UK FEATURE: Debt funds hungry as the banks lose appetite for risk

With frustration growing at the banks’ rigorous selection criteria, the development finance market appears to be opening up for alternative lenders. Lauren Parr examines how the market may evolve.

For debt funds that engage in project financing, a chink has opened up in a part of the UK development market historically served by traditional lenders.

Naturally skewed towards the lower-risk end of the development spectrum, banks’ tolerance of risk has moderated further over the past six to 12 months as a result of slotting regulation and uncertainty caused by Britain’s potential exit from the European Union.

“Volumes are substantially reduced in the investment and development market and with that it’s fair to say some sources of finance are currently holding off to see how the market evolves in the short term,” says Anthony Shayle, head of global real estate – UK debt and portfolio manager for UBS-PREMF.

Developers bemoan the fact that there is less visibility than ever before on the banking market. Banks each have specific criteria against which they are prepared to lend, and that check-list seems to be changing quarterly.

Says Mike Ingall, chief executive of Allied London: “You might need to speak to eight to ten banks to find a deal because each has different boxes they need to tick. Some won’t do offices or residential, some prefer pre-lets, some only do 50 percent LTC.”

Essentially, he says, banks are being more particular: “They are assessing risk much more closely.”

Pricing out

Pricing has moved out slightly by 25 basis points (bps) to between 250 and 325 over Libor for partially pre-let commercial developments in the core market over the past year, due to general uncertainty.

As a result of banks’ reluctance to get involved, alternative financiers including PGIM Real Estate (formerly Pramerica) are reporting more opportunities this year than last.

“There is a slight reduction in banks’ risk appetite, meaning schemes on the edge of being seen as ‘good quality’ have tipped over into the ‘lower quality’ bucket,” says Chris McMain, transaction director at debt intermediary Laxfield Capital.

Development finance is particularly harder to come by for prime Central London residential property valued at more than £1,500 per sq ft, a market which has softened of late. Royal Bank of Scotland and Lloyds were active in this space last year, but are “struggling with allocations to that sector this year” according to a debt fund manager.

The location of commercial assets is also under the microscope.

“Banks may be thinking ‘we’re not so sure property on the fringes of the City or West End is still core and if it’s not core maybe we are uncomfortable looking at it’ while alternative lenders might be saying ‘we should be making hay while the sun shines’,” says Shayle.

Looking to de-risk

It could be that Old Street roundabout, Southwark or Hammersmith for example are no longer viewed as core destinations, save for pre-lets. “That’s the subtlety; it’s not a simple case of saying the line on the map has been redrawn. Banks are looking for de-risking factors like lower loan-to-cost (LTC) ratios,” he says.

Typically, LTC ranges up to 60 percent and a pre-let equal to circa 50 percent is required.

Concern surrounds who the end investors in completed schemes will be, off the back of a marked reduction in overseas investors looking at Central London offices. Yields have moved out over the past six to nine months at the prime end and there is an expectation that rates of rental growth will slow down as well.

“Central London is where it begins, with a ripple effect spreading out to the regions. Where banks had started to dip their toes into the regional market and were starting to be a little more aggressive in terms of pricing they are probably saying ‘we should wait and see what happens during the course of 2016 in the regions’,” Shayle says.

Laxfield’s McMain has a birds-eye view of the market, and his observation is that it is becoming a two-tiered one.

The core end of the market relates to affordable build-to-sell residential property and private rented sector (PRS) stock and good, pre-let, particularly office space in London and major regional cities.

Such projects are readily financed, predominantly by UK clearing banks.

“There are signs that non-clearing banks and non-domestic institutional money is trying to get into that space,” McMain notes.

On the commercial side, French and German banks are becoming more prevalent on pre-let deals.

Core institutional investor TH Real Estate is currently in early talks with one French lender, one German lender and a UK bank for a development it is preparing in the City. It is seeking a 50 percent pre-let, with pricing looking likely to be in the range of 2.5 to 3 percent.

A handful of speculative financings are available on landmark projects like The Post Building in Holborn. BNP Paribas and pbb Deutsche Pfandbriefbank in January provided existing clients Oxford Properties and Brockton Capital with £230 million of debt for the office redevelopment, thought to be priced in the mid-200 bps range at a 60 percent LTC ratio.

The higher-risk end of the market encompasses high-value residential property and speculative commercial schemes funded by alternative lenders from small-ticket providers such as Topland, Omni and Urban Exposure, to low-teen net return mezzanine and whole loan issuers like LaSalle Investment Management and PGIM Real Estate.

‘Biggest this cycle’

Hedge fund The Children’s Investment Fund is backing Almacantar’s redevelopment of Marble Arch Tower and 466-490 Edgware Road with a £400 million loan in one of the biggest speculative deals this cycle and the financier’s first real estate loan in the UK. The project involves a mix of offices, flats and retail.

“The bulk of alternative lenders are prepared to do some development and take a bit more risk. Whether they look for pre-letting or not depends on the quality of the opportunity and what returns can be achieved, while limiting their exposure on an LTC basis and asking for all equity up front,” says Shayle.

“We will lend on speculative development providing we can satisfy ourselves that the market is provable on a lettings basis. We come at it from the property end of the market, taking a pure equity view as if we are holding the asset ourselves. We then look at a developer’s track record and ability to deliver a project.”

