Regions are back on the map as lenders look beyond M25


Conference reports lender interest in funding regional resi development, writes Doug Morrison

Lenders are starting to look beyond London’s buoyant residential sector and once again consider providing senior and mezzanine debt for developments in regional markets.

As Savills’ senior director William Newsom told delegates at the annual Residential Development Funding conference earlier this month in London: “The no-go area outside the M25 is now definitely a go area, provided the propositions are right.”

Newsom’s conclusion was based on a pre-conference straw poll that he carried out with 37 lenders active as providers of senior debt, mezzanine or bridging finance to the residential sector.

Among the lenders that said they would back regional projects are Aldermore Bank, Bank Leumi, Cheyne Capital, Close Brothers, Contour Capital, Dragonfly Property Finance/Maslow Capital, Investec, Southern Group, Strata Fund and Titlestone.

The high street banks – Barclays, HSBC, Lloyds Banking Group, the RBS group and Santander – also made the list Newsom revealed to the conference, which was held by LD Events on 2 July.

Newsom said 60% of RBS’s senior debt is secured against regional property. “I suspect that goes for the other UK clearers,” he added. “All the UK clearers are described as universal banks across the UK and to that extent relationships are very important.”

Yet surprisingly only the private banks in Newsom’s poll highlighted the importance of relationships with customers when it came to residential development lending.

However, the appetite for the provinces comes with predictable conditions for the borrowers: a proven track record and enough financial backing to cover potential cost over runs. Newsom said many lenders also seek personal guarantees from principals.

Scott Harvey, managing director of mezzanine specialist Contour Capital, told delegates: “We are starting to see a little value in the regions,” but stopped short of an outright endorsement.

Searching for a regional exit

He added: “We’ve looked at a number of regional opportunities and have very strong developer contacts we’d like to lend to. But I haven’t been able to get my head round the exit risk. We can underwrite a deal, but what is really fundamental is making sure you’ve got the exit route to get the money back.”

The backdrop to the conference was a widely acknowledged rise in property lending; Harvey described “an explosion in the number of lenders”. But until now the appetite for big residential developments outside London has been isolated to a few institutional investors, notably Patrizia Immobilien, Germany’s sixth largest property group.

Andrew Pratt, Patrizia’s new head of UK residential, who chaired the conference, last month outlined to Real Estate Capital a policy of not just residential investment in major provincial cities, but development too.

Like Patrizia, non-bank lenders appear willing to accept slightly higher risk by venturing outside London. Some conference delegates and speakers suggested that the renewed interest in regional opportunities has been partly influenced by the sheer competition among equity and debt investors alike for housing in the capital. Yet there was scepticism in the conference hall over the major banks’ commitment to writing new loans for residential projects.

Bob Sturges of Omni Capital, the bridging loan specialist owned by entrepreneur Christian Candy, said its “relative success” was due to an absence of mainstream banks in the market. “While we welcome the banks’ absence in a purely selfish fashion we recognise it is a disadvantage to the economy as a whole,” he said. “Customers give us the impression that banks are out of the game for another three to five years.”

But Phil Hooper, RBS’s head of UK residential development, defended the bank’s position and claimed it has provided “a bedrock” of senior debt finance to the residential market.

“We’ve got £3bn of drawn commitments to residential and an appetite to do more,” he said. “Our commitment is across the UK with no restriction on any particular parts of the asset class. We’re very keen to work with both existing and new clients. We write about £1bn of residential business every year.”

Hooper said that while RBS favours certain strong markets – and London is “particularly hot” – there “remains a risk associated with this asset class” not least because various government initiatives to boost supply and mortgage lending are still unproven. RBS’s £1bn is nonetheless broadly based – covering refinancing, asset-specific loans and unsecured lending to new and existing clients, which range from small businesses to national housebuilders.

He added: “A lot of entrants pulled out when the market got difficult but we remained consistent throughout that period and aim to do so as we look ahead. We will adapt our strategy. The market will become more competitive and we need to remain relevant to our clients and to the sector.”

