James Hokans January 2010 A Builders Warranty Scheme: Would it help Unleash Finance into the Lower-end of the Mortgage Market?

James HokansJanuary 2010

A Builders’ Warranty Scheme:Would it help Unleash Finance into the Lower-end of the Mortgage Market?

Some keys to a functionalaffordable housing finance market

Builders warranty scheme (BWS)can facilitate developer (debt) finance

Vexing problems inurban low-income housing markets

Land security and affordability due to the limited supply of regulated land

Limited number of financial institutions delivering small mortgages at scale within acceptable risk parameters

How to attract reputable developers/builders? Difficulty of developers accessing construction finance Lack of standardization of acceptable building standards

and processes Lack of consumer education and protection against

rectifying building defects Others…

Source: Monitor 2007

5

Housing finance segmentation (typical)

Informal income;no legal title

Urban;Middle/upper

National poverty line

Primarily rural; very poor

Formal employment Title to land

Sources of developer finance

I. Developer equity

II. Pre-sales and/or buyer pre-payments

III. Equity investors

IV. Conventional debt finance (banks/NBFCs)

Limits and other problemswith these first two sources:

I. Developer equity is limited in quantity Fewer projects get developed

II. When homeowners finance construction via deposit payments to developers, results include:

Homebuyer bears construction (unmitigated) risk Risk of developer fraud Many creditworthy buyers don’t have ample savings

decreases effective demand

BWS helps develop affordable housing finance markets

byfacilitating developer access to conventional

debt financing,*as in South Africa (discussed later)

* The prospect of raising equity investment (from passive or institutional investors) is not discussed here. Such investment is unlikely to precede the leverage provided by conventional debt finance.

Virtuous circle of BWS:

What is a builders warranty scheme?

Two models:

Netherlands: Insure homeowners’ pre-payments in case developer defaults prior to completion

South Africa: Coverage for building defects for a certain period after owner occupancy

The latter is the focus of this presentation.

South African Context

Post-Apartheid: President Mandela wanted to get the private sector involved

Capital subsidies available Other institutional start-ups National Housing Builders Registration Council

Details of South African example

Administered by NHBRC, which: sets national building standards manages registration & rating of all developers

Independent inspection prior to occupancyCovers major building defects for 5 yrs.

Covers minor building defects for 90 days

Threat of license revocation if developer fails to correct defect

Homeowner fee:1.3% of construction cost, and can be capitalized in loan or paid

Developer fee: $100 in Year 1; then $25/yr.

Desirable outcomes of BWS in SA:

Standardized housing design reduced costBetter quality housing stockContributed to rapid development of 1 million

new affordable houses (bank-financed)

Analysis of BWS Fees (all in USD)

Grade Sale price Fee calculation Maximum fee

A Up to $64,500 1.3% of sale price $813

B $64,500 - $129,000 Level A max, plus1% * (Sale price – Level A max) $1,485

C $129,000 - $238,000 Level B max, plus.75% * (Sale price – Level B max) $2,454

D $238,000 - $645,000 Level C max, plus.75% * (Sale price – Level C max) $4,391

E $645,000+ $4,391 $4,391

Business Case for BWS can be positive:No Fiscal Contribution

Big Assumptions: 1.0% warranty fee 1.1 m units under warranty yr 5 Inspector salary $30k/yr.,

completes 12 per day 1.5% make claims $2,250 (50%) cost per claim,

with half ($1,125) covered by developer and half by BWS ($1,125)

Other operating costs at 35% of revenues

Fiscal contribution $.5m 1st yr

Year 1 Year 2 Year 3 Year 4 Year 5

Revenues $2,375,000 $3,493,750 $6,918,750 $14,896,875 $22,921,875

Homeowner fees $2,250,000 $3,375,000 $6,750,000 $14,625,000 $22,500,000 Sale price $4,500 $4,500 $4,500 $4,500 $4,500 Fee 1.0% $45 $45 $45 $45 $45 # of new units put under warranty 50,000 75,000 150,000 325,000 500,000 total # of units under warranty 50,000 125,000 275,000 600,000 1,100,000

Developer fees $125,000 $118,750 $168,750 $271,875 $421,875 Initial registration fee $100 $100 $100 $100 $100 $100 # of new developers registered 1,000 750 1,000 1,625 2,500 Initial registration fees $100,000 $75,000 $100,000 $162,500 $250,000 Renewal fee $25 $25 $25 $25 $25 $25 total # of developers registered 1,000 1,750 2,750 4,375 6,875 Renewal fees $25,000 $43,750 $68,750 $109,375 $171,875

Expenses $2,313,542 $3,404,479 $6,821,250 $14,773,646 $22,631,250

Inspector training $52,083 $26,042 $78,125 $182,292 $182,292 Cost per inspector trained $3,000 $3,000 $3,000 $3,000 $3,000 # of new inspectors trained 17 9 26 61 61

Inspector compensation $520,833 $781,250 $1,562,500 $3,385,417 $5,208,333 Annual cost per trainer $30,000 $30,000 $30,000 $30,000 $30,000 # of working inspectors (12 inspections/day) 17 26 52 113 174

Cost of claims payouts by warranty scheme $1,265,625 $1,898,438 $3,796,875 $8,226,563 $12,656,250 # of claims made this year 2.25% 1,125 1,688 3,375 7,313 11,250 Repair cost per claim 50% $2,250 $2,250 $2,250 $2,250 $2,250 Repair costs paid by developers 50% $1,125 $1,125 $1,125 $1,125 $1,125 Repair costs paid by warranty scheme 50% $1,125 $1,125 $1,125 $1,125 $1,125

Other operating costs 20% $475,000 $698,750 $1,383,750 $2,979,375 $4,584,375

Net Income $61,458 $89,271 $97,500 $123,229 $290,625

Fiscal contribution $0 $0 $0 $0 $0

Reserve (retained earnings + fiscal contribution) $61,458 $150,729 $248,229 $371,458 $662,083

Concerns and potential downsidesto be carefully managed

Developer resistance (costs, admin.) Insurer over-zealous resistance to pay claims Does not address developer default pre-occupancy Inadequate number of inspectors Added development costs (~ 1%) Insurer liability if unexpected claim rate

Key elements of BWS:

Competent, well-positioned and politically supported institution to administer it

Setting appropriate building code standards Low entry barriers & training for developers Availability of inspectors Efficient dispute & claim resolution process

Contact: James [email protected] Grove Street, Suite 303Somerville, MA 02144 USAUSA Tel: + 1 617 628 – 0711India Cell: 00 91 971 762 7122

Thank you!