McMain says “alternative lenders are entirely dominant in their market segment; it’s not a space where institutional lenders tend to play”.

They constitute a relatively small part of the development financing market, with only selected debt funds providing such loans as undrawn committed lines are expensive; and most need income.

Ticket sizes are often smaller (typically less than £50 million), while LTC ratios are higher (up to 75 percent LTC). Pricing is steep compared with bank finance, yet borrowers are willing to pay margins above 500 bps on speculative commercial developments in order to help unlock projects.

Andrew Macland
Andrew Macland

“Our funding is complementary to equity to get schemes off the ground at an early stage of the process,” PGIM Real Estate’s head of UK Andrew Macland explains.

The capital it invests works well where developers have got an anchor tenant pre-let (20 to 30 percent) which is insufficient for banks’ capital but the scheme is “hard baked” i.e. without planning risk.

PGIM Real Estate underwrites the whole construction programme on day one, with senior bank debt coming in subject to certain pre-let hurdles (60 percent-plus) being achieved.

“We take a joint venture type approach, taking the risk of completion and pre-lets kicking in but having priority return,” he says.

A prominent deal involved the financing of Allied London’s Spinningfields business district in Manchester. Lloyds, PGIM Real Estate and the North West Evergreen Fund provided a £120 million loan to bring forward the No.1 Spinningfields office tower (15 percent pre-let to PwC) at the heart of the estate.

Funds more ‘conversational’

Liaising with a debt fund “is more like having a conversation with a partner than a lender”, reflects Ingall. Often such lenders are approached before the banks, and sometimes it is simpler to use debt fund capital to fund all of a project.

“They are looking at exit and where the return is rather than necessarily focusing on the risk,” Ingall says.

UK development funding has been improving in the aftermath of the global financial crisis but is still coming off a low base, far below historical levels. Banks remain hesitant, bound by regulation which makes allocations to development finance more costly than investment finance.

With the EU vote on the horizon their message to developers is “talk to us after,” says Ingall.

While terms and pricing are comparable among banks, as with investment loans, development loan margins have gone up as a by-product of uncertainty.

Says Andrew Antonaides, a senior director at CBRE Capital Advisors: “The possibility of Brexit has not helped development finance; the same can be said of the provision of debt finance generally. However, should the UK vote to remain, we are predicting transactions will pick up again relatively quickly. The question is whether this creates an opportunity between now and the vote for lenders who are willing to provide debt to take advantage of reduced competition.”

Weak fundamentals emanating from the Central London market are a reason for continuing caution among all lenders, although banks are expected to be more selective in their activity than debt funds.

“You won’t see margins doubling but the availability of bank debt may well become more constrained. You’ll find lenders are more choosy and thoughtful and when they are ready to lend their appetite for higher LTC may be curtailed,” says Shayle.

This could hold the door open for alternative lenders, with developers’ track records their steadfast priority.

Little call for alternative lenders in German development market

The German market for development finance is on a different course to the UK, with ample availability, reduced pricing and little call for alternative lenders.

For the last few years development finance has been readily available for more or less all asset classes. “That goes for smaller ticket sizes and large-scale deals of a few hundred million euros, as long as the project is of good quality and the location is right with some pre-letting in place,” says Michael Windoffer, head of cross-border business real estate clients at HSH Nordbank.

There is strong interest by banks to finance residential developments because “the selling risk is pretty low considering the tremendous shortage of housing in metropolitan areas like Hamburg, Stuttgart and Munich,” says Windoffer.

Speculative financing is easiest to obtain in this sector, according to Markus Kreuter, head of debt advisory in Germany at JLL. “Multi-family property let to private tenants in Berlin is something any bank would touch as it’s the hottest market you can see,” he says. As such, developers can secure “reasonable LTCs” of 70 to 80 percent.

‘Spec’ financing is more limited for office projects given the high level of space coming online in a market like Frankfurt, for example. Commercial schemes that are pre-let to one or more tenants are straightforward to finance, with logistics and self storage assets growing areas of development.

The German bank market is strong, partly as a result of German banks having refocused on their home market. Competition has driven down pricing for development finance, from 240 bps over Euribor three years ago for residential property to circa 200 bps or less today. Commercial schemes range more widely depending on the location and how much equity there is in a transaction, although margins have come down in general by 40 bps over the same period.

There is little requirement for non-bank finance as “senior lending for development goes up to 80 percent LTC which doesn’t leave much room for alternative debt providers,” says Windoffer.

A gap for mezzanine funding does exist in the residential sector, where some German developers are weak on the equity side and additional capital is brought in via mezzanine money in equity structures.

Tishman Speyer has only financed developments using conventional bank funding, where it has found sufficient liquidity for its “fairly conservative” requirements.

Says Michael Spies, who is responsible for Tishman’s European business: “German lenders remain strong lenders across Europe and with German regulators keen to see lending within their domestic market, when there is an opportunity to lend in Germany there has been particular interest.”

His sense is that more lenders are prepared to lend on development in Germany than in France. Tishman has financed a ground-up office development on the edge of Paris with a cost of €180 million with 60 percent LTC debt from French banks.

“You’re not getting bids from five or six French banks. In most cases it ends up being a couple of banks that come together on a deal. There is still a sense of caution; it’s a conservative lending environment.

“Banks generally are cautious. It’s a period with increased scrutiny from regulators and ongoing awareness of risk,” he says.