Hooper also welcomed the new wave of residential lenders and equity investors as a healthy development. Several speakers said one of the most powerful market influences was the emergence of specialist senior and mezzanine debt funds (see p12).

Contour’s Harvey said debt funds are by far the most dominant force among the 30-plus providers of mezzanine finance he believes are targeting residential.

 Mark Bladon, a senior director of Investec Bank’s structured property finance team, suggested that debt funds represent both a threat  and a potential boon to established property lenders.

“Over 12 months ago we were lending 60-65% of cost to very strong borrowers with recourse in good locations,” he said. “Over the past 12 months there has been more market entrants, predominantly debt funds, because the terms I have described are very attractive and if you can get 10%-plus returns per annum, that’s attractive to investors.”

Bladon said: “Debt funds are interesting in that not being regulated they probably have fewer layers of compliance and credit authority and so can be competitive. But I also see that as a potential opportunity. We’ve done a number of 50/50 joint ventures with debt funds and they
can be quite commercial and it’s been beneficial to us and the client.”

Debt funds offer many tranches

He added: “What I like about joint ventures with debt funds is that they are more willing to provide senior and mezz, and possibly equity, so we share in all of those tranches.

“Before 2006 the more traditional structure would have been a high-street bank providing cheap funding on a lowly geared basis and someone like Investec providing mezzanine finance. At that point you were taking a subordinated position and missing out on the senior income.”

Bladon thought it will be around three to five years before most debt funds are fully invested or have reached their approved term. “By then, high-street banks will be back in the market and maybe some European and other foreign banks. “That will drive down funding costs and I think it will be harder for debt funds to raise money,” he said.

By then, perhaps there will be another force in development finance. As delegates heard, one emerging source of joint venture partners is the construction sector – contractors as providers of equity finance.

“I’m hearing increasing incidence of contractor finance,” Newsom said. “There are big construction companies out there who are cash rich.” Bouygues, Galliford Try, Kier, John Laing and Sir Robert McAlpine are understood to be among the major contractors prepared to form joint ventures to fill the funding gap for developers.

Robert Finch, director of Sativa Finance, said contractors are not only flush with cash but keen to get building. “They can be a very good potential joint venture partner,” he said. “That’s a really interesting area for the right project. They have the balance sheet, expertise and the equity and can also make finding senior debt more straightforward.”

One small step for resi REITs, but a giant leap needed in legislation

The flotation in May of what some have described as the UK’s first residential REIT, by Gravis Capital Partners, was greeted with little fanfare. Then again, as its name reveals, GCP Student Living is a specialist company.

Even by the standards of this thriving sub-sector, a company with a market capitalisation on flotation of just £73m is tiny. The truth is that the REIT regime has singularly failed in what it was set up to do – attract mainstream institutional investment in housing.

Cane: "There is a well publicised financing gap and new sources are needed to fill it"
Cane: “There is a well publicised financing gap and new sources are needed to fill it”

As Marion Cane, executive director and property tax specialist at Ernst & Young, told delegates,the REIT structure’s tax benefits are insufficiently attractive to institutions to compensate for the restrictions.

In essence, REITs are income-based vehicles and forbid trading of assets as a means of generating revenue. Yet that is how residential investors overcome the low income yield of residential and achieve superior total returns over commercial property.

There have been incremental reforms of the REIT laws. However, Cane said that “if the government is serious about large- scale institutional investment in the residential market” it should lift the trading restrictions and amend similarly prohibitive VAT and stamp duty rules.

Cane also called for an industry-wide consultation on mortgage REITs, which are debt funds that she believes could increase the supply of finance to developers.

The Treasury considered mortgage REITs last year before kicking the concept into the political long grass, not least because of their turbulent history in the US. But in the US they are aimed at homebuyers and highly geared.

“The vision for the UK would be to provide finance for property lending, including loans to residential developers, backed by investor equity – conservative gearing and match term funding,” said Cane.

She added: “With the backdrop of increasing bank regulation discouraging lending there’s a well publicised financing gap and new sources are needed to fill it.”