Absent any special condition to the contrary a mortgagee is entitled to insist that 100% of all monies owing be paid before releasing any part of its security. There is no implied legal right to a partial discharge.
A partial discharge is therefore a matter of grace and favour. “Grace and favour” is a legal expression meaning a benefit, permission or indulgence granted at discretion, not as of right. Thus the mortgagor receives a partial discharge because the lender chooses to grant it — not because the mortgagor is legally entitled to it.
In construction financing, sell-down is typically piecemeal rather than wholesale. For that reason, lenders often grant partial discharges to facilitate the orderly sale of lots or units.
Partial discharges are frequently inconvenient for lenders. The debt is repaid in dribs and drabs and administrative work increases.
Some lenders will permit off-the-plan contracts to settle shortly after registration of the strata plan, but then require the residual stock to be refinanced in one line.
Borrowers are usually keen to do this, as pricing often drops materially — for example:
- from 16%+ default rates under expired senior debt facilities; or
- from even higher rates if there is a mezzanine facility
Where a partial discharge is granted (as an act of grace and favour), it is customary for lenders to require that 100% of surplus sale proceeds, after approved sale costs, be applied in reduction of the secured debt. A second mortgagee granting a partial discharge will require 100% of surplus proceeds to be paid to the first mortgagee.
Sale costs typically include:
- real estate agent commission (often 1.5%–2% for standard residential sales); and
- standard conveyancing adjustments.
However, many construction projects are marketed off the plan through specialist project marketing firms. These firms are not paid until long after contracts are exchanged (once funding is obtained and construction completed and the majority of settlements occur). Consequently the commissions they charge are much higher (commonly 3%–6%, and sometimes higher for boutique or international campaigns).
To secure payment, project marketers will sometimes take a charge or security interest over the project. This security is frequently not disclosed to construction funders and only becomes apparent after registration of the strata plan, when the project marketer lodges a caveat.
In some cases, the developer may have told the project marketer that commissions would be progressively paid as units settle, even though the construction facility makes no allowance for this. As a result:
- the project marketer may be reluctant to withdraw its caveat during sell-down; or
- may seek to divert a portion of each settlement to recover commission.
Lenders will often respond by saying, in effect:
We will not permit full payment of what you claim. We may allow, for example, up to 3% of the sale price to be treated as sale costs for each lot.
This becomes a commercial negotiation.
Well-organised lenders, developers and project marketers will negotiate:
- whether partial discharges will be permitted at all;
- a formula for calculating release prices; and
- document the allowable sale costs upfront,
this is then encapsulated in special conditions of the facility agreement.
However, there is often a temporal mismatch:
- the agreement between the developer and the project marketer is usually entered into well before construction finance is negotiated; and
- the construction lender may have no appetite to include a provision for cash out before its own debt is repaid.
In those situations, the project marketer is often told by the developer:
I know I said I would obtain finance that provided for you to be paid progressively but it is better for us both if I accept this finance offer that makes no allowance for progressive commission payments than to have the project not proceed at all!
Our advice to lenders is to be commercially generous where the loan-to-value ratio allows it. If:
- there are strong equity buffers;
- the borrower is willing to continue paying the applicable interest rate (often the higher rate)
then allowing as an act of grace & favour:
- partial discharge
- a generous allowance for sale costs, and
- even permitting the borrower to retain a modest surplus
can generate significant goodwill. Importantly, this goodwill is not just with the borrower, but with:
- brokers; and
- the broader market.
Over time, this positioning means brokers will tend to bring high-quality transactions to reasonable lenders, while directing marginal or higher-risk deals to lenders who are less commercial.