UK development finance: A question of location

With an acute shortage of housing across the UK’s cities, the regions can offer more attractive financing opportunities than London, says alternative lender ICG-Longbow.

Through its £427 million (€505 million) segregated UK development lending mandate, ICG-Longbow has funded residential schemes in cities including Bristol, Cardiff, Southampton and Bath. In January, the firm closed its first London deal for the mandate; a £135 million loan to LBS Properties for The Madison, comprising 53-storeys of apartments in Canary Wharf. This is understood to bring the fund to over 50 percent invested.

Martin Wheeler

ICG-Longbow co-founder Martin Wheeler and managing director Adam Hayner discuss the non-bank provision of development finance and the merits of investing in London and the regions.

Real Estate Capital: How are alternative lenders capitalising on clearing banks’ reduced appetite for development financing?

Martin Wheeler: The reason the banks have stepped back isn’t just the perceived risk of development but the overhead you need to carry to be in business in terms of monitoring the development loan and on-going servicing. That’s why the specialist lenders are stepping into the gap and putting teams together that are the right size with the right skillset to originate and manage the loans.

Adam Hayner: There is a need for 240,000 new-build units per year across the UK, and at best 140,000 have been delivered. Another interesting statistic is how the development market is made up– in the 1980s smaller companies delivered about 45 percent of new-build housing but after 2008 it’s down to 11 percent. There is an opportunity for us to go out and identify these smaller groups and help them grow market share. There is finance available for developments of up to £10 million but there is less support for projects over £20 million.

MW: Lending outstanding to residential projects has halved since the peak of the market, which is a problem for the developers but it is the gap that alternative lenders have identified and it underpins the opportunity.

REC: Why did you opt for a segregated mandate with the residential development fund?

MW: Development funding sits better with a single-investor framework where you build an understanding with your investor over exactly what part of the market you’re targeting and why. It’s probably an investment type that’s suited to more sophisticated investors who have already got knowledge of real estate debt from investing in it on their own account elsewhere.

REC: How did your recent loan to an apartment tower in London tie in with your strategy for residential development?

AH: We focus on supporting projects where the land value hasn’t gone crazy so that they can be priced at a level which buyers consider affordable and at which they can obtain mortgages. With Canary Wharf, there was an opportunity to support a developer which had owned the land for several years and had created value by taking it through planning and providing evidence of buyer demand. The units there are one and two-bedrooms and priced around £700,000-£900,000, which isn’t cheap but is fairly priced for London.

REC: Recent media coverage of London residential has dwelled on an oversupply of expensive apartments in the face of weaker international buyer demand. Does that concern you?

MW: The concern that has been expressed in the market is that the stock has been built with a price point that cannot be afforded by London workers, which is where the demand is from. We’ve seen prices start to fall at the high end but less so in the market we’re in and even less so as you go more affordable. We have not been involved in high-end London development and don’t intend to be. We remain cautious on London but do believe there will be opportunity to invest further in projects that are appropriately priced.

REC: How would you compare regional residential development versus London?

MW: To a certain extent, it’s the same dynamic. There is an undersupply of new residential stock in most urban centres and demand from employees who want to work and live in each of these cities. And there’s a growing trend linked to the concept of urbanisation where younger employees want to live close to where they work in major cities across the UK, not just London.

AH: The idea of ‘live, work, play’ makes a lot of sense, but it’s important to focus on the characteristics of each place. You can’t apply a single template to everywhere and think that it will work, and this goes back to the point that development takes a lot of work and specialisation. We do spend a lot of time going to all these cities and understanding what’s going on, where the employers are, what the retention rates are from universities and what has been the scale of new-build development so that we can understand the characteristics of these places. The domestic market is very location-specific but certainly in London it is accepted that below £1,000 per square foot you get much more domestic demand.

REC: Does venturing outside London mean inevitably going up the risk curve?

MW: We think it’s the reverse, given that capital value volatility is relatively low in regions compared to London, especially when you look at the higher end of the London market.

Volatility is a straight proxy for risk and so when you’re in the regions you’re exposed to relatively low levels of the market risk. The risk then comes in getting your project underwriting wrong. If you’re not familiar with a market the underwriting risk increases, which is why you’ve got to be specialist and disciplined in your approach.

AH: Schemes need to be of an appropriate size for their markets, so that lenders do not fund the delivery of more stock than is supported by a market’s historical levels of demand.

REC: How has pricing of residential development finance changed?

MW: When we started this programme in 2015 we were expecting to see pricing compression and more competition coming into the market. But the banks have continued to pull back and, if anything, pricing has improved from a lender perspective recently. But when you think about it from a borrower’s perspective, land prices have adjusted, so equally the profitability on the development has been increasing providing the entry point on the land is correct.

REC: The development fund has gone for mixed-use projects as well as pure residential. Why is that?

AH: We like mixed-use schemes where the majority is residential but there are commercial elements as well – maybe ground floor retail or a food offering – and there is a mix between residential for sale and for rent. That mix helps to create a vibrant environment. It adds a level of complexity to understanding the various value elements within the scheme, but it also creates diversity of income.

REC: And reduces risk as well?

MW: It’s undoubtedly more difficult to underwrite as you need to work out the demand for the separate elements of the scheme but if it works, the demand should feed off each different element. If you get the combination right – backing the right developer in the right location – then it does de-risk it with the multiple sources of demand and the multiple exits.

REC: What is the outlook for the market?

AH: We expect Brexit is going to create more uncertainty and negative news; and that may have an impact on the availability of funding. Clearly with ultra-low interest rates and unemployment, there is risk on the downside. However, the shortage of new homes isn’t going away and we think that underpins the opportunity to fill a capital provision gap that we see as continuing and growing for some time. It’s important to understand the underlying metrics of the residential market – the demand, supply, profitability and the skill-set of potential developers – in order to be able to support the sector going forward.