Why do banks finance shared construction as mortgages instead of financing it directly and selling the apartments in a building?

Question

The numbers in this question are for a developing country, so rates may seem high, but I tried to make them look reasonably related to each other to illustrate this question. The question also assumes "hot" real estate market - where people buy real estate happily and apply for mortgages.

So there's such thing as shared construction agreement. Here's what it is about: a Large Development Company starts construction of an apartment building and individuals who want apartments may throw in their money into this construction before the construction is complete and then once construction is complete they own their apartments as property and can sell/lease them or just live there.

They key is they throw in actual money but they only get a promise of apartments because a lot of things technically can go wrong and it may so happen that construction is paused for long time or the developer even goes bankrupt. They also have to wait before construction completes and so they freeze their money and cannot invest it elsewhere. This is why this shared construction thing bears some investment risk inside.

Risk decreases as construction advances. Prices here are for illustration only. The promise of an apartment may start at $70K USD when there's just a construction site and no equipment yet, then rise to $100K when all the walls are there, then rise to 130K when the construction is technically complete - electricity and elevators are there and working. Then the development company must contact the authorities and formally register parts of the building which turns them into actual apartments and once that happens price can easily reach $150K.

Given the fact that such a building can be crafted and registered in just two years it means that a person can invest $70K and then sell the apartment (assuming it sells) and get $150K which means something like 45% rate of return. Even better, some investors don't wait for completion, instead they sell the promise to someone who wants less risk - they pay $70K when there's just a foundation pit, wait one year until it looks like a building, someone else is willing to pay them $100K to get their right for the future apartment (assuming there are such people). It's still something like 30% rate of return.

Some people don't have the necessary $70K, so they apply for mortgages. A large bank gives them a loan, they invest into shared construction and meanwhile start paying their loan back to the bank. A promise of an apartment to be constructed becomes a collateral.

A mortgage interest rate is 10%. An interest rate when investing into shared construction is about 40%. A large development company with good reputation and transparent enough looks more reliable than a handful of individuals who can just get bored at their jobs and default on their mortgages. It looks like the bank should just invest into construction, wait before construction completes and sell the apartments at $150K. Instead it issues mortgages to individuals at much lower interest rate.

Why would a bank prefer mortgages to individuals at lower rates over direct investment at higher rates?

Answer 1

Remember that risk should correlate with returns, in an investment. This means that the more risk you take on, the more return you should be receiving, in an efficient marketplace. That's why putting your money in a savings account might earn you <1% interest right now, but putting money in the stock market averages ~7% returns over time. You should be very careful not to use the word 'interest' when you mean 'returns'. In your post, you are calling capital gains (the increase in value of owned property) 'interest'. This may be understating in your head the level of risk associated with property ownership.

In the case of the bank, they are not in the business of home construction. Rather than take that risk themselves, they would rather finance many projects being done by construction companies that know the business. The bank has a high degree of certainty of getting its money back, because its mortgages are protected by the value of the property.

Part of the benefit of an efficient marketplace is that risk gets 'bought' by individuals who want it. This means that people with a low-risk tolerance (such as banks, people on fixed incomes, seniors, etc.) can avoid risk, and people with a high risk tolerance (stock investors, young people with high income, etc.) can take on that risk for higher average returns.

The bank's reasoning should remind you of the risk associated with property ownership: increases in value are not a sure thing. If you do not understand the risk of your investment, you cannot be certain that you are being well compensated for that risk.

Note also that most countries place regulations on their banks that limit the amount of their funds that can be placed in 'higher risk' asset classes. Typically, this something along the lines of "If someone places a deposit with your bank, you can only invest that deposit in a low-risk debt-based asset [ie: you can take money deposited by customer A and use it to finance a mortgage for customer B]". This is done in an attempt to prevent collapse of the financial sector, if risky investments start failing.

Answer 2

Grade 'Eh' Bacon answers it well, the issue is risk. To explain further, when a bank issues a loan, that loan comes with certain legal rights. If the bank decided to partner with a construction company, many of those rights to collect would be gone. Debt is treated differently than equity in the legal system. Banks are good at debt, investors are good at equity.

We also oversimplify it by asking why banks don't prefer equity to debt. Some investment banks also like to deal in equity, so it's probably an inaccurate assumption that you start with.

Answer 3

The most succinct answer is "Banks are in the Money business". Not construction, not real estate, not any of the other things they may find find themselves sometimes being dragged (foreclosure) or tempted (construction) into. "Money" is their core competence, and as good business people they recognize that straying outside that just dilutes their focus.

