Construction finance: Arrested development

Construction finance remains scarce across the UK and continental Europe,
but alternative capital’s appetite may be growing, writes Lauren Parr.

Cain Hoy’s £450 million (€524 million) financing of a new office scheme in London’s docklands in April stands out in an otherwise supply-constrained market for European development finance. The private lender – itself also a developer – partnered with the Qatar Investment Authority to fund One & Five Bank Street, a 715,000-square-foot scheme under construction by Canary Wharf Group.

Banks are reluctant to underwrite large construction schemes and non-bank financers of development are typically focused on the smaller-scale, high-yield end of the spectrum. Cain Hoy’s deal hints that alternative capital providers’ appetite for large-scale development is growing.

John Cole, managing director of Cain Hoy, describes the transaction as a “proper property deal” which was underpinned, in part, by a 40 percent pre-let of the building to Société Générale. “The deal fit in well with our strategy of backing quality sponsors with a single cheque for large ticket finance at a time when traditional bank debt isn’t as plentiful as before,” Cole says.

One & Five Bank Street, London, financed by Cain Hoy.

In the UK market, development finance liquidity had improved prior to the country’s referendum on EU membership. De Montfort University’s year-end 2016 lending figures show there was £8.3 billion of development lending last year – not far below the £8.5 billion recorded in 2015. Of last year’s total, UK banks and building societies were responsible for 65 percent, demonstrating they were not closed for business.

However, the referendum has impacted banks’ willingness to support development, with them prioritising existing sponsors and recalculating terms. “Many transactions that originated before the referendum but advanced afterwards had their terms revised: a reduction in the quantum of debt offered and slightly increased margin,” says Andrew Antoniades, head of CBRE’s debt investment advisory team. “In the months since, lending margins have continued to increase.”

Around 2011, pricing for prime central London residential development schemes stood at 3.75-4.5 percent over Libor, Robert Pritchard, associate director in CBRE Capital Advisors’ investment advisory team, says. Prices were competed down to 3.25-3.75 percent by around 2015 and have since settled back at circa 3.5-4.25 percent, he adds.

Across De Montfort’s UK sample, average margins for residential development finance increased from 434 basis points to 528 bps last year, with the average loan-to-cost ratio at 76 percent. Margins on fully pre-let commercial development climbed from 339 bps to 401 bps, while 50 percent pre-let schemes saw pricing increase from 351 bps to 480 bps. Speculative financing, rare as it is, leapt from 384 bps to 556 bps across De Montfort’s sample.

“A gap has opened up in the market over the past eight to 12 months for large schemes with a debt requirement over £75 million-£100 million as uncertainty has crept into the market. With many lenders not wanting to be overly exposed to a particular scheme, borrowers often need to pull together multiple lenders to finance larger schemes,” says Pritchard.

One of last year’s major development financings, the £500 million funding of Brookfield’s 100 Bishopsgate Tower last July was done by a banking syndicate including Wells Fargo, Helaba, BNP Paribas, Italy’s Banca IMI, Singaporean lender UOB and Chinese bank ICBC. The five-year loan was understood to be priced around 300 bps in what market-watchers saw as a Brexit-defying deal.

So-called ‘slotting’ regulation has played a role in dampening UK banks’ development lending as construction loans are immediately categorised as higher-risk regardless of the individual circumstances of the deal. “Banks are simply dis-incentivised to lend to development, whether de-risked or speculative. This has had the impact of curbing the supply of debt,” says Antoniades.

European supply

Across continental Europe, the availability of development finance is patchy. German banks continue to embrace development as a means of improving returns in an ultra-competitive market (see panel). Some German banks have expanded into jurisdictions outside their domestic market, albeit on conservative terms with leverage usually capped at 60 percent.

Around 12 percent of Deutsche Hypo’s book relates to development, with ‘last mile’ logistics and mid-range residential properties within the bank’s target sectors, says Sabine Barthauer, a member of the bank’s board of managing directors: “Smaller projects nearer cities make it possible for big logistics providers like Amazon to deliver within a matter of hours. There are good business opportunities for banks in the Netherlands as well as France relating to modern, affordable residential projects which are in high demand but short supply.”

