Forests of cranes were a familiar sight on Europe’s cityscapes during the real estate boom leading to 2008. This time around, building activity is far more limited.
A tight supply of construction finance, particularly in the UK, has contributed to the lack of development. Banking regulation has attached higher risk-weighting to construction loans, dampening many lenders’ appetites.
Things are changing in some areas. Core investors have plenty of equity to deploy, but fewer prime buildings are coming to the market to satisfy demand. As a result, some are turning to ‘build-to-core’ strategies – buying non-core buildings in the best locations and turning them into institutional-standard product.
Speaking at a briefing to journalists in London in March, AXA Investment Managers – Real Assets chief executive Isabelle Scemama acknowledged that upside in the market can be found through development. “We have €9 billion in development across Europe, mainly in offices,” Scemama said. “We are a very large developer in the office sector. It is a way for us to capture the development margin when assets are expensive. We are strong believers in development in places like Germany and France.”
Lenders, who are also seeking additional returns in a low-margin senior lending market, seem to be responding to such strategies. Allianz Real Estate, a conservative lender, has broadened its debt capabilities to allow for development financing alongside its senior strategy. The rationale, explains head of debt Roland Fuchs, is to capture additional returns by backing schemes that Allianz would be prepared to invest in through the value-add strategy of its equity real estate business.
Continental European banks also appear keen to selectively back development. The head of real estate lending at one organisation says there is an impetus to increase the bank’s development finance portfolio, with “heavy renovation” activity happening across key markets.
“There is more interest in development finance in continental Europe, from banks and funds,” says one debt advisor, “although very few are capable of taking planning risk.”
Indeed, much bank interest is focused on relatively low-risk schemes in core locations. Refurbishment and redevelopment, rather than speculative, ground-up construction, is likely to be the focus.
In general, development finance remains a scarce commodity. The picture varies across Europe, although construction debt remains a distant second to investment financing in most lenders’ books.
German banks are prepared to fund schemes, to supplement their lending activities in the investment financing arena, which typically provide low margins. Development loan margins in Germany can be in the region of 200-300 basis points, which represents a healthy premium on senior investment lending, which can be sub-100bps.
The mid-2017 German Debt Project research by Bavaria’s University of Regensburg highlighted an uptick in construction lending in 2016. New business to finance development projects was 26 percent of activity, up marginally from 23 percent in 2015.
“The biggest constraint is not the availability of finance, but the fact that land has become too expensive for most developments,” says Michael Kröger, head of international real estate finance at Helaba. “Sellers of land want a premium and land prices are a residual value calculation. Many schemes for which finance is being sought are on land bought some years ago.”
Office schemes in markets such as Germany and France can attract finance, provided an adequate proportion of a scheme’s floorspace is pre-let, Kröger says: “The scarcity of finance is for speculative schemes. Pre-lets that provide 100 percent interest coverage are helpful for lenders, although additional capital reserves are needed.”
UK debt market participants note the continued lack of availability of finance, due predominantly to construction finance’s treatment under the Bank of England’s ‘slotting’ regulation. However, research shows that there has been a pick-up in construction activity.
Birmingham, Manchester, Leeds and Belfast all saw a sustained, or increased, level of development across sectors including offices, residential, hotels and student housing, according to the Deloitte Real Estate Crane Survey UK, published in February. The consultant noted 17,000 residential units under construction across the cities surveyed. In Birmingham, it identified 13 new residential construction starts, 1,782 student beds underway and 1.4 million square feet of offices in the pipeline.
“In cities such as Manchester, mainstream lenders ducked out of the market years ago,” says Simon Bedford, partner and regional head at Deloitte Real Estate. “They have been replaced to a degree by sovereign wealth funds and there are a lot of forward funding deals. UK pension funds have provided equity funding for schemes – not in huge lot sizes, but they are in the market.”
From a debt perspective, though, market participants say financing construction projects remains a significant challenge in the UK. “Development finance is constrained and will never return to the levels at which it was available, pre-crisis,” says Andrew Antoniades, head of debt investment advisory at CBRE.
“Banks have changed their models for some time now. Slotting makes it very difficult to fund development, so there has been a twofold retraction; there is a lack of overall quantum of debt made available for development, and the terms at which the banks are prepared to lend have been tightened.”
Conventional construction finance from traditional lenders is rarely available above 65 percent loan-to-cost and to get to 75 percent LTC is a challenge for developers, who need to seek out alternative non-bank lenders, Antoniades explains. “Liquidity from banks may increase a little over time, but they appear unlikely to do significantly more. They seem to only want to target the major developers. The alternative lenders are left to take up the slack, but it falls far short, as the financing gap is billions of pounds of liquidity.”
At the smaller end of the scale, specialist lenders are financing typically residential projects. Loans are usually below £10 million (€11.4 million), up to 85 percent LTC and with short durations and high margins. At the larger end of the alternative lender market, a few major well-capitalised debt funds provide development debt, selectively, providing scope for larger-ticket deals.
Raising finance for big-ticket, prime schemes in London is possible, although deals will typically be arranged by clubs of lenders. “The big developments are a special case. If a developer needs £400 million, there are only a handful of banks, and then maybe a couple of alternative lenders, who can make that scale of a deal happen,” says Antoniades.
However, assembling a suitable club can be challenging, as lenders’ risk appetites vary. Senior lending banks might be prepared to lend against a part-pre-let development scheme at 250-300bps – but few would go beyond a 65 percent leverage cut-off point. The handful of alternative lenders which can lend in scale might be prepared to offer leverage up to 75 percent, but the pricing they would charge would be far higher.
“The problem is, when developers are trying to source that quantum of debt, the German banks and alternative lender structure deals differently. Then different lenders will have different pre-sales hurdles. Unless the lending club consists of lender who are very similar, there is a risk of borrowers having a misaligned club with an amalgamation of the worst terms,” says Antoniades.
Anyone hoping for a deluge of development finance to flood into Europe will most likely be disappointed. However, as core investors explore build-to-core strategies, senior lenders’ appetites for construction lending are likely to be whetted. In the wider market, however, real estate finance providers are likely to remain cautious about putting money into building sites.