Authors: Kon Nakousis, Elias Stephen, Nick Lazarou, Ben Fuller, James Frixou and Caitlin Cleary
The Australian Build-to-Rent (BtR) market is attracting significant levels of both foreign investment (especially from established UK Build-to-Rent and US “multi-family” developers and funds that are familiar with the sector) and significant investment locally from superannuation funds and other Build-to-Rent funds. Whilst Build-to-Rent projects tend to generate lower yields compared to other real estate assets such as commercial office buildings, there is growing institutional investor appetite for this asset class particularly amongst large global real estate funds who view it as a sustainable long-term market.
Up until recently, tax, duty and planning law hurdles have deterred many investors (especially foreign investors) from investing in Build-to-Rent assets rather than other real estate asset classes (such as commercial, industrial or retail assets). However, some positive change is in the wings on these matters.
Over a series of four articles (of which this is the third in the series), we consider the fast developing Build-to-Rent market in Australia and consider some of the key issues relevant to investors considering an investment in the Build-to-Rent or Build-to-Sell (BtS) market. We consider not only the growth of the private rental market housing sector but also social and affordable housing and the funding sources available for such developments.
In our first two articles, we provided an introduction to the Build-to-Rent market, considered some of the key commercial issues in a Build-to-Rent project, looked at the structure of a Build-to-Rent project, the categories of fund investors and tax aspects of a Build-to-Rent project.
In this article, we look at some of the key construction, real estate and planning considerations in a Build-to-Rent project.
Key construction issues in a Build-to-Rent Project
In the current environment, there are a number of risks that any Build-to-Rent project faces in its construction phase. These risks are not unique to Build-to-Rent developments and will arise for any major construction project. However, it is useful to identify them.
1. Project Scope
In any development project, the scope of the project work is critical – in this regard strong project planning is essential to avoid the risk of incomplete, unfit or substandard work, especially for Build-to-Rent projects where any scope issues may impact long term operating costs. To minimise scoping issues, strong project planning requires carefully drafted and comprehensive principal project requirements, a thorough engagement with prospective builders during the tender phase to ensure deliverability of scope on time and at cost, fitness for purpose warranties as at the time of completion and, where possible, for a further operational period and ongoing project management during the construction phase to ensure delivery of scope and quality.
2. Negotiation of Building Contracts and O&M Contracts
A key risk management, mitigation and pain point for Build-to-Rent projects is the drafting of building and Operations and Management (O&M) contracts. While the market for smaller and mid-sized developments usually turns to Australia Standard contracts, a more appropriate whole-of-project approach for the Build-to-Rent sector may be achieved via a bespoke suite of contracts.
Relevant contractual considerations include risk allocation (and the impact of contractor distress and/or insolvency), consequential loss exclusions (which may not be appropriate for Build-to-Rent projects in respect of loss of revenue and profit) and delineation of roles and liability (as Build-to-Rent projects require detailed consideration of how risk and liability is allocated over a wider range of participants, going beyond the traditional developer-contractor relationship to extend into facilities management and operation).
3. Construction Costs
Rising construction costs have impacted developers by placing pressures on margins. Financial stress, however, has also been increasing across the supply and subcontracting landscape and may cause sudden shocks to the progress, as well as cost of delivery, especially in light of the recent ‘ipso facto’ insolvency reforms which may restrict termination and enforcement against an insolvent contractor. The increase in construction costs has been driven by inflation, supply chain issues and a tight labour market, whilst productivity in the construction industry has continued to stagnate. Developers may wish to consider leveraging construction technology such as data automation, AI platforms and tracking identification technology to better control and manage construction costs.
4. Regulatory risk
As Build-to-Rent developments are a newly emerging asset class within Australia, the current legislative framework for residential construction tenancies in each state and territory has not yet had time to develop with Build-to-Rent projects in focus. Legislative reform may be required to recognise and provide for the different nature of Build-to-Rent assets and tenancies, which reform may impact the construction as well as the management of Build-to-Rent assets. Construction contracts (and consultancy agreements) should adequately recognise and allocate risk for any applicable reform of this nature.
