Last month marked 10 years since the collapse of Lehman Brothers, an event that sent shockwaves around the world. With a consensus that the UK real estate market is late into the cycle, and many predicting that there could be a significant price correction, have all the lessons from 2008 been learnt?
In the UK development finance space, most lenders are exercising caution. The mainstream banks that bore the brunt of the 2008 fallout are understandably reluctant to lend at loan-to-cost ratios above 60-65 percent, while even the new breed of alternative lenders – with higher risk/higher reward strategies – aren’t straying much beyond 70-75 percent.
And yet a quick look on the internet or chat with a debt broker will reveal that leverage is readily available, from some parts of the lending market, at as much as 85-90 percent loan-to-cost, often reported as around 70 percent loan-to-value. This sort of debt is available in a market where prices are softening, demand has stagnated and there is a real threat of higher borrowing costs.
What is driving this? The make-up of the lending market has changed significantly since 2008. Ten years ago, it was the clearing banks who took on that sort of risk. Only because they were too big to fail did the likes of HBOS and Royal Bank of Scotland survive via taxpayers’ money.
The void left by the retrenchment of high street banks from stretched senior development and mezzanine finance has been filled by a new breed of specialist lender, often backed by private equity capital. These platforms have high hurdle rates and IRRs to meet, reflecting their higher cost of funds. To achieve this pricing, lenders need to take more risk. Borrowers seeking this level of leverage tend to fit a certain profile: limited track record, small amounts of their own capital invested and under-developed banking relationships.
If – or when – the music stops and the developer collapses, their problems become the lender’s. Market players will acutely remember this happening when the Irish and UK clearing banks got into trouble in 2008. There is a danger some smaller and less capitalised borrowers and lenders will head the same way, with distressed asset coming to the market for more experienced developers to pick up.
However, there are factors which will limit the fallout if these highly leveraged loans go into default. The type of private equity investors that fund higher leveraged lenders will not cause a country-wide financial crisis – unlike the banks last cycle, they do not present a systemic risk to the UK economy.
Private equity investors also have experience investing in higher-risk markets, more so than their predecessors, the UK clearing banks. Indeed, at this stage of the cycle, a number of private equity firms see high leverage debt as a better risk adjusted investment than equity, given the third-party equity buffer ahead of their loans. As traditional equity investors they should also be better equipped to weather cyclical, or politically inspired market downturns.
Predicting what 2019 will bring is a fool’s game. The macro picture is increasingly uncertain, exacerbated by the ongoing political turmoil which has been reflected in recent Savills data that pointed to a softening of overseas money pouring into the market. The days of cheap borrowing could be coming to an end with construction and labour costs remaining stubbornly high.
However, favourable supply/demand dynamics exist for a range of property types across the UK that will bring opportunities to generate significant returns during the uncertain times ahead. For borrowers that are looking for an alternative to high-leverage, high-margin debt funds, there is value in fostering relationships with client-led lenders that can offer certainty of funding, a quick turnaround and a more stretched senior product than the high street banks.
While the availability of high-leverage debt in the UK real estate space is a concern, its impact on the overall market should be limited. For the wider market, there are reasons lenders which are not chasing such high-risk strategies should be cautiously optimistic for real estate markets in the short to medium term.