They say life is tough at the top, but in truth, the largest public and private property companies with a strong balance sheet have relatively easy access to development finance and can often use corporate banking facilities or capital market funding (corporate bond issues, private placements etc.) to fund their development activities cost effectively.
In addition, many banks are willing to lend anywhere in the UK on development projects, provided it is for the right sponsor with the right project in the best location, and at least partially pre-let. International banks are typically more ‘London-centric’ and prefer larger transactions in prime city centre locations.
However, following the introduction of Slotting, UK bank regulation has become more restrictive, and increased regulatory capital requirements have imposed additional costs on development lending, particularly for speculative development. Therefore traditional bank development finance, particularly for speculative development has fallen sharply (see chart below); it is now restricted by leverage (c. 60% maximum Loan To Cost), contingent on pre-lets and usually relationship led.
So while banks still dominate the market for senior lending on pre-let and pre-sold developments to large scale REITs and developers, alternative lending platforms are now providing an increasing proportion of development finance for speculative schemes and developers who are outside the group of the largest public and private property companies.
Non-bank alternative lenders are not subject to the regulatory costs imposed on banks, therefore they have stepped in to fill the gap in the market for speculative development finance that banks largely avoid due to regulatory capital charges.
ALTERNATIVE LENDERS – PLUGGING THE GAP
Non-bank alternative lenders are a broad group, operating diverse business models that target specific lending sectors to meet investors’ IRR expectations.
Until c. 18 months ago, many alternative lenders focused mainly on residential or residential-led schemes in London and the South East but most now lend across the UK. Increasingly alternative lenders are targeting purely commercial schemes in major cities and regions across the UK. At Aeriance our debt funds were originally targeted at residential development in the ‘golden postcodes’ in the West End of London, but since 2013 we have been lending against residential and commercial development opportunities across the UK, with an increasing focus outside London
The shift in focus for alternative lenders away from residential development is outlined in the charts provided by De Montfort University in their UK Commercial Property Lending Market Report (see below). The figures for 2015 are expected to confirm that the trend towards diversification across asset classes has continued.
Alternative lenders now cover the full spectrum of development finance projects, from senior debt for a refurbishment project, to mezzanine finance for a speculative commercial development.
Due to the diversity of business models, alternative lenders’ IRR targets range from 7% to 20%+ dependent upon the lender’s risk appetite and sector focus; like traditional lenders returns are met through a combination of margin/coupon and fees, though profit shares and other types of return participation can also be considered.
Typically, alternative lenders offer stretched senior loans or whole loans, but some will also consider providing mezzanine debt behind a traditional senior lender. The ability to offer a whole loan solution for developers is a key competitive advantage for debt funds as it provides borrowers with certainty of funding, while reducing the execution risk, timescales, cost and complexity of a more ‘structured’ solution with multiple lenders.
Whole loans are typically available at up to 85% Loan to Cost, though some lenders may stretch to 90% in certain circumstances. This can boost IRR returns for developers to make projects economically viable, reduce the need for joint venture partners, and allow developers to proceed with multiple transactions.
Developers are attracted to the more bespoke and tailored financings offered by smaller debt funds who are more flexible than traditional banks with set credit criteria. Debt funds have the ability to deliver funding solutions quickly, with loans provided in a matter of weeks, often considerably faster than institutional lenders.
Debt funds are also an increasingly popular investment for institutions eager to increase their real estate exposure and benefit from strong fixed income returns, at a relatively low risk.
THE RISE OF PEER TO PEER LENDERS
‘Traditional’ funding options for small developers are very limited compared with those available to their larger counterparts, as only a handful of banks will lend conservatively in the sub-£5 million space.
There are however, several alternative lenders that specialise in funding smaller developments. In addition, the past few years has seen the emergence of a new type of lending platform, the Peer-to-Peer lender. Peer-to-Peer lenders match retail investors’ (ordinary savers) risk appetite with borrowers, making it well suited to financing smaller developments.
Peer-to-Peer lenders offer retail investors fixed income returns that are higher than those available in UK savings accounts, though clearly there is greater risk for the investor as their investment is secured against a property or development project.
Peer-to-Peer lenders operate a range of business models, though many initially fund loans using an existing pool of money, pre-sourced from high net worth individuals or institutional investors before then selling down all or part of the loan to retail investors.
To date, the main sector focus has been residential, though an increasing number are now lending against student accommodation, commercial and mixed-use developments.
Peer-to-Peer lenders have focused on smaller deals with loan sizes range from sub-£1 million up to c. £10 million. Like other alternative lenders, loan pricing varies widely, depending on the usual factors such as location, sector, developer and LTC/LTV. Given the fixed costs of the origination and syndication platform, coupled with the coupon requirements of investors, pricing for smaller developments ranges from 8% – 15%+ coupon, with arrangement and exit fees in addition.
Peer-to-Peer lending is a fast growing and evolving sector of the development finance market. Some platforms are intending to include Peer-to-Peer exposures in tax-free ISAs, and there are vehicles to enable the inclusion of Peer-to-Peer loan exposures in Self Invested Personal Pensions (SIPPs). In future, alternative lenders and banks could move into the Peer-to-Peer space by acting as a conduit for retail investors; therefore this sector of the market is likely to see continued innovation and rapid growth.
One area of concern in relation to Peer-to-Peer lenders is that due to their ‘start-up’ nature and the timing of their entry to the market, their credit and risk management capabilities remain untested.
THE FUTURE OF THE DEVELOPMENT FINANCE MARKET
For many investors, 2015 has been a cyclical ‘sweet spot’, with property companies finding little difficulty in obtaining debt finance if they are a large, established developer with a good track record; and increasing exit prices for completed schemes.
We consider the breadth of funding options for developers to be beneficial for the broader real estate market; diversity of lenders can contribute to financial stability by spreading risk and exposures across a greater range of investors, and increased competition has reduced pricing.
However, looking ahead there are increasing concerns regarding rising site costs, construction costs and potential overheating, particularly in the central London market. The uncertainty over Brexit will also linger until June, though we have seen no evidence of a slowdown in loan enquiries as most developers do not have the luxury of being able to sit on sites which are ready to develop.
On the funding side, many new entrants to the market have yet to experience a downward cycle in the real estate market, others are staffed with experienced former bankers who have worked through a number of recessions and crises.
We anticipate a steady increase in development activity once the Brexit referendum is behind us, as sustained occupier demand is likely to lead to more development; with increased competition among lenders to finance the best schemes.
We expect increased liquidity in the development finance market driven by alternative lenders, as new entrants come to the market and established alternative lenders deploy newly raised debt funds. Bank development lending appetites are likely to continue to be severely constrained by regulatory capital issues.
Increased liquidity is likely to accelerate the trend of lenders looking to the regions to source deals and should increase the availability of speculative development finance. The prevalence of mezzanine development finance is also likely to increase as investors move further up the risk curve to meet their return requirements.
Additional liquidity is likely to lead to lower pricing, though regulatory capital constraints for Banks and investor return requirements for alternative lenders should ultimately put a floor under pricing for development finance.