Opinion: Why capitalising interest on development loans can make sense

By Bruce McKay

Is Capitalising Interest Wrong?

In the debacle over finance companies much comment has been made about capitalising interest loans. These are loans where interest is added to the loan balance each month and is paid in cash at maturity. These loans have been particularly prevalent with finance companies that were focused on funding property development. Other interest payment types are principal and interest (P&I), much like a residential mortgage and interest only, which is common in business finance.

Consumer loans are P&I as are equipment leases. The accusation is that by allowing borrowers to capitalise their interest, the finance companies did not generate cash flow, allowed borrowers to get out of control and then paid themselves dividends based on earned, but uncollected income.

Comments on articles about finance companies here on Interest.co.nz have been full of opprobrium for finance companies and their directors for doing this.

The first point to note about capitalising interest is that it is not illegal and in many cases makes sense. Investors putting funds into finance companies are also quite keen on capitalising interest, a point that is often left out. My experience is, and based on discussions with others, that about half of depositors’ funds were on a capitalising interest basis at any one time.

Why? There is a yield enhancement from capitalising interest compared to quarterly interest paid out and many investors like this uplift in return. From a lenders point of view it makes sense to have a portion of your loan book in capitalising interest loans because of the same yield enhancement.

The wrinkle is that RWT still has to be paid in cash each quarter on deposits with capitalising interest so this suggests that one wouldn’t want more than one third of the book to be in capitalising interest loans.

The next part of the equation is the term of the capitalising interest loans compared to the term of the deposit book as a whole. To conservatively manage a finance company the average term of the loan book should be shorter than the term of the deposit book, so in theory you collect all the loans before the money is due to the depositors. The issue with property development is that it is in many cases the project has to be completed before the sales can start, which generates the funds to pay back the loans. It’s similar to building a hydro dam; it has to be finished before the first megawatt of power is generated and thus the first dollar earned.

Capitalising interest is generally the only way of advancing funds on property developments (and hydro stations) because of the way the cash flows work. My view has always been to keep capitalising interest loans as short as possible; a maximum of 12 months and generally an average term of around six months.

This linked with a robust exit and low LVR means that the risk of making these loans can be managed. The problem that many of the property development finance companies found themselves in was that they advanced capitalising interest loans for extended terms (2 years +) based on the hope or expectation that the developments would be completed, finished property sold and the money paid back. It had worked well up until 2007, and everyone involved believed that this sort of thing could continue on.

Then the GFC hit and the property market in New Zealand effectively stopped dead. Today it is still very difficult to find finance for anything other than residential property. Banks are quite happy to lend on completed houses, but won’t lend on building them. In the current environment any lender to property development has big problems. The banks are in the same boat as the finance companies; the difference is that the property development focused finance companies didn’t have the diversity of business or size of banks to absorb the losses.

Did directors of these finance companies pay dividends to shareholders out of earnings from capitalising interest loans?

Maybe, but that is not illegal. Before a company can pay a dividend it has to satisfy the solvency test; this is set out section 52 of the Companies Act and broadly states that a company has to be able to meet its liabilities as they fall due in the normal course of business after the payment of the dividend, and that its assets exceed its liabilities. Auditors ask directors for similar information, generally in the form of a cash flow forecast, as part of their assessment of whether a company is a going concern. If the directors formed a view that the company could pass the solvency test then the dividend could be paid.

The issue about paying a dividend is not where the profit came from, but can the company meet its obligations in the future once the dividend has been paid. This is something that many companies spend quite some time considering and seeking advice on. Whether finance companies did or not I cannot say.

* Bruce McKay is a director of Saffron Capital and Viaduct Capital, an Auckland-based finance company that is now in receivership. He has written commentaries for The Dominion Post and The Independent.