Spanish retail owner Neinver is one sponsor currently aiming to source development finance. The firm is planning to develop a 19,000-square-metre outlet centre at the Sugar City complex near Amsterdam’s Schiphol airport. “We’ve noticed more liquidity in the market and greater competitiveness among mainly local institutions, which are starting to offer more favourable terms for development projects thanks to improved market conditions and the characteristics of the project itself,” says Francisco Javier Cortijo, finance administration and controlling director at Neinver.

While there is a degree of availability of development finance from some European banks, most are cautious and do not tend to stray from core opportunities. Across both continental Europe and the UK, alternative lenders are more willing to finance construction, as a proportion of their activity, lending around the fringes of where clearing banks will go in both terms and pricing in pursuit of higher returns.

“We have noticed an ebb and flow of activity by mainstream lenders, be they clearing or mortgage banks. What appears to characterise banking appetite is cautious LTC, inflexibility and a requirement for all equity in up front. For that kind of lending banks are typically a little cheaper than us, but sponsors aren’t getting a lot of money,” says Anthony Shayle, portfolio manager of the UBS Participating Real Estate Mortgage Fund.

Non-banks step in

Alternative lenders will consider leverage up to around 75 percent LTC and can be open-minded on pre-sales and pre-lets. Many are flexible with regards to structure, providing senior, whole loans, mezzanine positions and preferred equity.

Shayle points to UBS Asset Management’s UK whole loan fund, which can write loans that straddle the development and investment phase. It may issue a two-year development loan to take a project to practical completion, before conducting another valuation then releasing equity. “Banks aren’t doing this yet. We are small team with a small portfolio which means we can act like private equity providers; it’s a different mind-set,” says Shayle.

“A development might take 18 months and generate us a great IRR, but that money has then got to be re-lent. If we’ve done the analysis to do the development financing, we should be happy underwriting the investment.”

Although alternative lenders’ aggregate capacity is relatively limited in comparison with banks, their impact is significant given banks’ aversion to risk. “In times of uncertainty, traditional lenders are more selective and will gravitate towards schemes that have been de-risked as far as possible, displaying a greater level of conservatism in their debt terms,” says Antoniades.

Under continued regulatory pressure, it is expected that banks’ overall development finance exposure will contract over the next few years. “There will always be schemes mainstream lenders will finance, but there is a role for us as well,” says Cain Hoy’s Cole.

The mix of lenders providing commercial development finance is likely to continue to evolve, argues CBRE’s Pritchard. “The commercial property market is often more fluid than its residential counterpart, and this can cause difficulties for traditional lenders with rigid credit policies,” he says. “Looking forward, it is likely that the more agile non-bank lenders will have a greater presence in the sector as they are better positioned to move with markets and capitalise on funding opportunities when they arise.”

German banks target additional margin through development

German banks continued to finance domestic development projects during Q1 2017, including HSH Nordbank’s €113 million sole underwriting of a large residential development at Media Harbour in Dusseldorf for developer Frankonia.

The latest figures recorded €32.3 billion of development finance in 2015, up 22.6 percent on the year before, according to the 2016 German Debt Project survey published by the real estate business school at Bavaria’s University of Regensburg.

Demand for funding by borrowers is high. HSH’s Michael Windoffer, head of cross-border business real estate clients, sees “a tremendous amount of residential development in metropolitan areas”. He also notes a trend among investors “who have, until now, preferred to invest in existing properties doing developments of their own”.

“This became much more visible last year and the beginning of this year because investors are facing pretty ambitious prices if they want to buy existing properties; they want to acquire some upside,” he says. Deutsche Wohnen, for example, recently acquired a large military site close to Berlin which it plans to convert to residential.

Borrowers are willing to pay higher margins of 180-200 basis points for development finance owing to the increased risk involved. Only a portion of such loans is eligible to be put into pfandbrief cover pools, which means development finance is mainly funded through the more expensive capital markets.

“The land part is used as a basis for pfandbrief then you incrementally add the balance you pay out every quarter to the amount eligible for pfandbrief, but that amounts to a small part of a development loan,” Windoffer explains.

Generally, banks remain conservative on the structural side. Loan-to-cost remains stable at circa 80 percent, while pre-let requirements are in the order of 30-50 percent. Only in Frankfurt, where large-scale office, retail and residential projects are springing up, is there sign of speculative construction.