Another key concern for developers / investors is the mooted rental caps which will pose a real risk to investment in the BtR sector. While the meeting of the National Cabinet on 16 August 2023 rejected the imposition of caps on residential rents as a measure to deal with the housing crisis, the heated debate about the policy was enough to put some major transactions on hold. Just recently in Victoria, the State Government released its formal position on the policy in Victoria’s Housing Statement on 20 September 2023 quelling fears that Victoria would introduce rental caps in the residential rental market. The Victorian Government’s rejection of rental caps was welcomed by industry, and in particular, by the Property Council of Australia arguing that such a policy would worsen the housing crisis by discouraging investment in housing, reducing the quality of rentals and distorting the housing market.
5. Supply chain disruptions and beyond
Surging material and labour costs have caused some developers to abandon planned projects or accept “rise and fall” provisions. Contractors continue to seek aggressive limitation of liability, including by limiting carve outs from liability caps, broad entitlement to extensions of time and delay costs and application of legislative protections (like the apportionment legislation) and while insurance costs remain high, insurance limits are a key risk mitigation factor for developers, while being relatively simple to price by contractors.
6. Market demand
Because the end-users market for Build-to-Rent projects are primarily tenants, the long-term success of Build-to-Rent projects relies on tenant satisfaction and the capacity of a project to meet prevailing and emerging market sentiments. Some characteristics of the Build-to-Rent -specific tenant market include general lack of data on tenant behaviour, given the relative youth of the Build-to-Rent sector in Australia, an increased focus on amenities due to rental restrictions on renovations, but with a sensitivity to the cost-benefit ratio of certain types of amenities and, especially in the higher end Build-to-Rent market, responsiveness of tenants to green rating credentials of Build-to-Rent assets. As a result, green rating metrics, amenity maintenance and upgrade programs should be incorporated into the Build-to-Rent Building and O&M contracts to ensure that the required standards are achieved and maintained throughout the life of the asset.
7. Practical Completion
While commercial real estate and Build-to-Sell residential assets can generally tolerate an extensive defects rectification process, a higher standard for practical completion may be required for Build-to-Rent projects to minimise punch list items and defects and the resultant disturbances to the occupation of the building. This is to ensure that projects are ready for uninterrupted residential use as soon as possible, and that the rectification of defects does not adversely impact the reputation of the building with tenants and thus the commercial prospects of the asset.
Security packages and other mechanisms (e.g. appropriate, more specific warranties and performance guarantees) should also be tailored into the relevant agreements to ensure that the asset is delivered to a suitable standard.
8. Project Management
Active project management is required to deal with delays and disruptions as well as the enforcement of developer rights under contracts. Otherwise mismanagement of directions and variation orders may result in increased project costs, delays in meeting contract milestones, interruptions to workflow, and failure to complete projects on time. In addition, compliance with contract terms should be strictly enforced throughout the life of the project to ensure certainty of process and party entitlements as well as the ongoing enforceability of time bars and similar protections.
9. Security of Payment
Although security of payment regimes have largely matured across Australian jurisdictions, minor reforms are likely to continue to be implemented from time to time. Legislative direction shows a continuing trend towards protecting contractors from further adverse monetary outcomes (see, for instance, the notice requirements for utilisation of security recently implemented in Western Australia), and an adjudication process that continues to favour the claimant.
10. Latent Conditions
Builders are reluctant to accept latent conditions risk without extensive site investigations by the developer which are then provided to the builder on a reliance basis. Some of the risks which can be encountered include sites with poor bearing capacities may be subject to significant remediation costs for earthworks and drainage and for brownfield developments, asbestos, buried objects (such as storage tanks) and protection works for neighbouring properties remain a key concern for builders.
Key real estate issues in a Build-to-Rent Project
Build-to-Rent developments can also be challenging from a real estate perspective for a number of reasons.
