Sector Focus: The changing face of residential development finance
James Thomlinson, Partner Voltaire Financial LLP
It makes sense to start with a few qualifying statements about the portion of the residential development market within which we operate. Our typical residential development client ranges from small or fledgling developers to medium-sized housebuilders.
Typical loan sizes are between £5-50m but with the ability to assist with smaller and larger. Our expertise is therefore largely focused on direct lending of one form or another (senior, mezzanine, joint venture equity) rather than bonds or IPOs.
Lender appetite: apparent vs actual
We’ve all heard the rumours of certain High Street lenders supplying terms in the full knowledge that they won’t be acceptable to or workable for the borrower in order to satisfy some internal quota (‘the terms were issued, the borrower chose not to take them..’). In reality I think instances of this are rare and increasingly so. Indeed the market currently has a positive and progressive feel to it.
However we have seen some evidence of this type of behaviour being applicable to certain debt funds albeit in more subtle ways. Given most debt funds are driven by IRR hurdles it is not just their pricing that one must scrutinise but also for example the timings of their redemptions. It is not uncommon for such lenders to shorten loan periods or generate agreed project cash flows (underwritten by covenants) that involve optimistic off-plan sales assumptions in order to quote meretricious headline terms.
Typical sources of finance: past, present and future
Fewer than 150,000 new homes were built in the UK last year and in the few years preceding that even fewer still. With mounting pressure on the population the Department for Communities believe that over 200,000 homes per annum are required. But does this supply/demand inequality necessarily lead to strong appetite across the board from lenders? Volumes of development finance have undoubtedly been increasing year on year but it is interesting to explore the type of funding source issuing these loans.
The germination of the post-downturn residential development lending environment was a slow and poorly attended one with only a few staunch regulars that saw the process through. These participants numbered a modest selection of private banks, specialist development lenders and newly-founded mezzanine providers. The pricing ranged from the reasonable to the downright larcenous and with everything in between.
The once overwhelmingly dominant pre-downturn position of High Street banks atop of the residential development tree is soon to be at an end with this category of lender now accounting for only just over 50% of total lending in the sector. The High Street have not been helped by the particularly risky classification of development lending by Basel II. The corresponding capital requirements on banks make it relatively costly for them to provide such loans.
Having started out in the short term finance sector, a good place to start given the small average loan sizes, P2P firms are now hiring experienced and specialist development originators out of banks to gear up for a serious challenge to the more established sources.
What or where - becoming more or less important?
There is now generally less appetite amongst lenders for super-prime opportunities with re-sales in excess of £2000psf. Somewhat esoteric asset classes within the wider definition of ‘residential’ are being considered more favourably than before such as serviced apartments, assisted living and so-called ‘pocket units’. Lenders are now more comfortable with larger/50-100+ multi-unit schemes. The extent to which these can be speculative is dependent on lender type. Debt funds have consistently been lending without any pre-sales but usually insist on covenants surrounding the quantum of off-plan sales that must be delivered. High Street banks still insist on a proportion of the scheme being pre-sold prior to first drawdown – typically as much as 20-30%. Leaving to one side the substantially differing levels of gearing available from these two types of source this creates another dilemma for developers. No one would deny the comfort of having de-risked a project through pre-sales but in a market that has seen so much capital appreciation during the last 5 years it is very tempting to keep alive the opportunity to see super-profit rather than lock in current sales prices, cap profit on those units and arguably constrain future achievable prices through setting a precedent.
Hand in hand with the move away from super-prime property comes a shift in focus from zone 1 London into zones 2-6 and beyond; within Greater London still represents most lenders’ geographical sweet spot. However a growing number of lenders are prepared to look farther afield and in some cases venture deeply into the regions including the South West and North East.
There is no doubt that sentiment will continue to change during 2016 and in many ways this will be welcomed by the marketplace. The recent announcement that permitted development rights will be extended beyond the current deadline of May 2016 will maintain the fuel for what has been a very feasible type of development. We look forward to seeing what else the new year will bring.
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