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Construction loans for major renovations

Marty McDonald - Wednesday, October 18, 2017

There’s a growing sector of home owners buying cheaper undesirable properties in ideal areas and doing major renovations to create their dream home. They may also do knock down rebuilds that require full construction of a new property. Their many ways you can go about funding these endeavors with equity loans and construction loans both fixed and unfixed being the main avenues of finance.

Equity loan / Cash Out Loan

Releasing equity via a new loan or increasing an existing loan is referred to as “cash out”. If you are planning to borrow for renovations and the amount required is less than say $300,000 and the property has sufficient equity as is then usually the easiest way to finance this is via a cash out loan. The borrower would then control the funds which would sit in an offset account or loan redraw until needed.

With most lenders, you can borrow up to 80% of the value of the property (AS IS), including existing loans. While some lenders may allow up to 90%, the borrower will have to pay lenders mortgage insurance and lenders will be more selective when it comes to proposed loan purpose.

If the renovations are major, structural in nature and more than $300,000 then most lenders will require you to undertake a construction loan as per below. Some exceptions apply

Fixed Price Contracts

The most common type of residential building contracts are fixed-price contracts. These contracts are for a set dollar amount and include a progress payment schedule. A typical schedule would be something like the below. Payments are made to the builder as each stage is completed.

1)    5% - deposit

2)    Slab completed - 10%
3)    Frame up – 15%
4)    Lock up - 35%
5)    Internal / fixing – 20%
6)    Practical completion – 15%

If borrowing for the renovation using a fixed price contract the lender will have the property valued “as if complete”. This would be more than the as is value (you would hope!) thus allowing additional borrowings without exceeding LVR guidelines.

With fixed price contracts the risk of cost overruns is somewhat in the builder’s hands. Accordingly, builders will include a margin for their risk in the contract price along with their profit margin on materials and labour.

What is not well understood is how variations affect the contract sum. Some things will fall outside of the contract scope even with a fixed price contract. For example, excavation cost could be included in a contract at say $20,000 but if rock is hit and the cost escalates to $80,000 this would be deemed a variation to the contract and the additional cost would be the responsibility of the owners to cover. This type of occurrence is of course far more likely when the project is bespoke as opposed to in a new greenfield development.

Another common type of variation would be an upgrade to the building specifications / inclusions. These can be included in the overall contract sum before the build commences so these don’t present an issue finance wise. Variations made after works have begun such as those resulting from a change of mind mid build on the other hand (if material to the overall contract price / house end value) can be an issue finance wise.

If finance is required for any part of the build cost then the lender will require that the construction loan is approved before works commence and that the owner’s contribution is paid first.

Cost Plus Contracts

A Cost Plus contract is a when the builder agrees to complete specific work for an estimated amount but the contract contains rise and fall clauses that allow the builder to charge for increased labour or material costs. The cost-plus contract price is not fixed.

The builder includes a profit margin on all actual costs incurred including direct materials, labour and expenses. With cost-plus contracts the builder does not have any risk of cost overruns.

So why would anyone agree to a cost-plus contract? Once a project gets to a certain level of complexity builders will generally not accept the risk of a fixed price contract and if they were to do so in theory they would have to set the contract amount a much higher price to allow for the added risk of unforeseen cost overruns.
Cost-plus contracts use an “open book process”.  Owners are entitled to receive progress payment claims with all of the supporting invoices or satisfactory evidence for each item of expenditure/direct cost as charged by the builder. With every single cost needing to be accounted for, cost-plus contracts are naturally much more administrative in nature than fixed-price contracts.
 
Most lenders do not accept cost plus contracts. The customer and therefore the lender is bearing the risk of cost overruns. The lenders who will consider cost plus contract will have a requirement that the contract estimate of works is over $1,000,000 and the customer themselves have access to substantial additional equity, borrowings or surplus funds to cover increased costs, should they arise.

How to Identify a Cost Plus Contract (Non Fixed Price contract)

  • Front page of the building contract to state cost plus contract or simple works contract
  • There will be no progress payment schedule
  • The contract will note progress payments to be paid on a monthly basis
About the Author: Marty McDonald is principal of mortgage broker “Mortgage Experts”. Marty specialises in assisting active property investors with loan structuring advice and implementation as well as helping credit worthy borrowers with slightly outside the box income and employment situations. Find Marty on  and LinkedIn.