1. Site identification and acquisition
Given the long term nature of the investment, it is essential that careful consideration is given to the identification and acquisition of a Build-to-Rent site. Particular areas of focus should be to ensure the site is situated within proximity to a major urban area, local amenities and transport links.
Given the limited land availability in the inner cities of Australia’s major capital cities, Build-to-Rent investors will need to be closely watching for any land release programs of local and State governments, as well as vacant land and property acquisition opportunities (including by way of acquiring and consolidating multiple adjacent blocks or conversion of existing buildings) and even distressed Build-to-Sell developments (which may be able to be converted to Build-to-Rent).
Build-to-Rent investors should be prepared for stiff competition for the best sites, not just from other Build-to-Rent developers, but also from Build-to-Sell developers or investors, who will be able to realise a return from the site at a much earlier stage, and therefore may be willing to bid more aggressively.
The developers of a Build-to-Rent project need to consider whether the project will be staged, is going to be a strata subdivision and/or will form part of a larger precinct comprising other commercial and retail components. Depending on the structure of the project, additional real estate documents may be required such as easement documents, strata by-laws, building management statements and precinct management statements.
3. Rental agreement
A template rental agreement will usually be prepared for a Build-to-Rent project. A Build-to-Rent Sponsor should draft the template rental agreement carefully to include any requirements of the Build-to-Rent developer and to comply with applicable residential tenancy laws. Some of the key points of difference with Build-to-Rent rental agreements are the length of the lease, less frequent rent increases and additional tenant rights and responsibilities.
4. Asset management
Build-to-Rent developments are usually managed by a single management entity with on-site access to management for tenants. Some key considerations for asset management are financial management; tenant management; maintenance and repair; compliance and risk management; and marketing and branding.
5. Setting the rent
From the perspective of the rental yield, Build-to-Rent projects can be sorted into 2 broad categories, Premium and Social and Affordable.
- Premium offerings: “Premium” Build-to-Rent projects typically offer a range of amenities from fitness centres, swimming pools and creches. Build-to-Rent investors are currently prevented from claiming GST rebates applied to other assets like hotels, while foreign investors who back the sector are not eligible for managed investment trust (MIT) concessions which benefit other asset classes, such as offices. This means investors are passing on the cost burden to tenants and rents for Build-to-Rent projects are currently higher than market rents. A recent Cushman & Wakefield report showed that a project located in Alexandria or Zetland in New South Wales must achieve a rent return 20% higher than surrounding properties to make an appropriate overall return.
- Social and affordable housing: Despite many Build-to-Rent projects being targeted as “Premium” offerings, as we have noted in this series, Build-to-Rent projects are also very often associated with social and more particularly affordable housing are being encouraged and supported by various Australian governments. As such, these “Social and Affordable” are becoming more common. A Build-to-Rent project developer for a social and affordable housing project may be required to enter into an agreement with a registered Community Housing Provider/State Government and procure that a certain percentage of the build-to-rent development be used for social or affordable housing at discounted rents. The inclusion of affordable housing may offer some incentives to developers (including potential access to NHFIC funding).
Key planning considerations in a Build-to-Rent Project
Planning law hurdles and associated “red-tape” have stalled the development of many affordable housing Build-to-Rent projects in recent years, with local councils refusing these developments in low to medium density areas off the back of opposition from residents or community groups.
As a result of the Federal Government’s National Housing Accord Target, the NSW Labour government has introduced legislative reforms to both the public and private sectors which seek to address the housing crisis in NSW by encouraging the construction of affordable housing and reallocating approval powers (which would otherwise have been with local councils) to either the Minister or Independent Planning Commission.
As part of these reforms, the NSW State Government has stated that 30% of new housing on public land must be affordable, social, or diverse housing. Affordable, social, and diverse housing are evolving terms which have most recently been described by the NSW Department of Planning and Environment and defined under the State Environmental Planning Policy (Housing) 2021 as follows:
- Affordable housing (managed by community housing providers) is available to low-income households eligible under the National Rental Scheme and limits or caps amount of rent that would otherwise be payable based on that household’s gross income.
