How Construction Financing Works

 
 
 
How Construction Financing Works

How Construction Financing Works

Pakistan’s real estate industry has seen a rebound in the past several months due to multiple incentives and regulatory measures provided by the government. The real estate sector is especially important for an emerging economy as it has forward and backward linkages with more than 40 allied sectors. The housing and construction sector is the main driver for real estate activity, and with the recent surge in demand for construction projects, the cost of raw material has risen sharply, making construction a difficult task for developers. Therefore, the subsequent construction activity has also been restricted, and people are investing more in buying plots than carrying our real estate development. The State Bank of Pakistan (SBP) has recently announced that financing for under-construction projects will also be provided by commercial banks, a first in the history of real estate in Pakistan. Continue reading to understand the difference between housing and construction finance, along with the role of main players and stakeholders in the segment.

Understanding Construction and Housing Finance

Most people are not familiar with the financing of under-construction projects, more commonly known as construction finance. The popular approach for banks remains to finance built properties on mortgages extending over multiple years. However, with the booming demand for construction in the real estate sector of Pakistan, the State Bank of Pakistan (SBP) has finally devised mechanisms for commercial banks to provide loans to under-construction projects. Under the new guidelines, horizontal and vertical development projects are covered, whereas the construction of high-rises will mainly benefit from the move. This means that purchasers of property in high rise projects will get units at a lower cost, banks will ensure strong monitoring of the project and also facilitate the timely completion of the project, and purchasers will have fewer maintenance costs in the initial years (Khalil, 2021).

A builder or developer can source funding for construction through diverse resources. The first source can be the builders’ personal equity which can be used in the buying process of land and getting the necessary approvals before starting the actual construction. The second source comes from pre-selling project units to buyers on a complete payment, instalments, or mortgage basis. This is an essential part of obtaining construction finance as banks consider the loan to cost ratio for each project. As banks will not finance the entire construction cost of any project, having a significant number of units sold assures the bank that the developer has enough equity to start and maintain construction. The third source can be from a construction lender who looks at the maximum number of pre-sold units, the loan to cost ratio, and if the project can be completed with the amount of loan being demanded by the developer. Once the maximum amount of loan has been determined, the financing is only released after the developer’s personal equity, and resources from the selling of units are used up. If there is a shortfall in capital in the future, the developer will have to arrange additional personal equity (Building and Construction CSI Specifications, 2021).

Why Construction Financing Important for Developing Real Estate Projects

The development and construction of high-rise buildings incur many costs and involve a variety of different stakeholders over time. From acquiring land to getting the necessary approvals from regulatory authorities, there are many hidden costs even before laying a single brick on the ground. Furthermore, construction is a complex multi-stage process which does not only cover the brick and mortar aspect of a building, but modern standards for high-rise buildings also require the deployment of multiple technologies and professionals from various fields for the successful completion of each project. This means that costs always remain variable and high. Developers are not well equipped to bear these costs on their own and usually have to pre-sell multiple units of their projects to gather the necessary resources for completing construction. However, not every investor chooses to buy an unfinished unit on complete payment. A large majority of people invest on an instalment basis or buy on mortgages. This means that the developer does not get his required funding as quickly as possible, and most construction projects stall in later stages. If the developer is not able to sell enough units or is facing other regulatory obstacles, it is also possible that he abandons the project in an incomplete state. Therefore, if, at this point, the developer is helped by construction lending institutes to complete their project, the building and construction sector are likely to experience a strong boost in activity and growth (Chileshe & Haupt, 2005).

Main Stakeholders of Construction Financing and their Roles

The three main stakeholders in the construction finance sector of Pakistan are commercial banks, the real estate regulatory authority, and the State Bank of Pakistan (SBP). The commercial banks or lenders design policies and risk assessment criteria for construction projects along with criteria for assessment of construction progress and builder’s financial capacity. A construction project’s success is based on multiple factors such as the environment, marketability, cost, risk of increase in material and labour cost, size of the market, and approvals from regulatory authorities. It is the job of these financial institutions to gauge the impact of all these factors in any specific case. In terms of a real estate regulatory authority, each province must develop their own as the Federal government will not have jurisdiction in provincial matters. The task of RERA is similar to that of a consumer protection agency that ensures transparency and safeguards for purchasers. Lastly, the State Bank of Pakistan must provide effective and broad guidelines to commercial banks to prevent taking an excess risk on their portfolios. This is ultimately damaging the market in the long run (Global Village Space, 2021).

Conclusion

Realising the importance of the housing and construction sector in the development of the economy in any country, the State Bank of Pakistan has allowed the financing of under-construction projects for vertical and horizontal real estate development projects. The financing of a construction project depends on the personal equity of the developer and the amount of pre-sold units in a project. If the developer is able to provide enough loan-to-cost ratio, and the banks deem it possible for the project to be completed in the demanded loan, construction finance will be given. The process also ensures timely delivery of construction projects as no payments will be disbursed before the completion of previously defined stages in a project.

Bibliography

Building and Construction CSI Specifications. (2021). Retrieved 9 20, 2021, from https://www.arcat.com/sd/specifications.shtml

Chileshe, N., & Haupt, T. (2005). Modelling critical success factors of construction project management (CPM). Journal of Engineering, Design and Technology, 3(2), 140-154. Retrieved 9 20, 2021, from https://emerald.com/insight/content/doi/10.1108/17260530510815376/full/html

Global Village Space. (2021). Pakistan’s housing market is leading the economy: What has changed? Retrieved from https://www.globalvillagespace.com/pakistans-housing-market-is-leading-the-economy-what-has-changed/

Khalil, I. (2021). Central Bank as Real Estate Regulator: Can the SBP’s Latest Guidelines Help Meet the Housing Shortfall? Retrieved from https://tabadlab.com/central-bank-as-real-estate-regulator-can-the-sbps-latest-guidelines-help-meet-the-housing-shortfall/

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Research Questions

What is the difference between construction financing and house financing?

Why is construction financing important for real estate development projects?

Who are the main actors and stakeholders of construction financing?[/fancy_box][fancy_box box_style=”color_box_basic” icon_family=”fontawesome” image_url=”8182″ box_color_opacity=”1″ box_alignment=”left” border_radius=”default” image_loading=”default” icon_fontawesome=”fa fa-envelope-open” icon_size=”60″]

Key Takeaways

Pakistan’s real estate industry has seen a rebound in the past several months due to multiple incentives and regulatory measures provided by the government.

The real estate sector is especially important for an emerging economy as it has forward and backward linkages with more than 40 allied sectors.

The housing and construction sector is the main driver for real estate activity, and with recent surge in demand for construction projects, the cost of raw material has risen sharply, making construction a difficult task for developers.

The State Bank of Pakistan (SBP) has recently announced that financing for under-construction projects will also be provided by commercial banks, a first in the history of real estate in Pakistan.[/fancy_box]

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