Commercial projects are yet to benefit from a surge in property lending, reports Doug Morris
These are frustrating times for commercial developers. UK plc has taken its initial, tentative steps on the path to recovery and occupiers have shown signs of expansion for the first time in years… just at the point when some familiar concerns have been raised about property lending.
Writing in the Financial Times on 8 April about the interplay between credit markets and so-called “safe assets”, respected commentator John Plender warned: “There is a slide afoot in lending standards, with a reversion to such pre-2007 bad habits as ‘cov-lite’ loans that provide poor protection for investors.”
Later that week, Ian Marcus, senior adviser at Eastdil Secured and chairman of the Bank of England’s Commercial Property Forum, was even more forthright as one of the speakers at an AEW Europe-organised economic briefing in London.
“I am astonished, even in the past three months, how not just the availability but the pricing has continued to move,” he said. “We’ve seen senior debt come in another 50 basis points this year, so we’re now looking at 140, 150 over Libor. That would have been 250 last year. We’ve seen loan-to-value ratios going over 80% again.” Marcus added: “Even development finance is now coming back.”
Banks favour new housing
Perhaps so, but it is largely coming back into new housing. So far, relatively little bank debt has found its way into commercial development. De Montfort University’s commercial property lending report showed that just 5% of traditional lenders’ allocations went to commercial development, compared with 12% for residential development and 83% for investment.
It is the latter that is causing consternation among the property sceptics, but it is the commercial developers who are struggling to be heard above the hubbub of anxiety. Recent CBRE study UK Development Funding: Is It Available? suggests that it is, but sparingly. CBRE estimates that bank allocations for development finance in 2013 will be a re-run of the modest totals for 2012: £12.4bn for residential development; £5.3bn for fully prelet commercial development; and as little as £1.8bn for speculative commercial development (see fig 1, below).
CBRE says this level of allocation “can be considered as a new, re-based equilibrium, where development debt constitutes an integral, but more limited, part of lending”. While commercial developers have yet to exploit any slide in lending standards, their residential counterparts have a beguiling choice of debt providers, both banks and newcomers.
William Newsom, valuation director of Savills, says as many as 50 debt providers are willing to back residential development – up from 45 a year ago. But “there is a world of a difference” between that sector and commercial, he adds, which invariably requires a prelet before attracting most lenders to the negotiating table.
“So far as commercial is concerned, an increasing number of lenders are talking about providing development finance, if the right opportunities arise,” says Newsom. “However, the number of closed deals actually struck where development finance has been provided remains very scarce and I don’t think I’ve heard of anyone providing speculative finance.”
Further bleak context is provided in De Montfort’s mid-year 2013 lending update, published in December, which confirmed “continued weak appetite for providing commercial development finance” – and this limited appetite was largely for prelet developments.
Contradictions in the lending market
De Montfort’s report sums up perfectly the apparent contradictions in property lending for it, too, warned of a potential mispricing of risk in property generally, following a decline in interest rate margins and increase in loan-to-value ratios across London and the south east.
Yet only three organisations provided De Montfort with speculative development data for this report, compared with no organisations for the year-end 2012 – an improvement in development finance, but not that you would notice.
As Newsom suggests, commercial development is an “under-populated area of lending”. He adds: “We have this huge splurge of lending and lending ambition, and everybody is busy reducing interest rate margins, increasing LTVs and relaxing loan covenants, yet is it not extraordinary that we’ve seen little or no commercial development lending, let alone spec?”
It is all the more extraordinary given the need for commercial development in provincial cities. Lenders’ liking for residential development is often attributed to the imbalance between growing but still moderate supply and huge demand, which renders this sector relatively low risk.
Yet CBRE director Andrew Antoniades, author of the Development Funding report, points out that a similar supply/demand imbalance exists for offices in many cities where there has been a dearth of new stock since the downturn.