Answer 4

Assumption - you live in a country like Australia, which has "recourse" mortgages.

If you buy the apartment and take out a mortgage, the bank doesn't care too much if your apartment gets built or not. If the construction fails, you still owe the bank the money.

Answer 5

Why should a bank get into construction specifically? Lots of business opportunities require capital. Conceivably banks could build factories, develop consumer electronics, complete with SpaceX, etc. It's all capital in, profits out, with varying levels of risk and returns. There's nothing special about constructing apartments.

The reason banks don't run businesses is because there are plenty of private firms that compete with each other for business. What's the chance that a bank, with all its bureaucracy, can deliver cheaper apartments than an apartment developer? Pretty low in fact, and that's why they would rather lend to an apartment developer rather than building the apartments themselves.

Banks are in the business of competing with other banks. The main work they do is to sort out good investments from poor ones. And if they can do that just a bit more efficiently than their competitors, they make big bucks. For example, it might only take a few additional hours to better vet a deal worth millions. Whereas with an apartment building, you wouldn't be able to make that amount of money per hour even if the materials and labor cost you nothing.

Answer 6

Historically, Banks are mandated to take relatively safe risks with their money. In exchange, they gain a de-facto permission to invent new money. They have regulations about what mix of assets they are permitted to own. Real estate speculation will be in a different category than a mortgage to someone with good credit.

Second, mortgages with a secured asset are pretty safe almost all of the time. That person might stop paying their mortgage, but it is secured; when that happens, the bank gets the secured asset (the right-to-apartment or house or what have you).

In a sense, the bank loses only if both the person paying the mortgage is less creditworthy than they look, and the secured asset cannot recoup their losses.

In comparison, the person paying the mortgage loses if the secured asset cannot recoup their losses.

The bank is buffered from risk two fold. What more, the bank uses the customer to determine what to invest in.

Deciding what to do with money is expensive and hard. By both having a customer willing to put their good credit on the line and doing due diligence on the apartment, the Bank in effect uses you as a consultant who decides this may be a solid investment. Much of the risk of failure is on you, so you have lots of incentive to make a good choice.

If the Bank was instead deciding which apartment where worth buying, who would decide? A bank employee, whose bonus this year depends on finding a "great apartment to invest in?", but the consequence of a bad choice doesn't show up for many years? The people selling the bank the apartments?

Such a business can exist. There are real estate companies that take money, and invest it in real estate. Often the borrow money from Banks secured against their existing real estate and use it to build more real estate. (Notice the bit about it being secured against existing real estate; things go south, Bank gets stuff).

The Bank's indirect investment in that apartment in the current system is covered by appraisals, the seller, the mortgage holder, and the system deciding that the mortgage holder is creditworthy.

Banks sell risk. They lend you money, you go off and do something risky with it, and they get a the low-risk return on investment of your loan. Multiple such low-risk investments provides them with a relatively dependable stream of money, which they give out to their bondholders, deposit account customers, shareholders or what have you.

When you take a mortgage out for that, you are buying risk from the bank. You are more exposed to the failure of the investment than they are. They get less return if things go really well.

Answer 7

Banks should be risk averse by default. They make loans to people and businesses after measuring their ability to repay.

After they approve a big project loan like an apartment building, they don't give all the money to the builders upfront. They give money as progress is made and they make sure the funds are not being used inappropriately.

There's no reason they couldn't do all this while owning the project, but that would also open them to lawsuits later on if anything wasn't built to code. By keeping the project at arm's length, they avoid future liability.

Answer 8

The core competency of banks is to lend money from depositors and re-lend that money to borrowers. They do not have the expertise to develop real estate.

They have trouble evening managing foreclosed real estate, such that they have to sell them at a discount.

Answer 9

You seem to underestimate the risk of this deal for the inverstors. A person purchasing a residence is happy to pay $70K instead of $150K now, and the only risk they take is that the construction company fails to build the condo. Whatever happens on the estate market in two years, they still saved the price difference between the price of complete apartments and to-be-build apartments (which by the way may be less than $150K-$70K, since that $150K is the price on a hot market in two years).

However, an investor aiming to earn money counts on that the property will actually cost $150K in two years, so he's additionally taking the risk that the estate market may drop. Should that happen, their return on investment will be considerably lower, and it's entirely possible they will make a loss instead of a profit. At this point, this becomes yet another high risk investment option, like financing a startup.