Last month, with its biggest interest rate hike in 27 years, the Bank of England made clear that the era of historically low rates is coming to an end. Combined with soaring inflation, this poses challenges for residential development lenders.
The low-rate environment has been a valuable selling point for construction finance as an investment strategy. For over a decade, when institutional investors looked at real estate debt products, development lending was distinguished by the higher returns on offer in a low-yield world.
Meanwhile, rampant inflation is increasing the costs of construction. This has heaped additional pressure on an industry already reeling from Brexit-related labour shortages and supply chain issues. In worst-case scenarios this can affect site viability, and delay developers from starting new projects. In the residential sector specifically, declining consumer spending power and the higher cost of mortgages could dent demand.
Tightening monetary policy and an impending recession therefore threaten to increase the risk associated with development lending, while boosting the yields available from lower-risk real estate debt products.
Some fear this will dampen investor appetite for construction finance. However, we foresee continued strong demand for development lending products, for various reasons.
First, this remains a low-rate environment, historically speaking. Investors such as defined-benefit pension schemes still have sizeable deficits to address. They will look to their illiquid ‘alternatives’ allocations to drive returns.
Second, energy prices were projected to level off in the first half of 2023 and fall steadily over the medium term, and will now be subsidised by the UK government’s fiscal support package. A general easing of supply issues and cost pressures should drive down inflation next year and beyond.
Moreover, investors seeking to go more ‘risk-off’ need not shy away from development lending. Underwriting complex, higher-returning development loans requires greater technical skill and labour intensity, rather than greater risk. Leverage points are usually lower for development loans than investment facilities. Informed investors can de-risk their holdings elsewhere without having to trim their exposure to the asset class.
Finally, there are tailwinds for development lending that will continue to attract investor capital. Banks’ risk appetite will be reduced in a recession, meaning less competition for debt funds in construction finance. In the UK residential market specifically, there remains a profound structural undersupply of homes – a more significant determinant of demand than a weakening consumer environment.
Therefore, development lenders’ access to investor capital should not be called into question. The bigger issue will be one of fundamental performance. How will the construction finance market perform amid an inflationary environment? How can lenders manage the increased risk of their borrowers defaulting or asset valuations falling?
We favour lending to developers with fixed-price or guaranteed maximum price contracts and carefully analyse any variable elements. We ask our project monitors to report on at-risk materials – such as steel, bricks, concrete, cement and insulation. We require overrun guarantees of up to 10 percent, and a performance bond from the main contractor or a parent company guarantee. We retain the right to step in and complete the development if the developer defaults, safeguarding against stalled builds. We originate loans with sufficient equity buffer to withstand substantial falls in valuation. And we build a diverse portfolio combining for-sale and to-rent properties, ensuring exposure to the countercyclical nature of the latter.
The need to take these proactive steps is real. The challenging environment will drive a bifurcation between better- and worse-performing development lenders. Not everyone can successfully offset delayed delivery timeframes and rising development costs – just those who can deliver better and more careful credit selection, underwriting and portfolio management.
Crucially, market fundamentals for financing the development of new homes in the UK remain attractive. We believe this will outweigh investors’ legitimate concerns about macroeconomic headwinds. It is important they do, because insufficient, expensive and poorly designed housing is a major contributor to the cost-of-living crisis currently wracking the UK. Maintaining funding for new homes is one way to address one of the root causes.
Randeesh Sandhu is co-founder of Précis Capital Partners, a development financing platform focused on the UK residential market that launched in March 2021 with the backing of private equity firm TowerBrook Capital Partners.