- Social housing (being public housing managed by the Department of Communities & Justice, community housing managed by non-government social housing providers and housing for Aboriginal and Torres Strait Islander people managed by the Aboriginal Housing Office); and
- Diverse Housing includes Build-to-Rent housing, Co-living housing, and group homes.
1. Private Sector Reforms
Large scale affordable housing developments are generally managed by the private sector in NSW and the reforms aim to incentivise these types of development by:
- Streamlining the assessment process – projects that propose 15% or more of affordable housing and have of a construction cost of greater than $75 million will be assessed as ‘State Significant Development’ (SSDAH Projects).
- Uplifting the permissible floor space ratio and height of building development standards by 30% for those SSDAH Projects.
- Creating exemptions to the state infrastructure contribution requirements for social and/or affordable housing providers.
2. Public Sector Reforms
In addition to streamlining the assessment process for larger scale social housing projects (with a construction value of more than $30 million), the NSW reforms expand the self-assessment powers of the NSW Land and Housing Corporation (LAHC) and Aboriginal Housing Office (AHO). Meaning that, projects with less than 60 dwellings across two storeys can be approved by the LAHC or AHO.
The NSW State Government has also committed to auditing surplus public land in NSW for the purposes of rezoning for social housing and expediting the release of such land.
The reforms endeavour to encourage a ‘Yes In My Backyard’ (YIMBY) mentality by responding to the housing crisis and, at a practical level, the reforms are largely focussed on incentivising large scale affordable housing developments and social housing developments.
Victoria is leading the nation’s Build-to-Rent housing projects, with 2,245 Build-to-Rent units having been completed as of July 2023 and an additional 13,000 in the pipeline. As of May 2023, 63% of the planning applications under assessment in Melbourne’s inner city are Build-to-Rent housing projects.
Victoria's progress of affordable and social housing developments can be attributed to the commencement of the 2016 Streamlining for Growth (SfG) program which made the approval process of these types of developments more efficient for developers.
The SfG program will finish in 2023, and the Andrews Government has considered legislative reforms which would further streamline the approval process for affordable and social housing developments in Victoria by adopting the ‘YINBY’ approach, similar to that recently adopted in NSW. One of the aims of this legislative reform is to address local council’s lengthy, and often heavily contested assessment process of these types of developments by expanding the State government’s approval powers.
In Victoria’s Housing Statement released on 20 September 2023, the Andrews Government announced a streamlined planning process under the Development Facilitation Program for medium-to-high density residential developments that deliver at least 10 per cent affordable housing. If construction costs are at least $50 million in Melbourne or $15 million in regional Victoria, the Minister for Planning will cut application timeframes for these types of projects from more than 12 months down to four months.
The Victorian Government have also foreshadowed a review and rewrite of the Planning and Environment Act 1987 (Vic) to build a fit-for-purpose planning system including amending timeframes for decisions and redefining roles and responsibilities for everyone involved in the planning system.
As part of Victoria’s Housing Statement, the Victorian Government have also promised to unlock surplus / under-used government land by rezoning such land to deliver around 9,000 homes across 45 sites in both metropolitan Melbourne and regional Victoria. As part of this work, the Victorian Government has set a target of at least 10 per cent of affordable homes to be built across such sites.
Queensland are also responding to the housing crisis by offering alternative residential projects, with three affordable Build-to-Rent housing developments (comprising 1,200 Build-to-Rent units and 490 affordable Build-to-Rent units) having been recently approved in Brisbane. Additionally, in an attempt to address the increased demand for affordable rental houses, the Queensland reforms now require at least 10% of all Build-to-Rent units to be affordable housing dwellings.
The introduction of the reforms to the Planning Act 2016 (QLD) in late 2022 saw changes to the assessment pathway of affordable and social housing in the state. Previously, these projects were assessed by local councils under the ‘development assessment’ pathway, whereas now these types of developments are assessed under the infrastructure designation pathway by the QLD Planning Minister.