Through CBRE, Antoniades also acts as a fund manager of the North West Evergreen Fund and Sheffield’s SCR JESSICA Fund, two European Regional Development Fund- backed vehicles that have helped fill the funding gap for development, but with regeneration and sustainability criteria including BREEAM benchmarking.
Those criteria aside, these funds have provided mezzanine finance – occasionally senior debt – for commercial schemes that would have struggled to secure capital otherwise. For instance, Evergreen backed the redevelopment of familiar Manchester landmarks the Soapworks and Citylab.
It is also reportedly in advanced talks to finance Allied London’s 160,000 sq ft Cotton Building speculative redevelopment in Manchester’s Spinningfields district. Antoniades says: “Somewhere like Manchester is desperate for economic recovery but can’t attract top occupiers until it can demonstrate it has got the assets.
“This is a common theme in the regions. Developers face pressure from occupiers who say: ‘We are happy to take a prelet, but can you prove that you can fund it?’ There is an acute under-supply of BREEAM excellent, grade A office space, but it is starting to come through.”
CBRE’s report says Lloyds Banking Group, Santander, RBS and Barclays demonstrate renewed appetite for develop-ment outside London, which is “a definite change” from a year ago. But Antoniades adds that banks prefer another lender, such as Evergreen, to take a mezzanine position.
Banks seek ‘derisked’ situations
“Frankly, they want someone else to take the risk,” he says.” They will fund a scheme, typically to 50% [loan to cost], maybe 60% if they have a strong relationship. But they would like a prelet of 50% or above, a first charge and all the priority in any inter-creditor arrangement, plus lots of headroom, and they will put their money in last. From my experience they prefer situations that are completely derisked.”
Availability and leverage are not the only issues in regional development. Pricing of development loans for provincial offices is far removed from the fevered competition for standing investments in London. CBRE says margins have increased to 400 basis points, typically, for more attractive, fully-let developments.
Antoniades says sentiment is changing towards commercial development partly because of recent concerns of a residential price bubble in the south east. “It is more of a concern for equity than debt, because debt lent at conservative leverage values can withstand a fall,” he says. “But equity must be very careful where there is a first loss.
“A sensible investor would not turn away from residential, but would make sure they have got their sums right, and consider commercial. The key with commercial is to derisk a scheme. Commercial schemes in London and the south east will get financing. A prelet and a banking relationship help; forward-funding could be the key for some larger schemes. When you move to the regions, you have to tick more of the boxes.”
Antoniades says listed REITs and bigger private property companies can do speculative development by borrowing corporately, at a 2% or 3% rate, he suggests. In effect they can use their balance sheets’ strength to kick- start development. But smaller and even mid-level companies have no such opportu-nity and often have to recycle equity on a scheme-by-scheme basis. “Some big-brand names out there lack equity,” he says.
Antoniades believes that where banks once led the way with innovative finance, it is now up to developers and their advisers to take the initiative by devising combinations of senior debt, junior debt, preferred equity and grant funding (see fig 3). “There is no one-size-fits-all, unfortunately,” he says.
He also suggests that “a healthy property market needs senior banks actively lending”, a similar sentiment to that of another speaker at AEW’s Europe economic briefing last month: Land Securities chief executive Rob Noel. Though concurring with Marcus’s concerns over property lending generally, Noel reminded delegates that the capital markets remained open to the major REITs, even in the dark days of 2008.
This allowed them to continue developing and to great effect, said Noel – they are able now “to let into the sweet spot of the property cycle” when prospective tenants are ready and willing to take space. He added: “Money is available to lend on now. What we don’t know is to what extent there is going to be a development response in the current market conditions.”
Pay off arrives at Kings Cross for ‘patient money’
“One challenge for borrowers is trying to align themselves with funders with a similar risk appetite and view of the duration of an investment,” says Mike Lightbound, a partner at developer Argent “That is particularly difficult in long-term regeneration projects, where you need very patient money.”
Most Londoners would say the patient money has already paid off at Kings Cross, where Argent and its partners London & Continental Railways and DHL have transformed much of a once-desolate, 67-acre site into a mixed-use community.
