate £14,000 of their cash at this stage. When they have their planning permission in place they can then draw down money for the foundations. They can get 95 per cent of these costs meaning that they only need to inject a further £2,500 in to the project at this stage.
The result can be seen clearly from the table below. With the arrears stage payment mortgage, the client who has only £22,500 cash actually needs a total of £130,000 cash to complete the project before getting a retention paid out which takes the borrowing to 95 per cent whereas, the client with an advance stage payment mortgage does not have this issue and their £22,500 cash is dripped into the project over its duration and there is not a call for additional short term funding because the lender has provided the client with the required cashflow.
Cash requirement
What this means is that an intermediary needs to spend time establishing the client’s cash requirements during the build and seeing how these match up with the client’s access to funds over and above what is available from the self build mortgage. There is no doubt that an advance stage payment mortgage eases the cashflow position and allows a client to keep more control of their project and be in a better position to deal with unforeseen events which always occur during a project.
So, during the credit crunch, when homeowners are having to be ever more mindful of getting value for money and protecting themselves from the risk of negative equity, self build and renovation is proving a very popular option. It can also provide intermediaries with a new direction and revenue stream, as long they use a specialist to offer the extra level of support and service they’ll need to serve their self build and renovation clients.