Operating as the Kings Cross Central partnership, they sold plots to fund £300m of infrastructure in 2009-10. The partnership also had to put in equity and proceed on a building-by-building basis, effectively funding and ring-fencing each one before generating receipts upon completion and recycling them for the next phase.
Lightbound says the strategy was always based on borrowing the direct construction costs for the offices and residential. “Debt funding of individual projects has been a smart way of derisking the whole project, because you’re not putting the whole site on the table at any one time.” It is worth noting that the site boasts two speculative office buildings with debt funding from Wells Fargo, both of which have been subsequently let before completion. The partnership is in negotiations with lenders about another speculative office building.
“It has got easier because land values have jumped significantly, so the amount of equity we have put in has notionally gone up a lot too, which helps,” says Lightbound. “The other thing that has helped with Kings Cross is that people get it now. We have always convinced ourselves it would be great and it has now reached the point where others can see that it is a place where people are buying into the value. We have sold enough residential and we have done enough office developments for credit committees in banks to take comfort.”
The Kings Cross track record is “definitely a factor” in Argent’s finance negotiations on other projects, says Lightbound, who also detects a more favourable view of the regions from lenders. “Six to nine months ago it was all about London, but now there is a recognition that there are good deals in the regions where the fundamentals of property – given the values there for many projects – are pretty sound.”
Non-bank lenders home in on tricky projects from Grosvenor Crescent to Greenwich
One is a regeneration project in a once unloved part of London, the other a super-prime scheme in one of the most desirable locations in the world – but both got development finance from niche, non-bank lenders. Banks were initially interested in financing both projects, but the schemes were too complex to fit their sets of rules.
The Greenwich Square project in Maze Hill, SE10, in the east of the borough, is a phased development in five different blocks, with 327 private and 318 affordable homes plus a leisure centre, library and health centre, shops and public space.
The private residential funding partners, LaSalle Investment Management’s Special Situations debt fund and Topland, together with Urban Exposure, were dealing with the borrower – itself a joint venture between Hadley Group and Mace Group – and four external parties: the Greater London Authority, Greenwich Council, NHS Greenwich and L&Q Housing Association.
Other developers had previously been thwarted by the complexity of the ownership and lack of available finance. In fact, says LaSalle director Michael Zerda: “We first looked at the deal in 2011, but there were so many pieces and parties involved, we asked to pause and see it again when the full capital structure was formed.”
The large scale of loan required for Grosvenor Crescent suited Russian lender LetterOne. The eventual 40-month, £80m of debt for the £130m first phase comprised a whole loan from LaSalle, Topland and Urban Exposure, as well as subordinated finance from other stakeholders in a highly structured deal, not unlike CBRE’s diagram above. The terms included a bespoke security package and deeds of priority.
“We eventually got comfortable with it because it was suited to underlying local buyer demand and Hadley & Mace are top Greenwich Square required a complex debt package involving a number of stakeholders quality groups,” Zerda says. The parties have an option to finance phase 2.
Grosvenor Crescent had a different set of challenges. One was the very large size of the senior loan, at £168.8m, and another was underwriting the likely value of the 11 Belgravia apartments: with lateral designs of 5,000-10,000 sq ft each, developer Wainbridge put their value at between £25m and £50m. The apartments’ clearing price is believed to be £2,500 per sq ft.
But it was also a project where design, timing and cost could all change and the borrower needed flexibility. “It is to the lender’s benefit to give that flexibility to get the best possible development,” says Nitin Bhandari, head, principal finance and special situations, at LetterOne, which was selected as the senior lender, with Urban Exposure a minority lender and the servicer.
LetterOne invests on behalf of Russia’s Alfa Group and with a large balance sheet with $10bn of assets, the size of Wainbridge’s debt requirement was an attraction: it also understands the scheme’s very wealthy target market. The four-year loan is conservatively geared and flexible, allowing higher or lower draws linked to the construction procurement and sales milestones.