Andrew Antoniades of CBRE explores what the UK’s EU referendum vote means for development finance
Following the momentous referendum vote on 23 June 2016, the challenges facing the development finance market which had begun to ease, have been replaced by new ones. The market is now characterised by caution, uncertainty and selectivity, but with great opportunities for some.
The medium and longer-term impacts of the EU referendum decision on development finance are still hard to tell and no doubt will take time to evolve. However, some immediate responses from lenders have been seen, and it is clear that availability of development debt is going to be of greater concern than affordability.
Even before the vote, there was a feeling that the property market had peaked and values were just beginning to soften. This trend in the investment market is having an adverse impact on development, as exit values and appraisal assumptions now arguably need to be adjusted.
In response to such uncertainty, some lenders are starting to take a more conservative stance on their lending terms; most explicitly in the margin and leverage. Many lenders have already increased the margins offered on new transactions and we expect leverage offered for senior loans to reduce by 5-10 percent loan-to-cost.
Lenders in the UK which are willing to fund development are adopting a more prudent and cautious approach to new transactions. They are being more detailed in their due diligence and are scrutinising all aspects of a development, particularly letting prospects, before committing to a sponsor.
The driver appears to be the risk premium associated with development lending, but also looks opportunistic for some lenders, which are charging more because they can. Borrowers are willing to pay a little more than before in order to ensure they can obtain a loan facility.
Debt availability in the context of demand
Until recently, availability of development finance was improving, but this was from a low base, far below historical levels, as demonstrated in the graph below left.
Given the greater degree of selectivity and conservatism being displayed by lenders, overall development finance will contract in the next few years. In times of uncertainty, lenders gravitate towards schemes which have been de-risked as far as possible through pre-lets and pre-sales.
However, following the referendum we expect the supply side to contract somewhat too, offsetting the contraction of debt availability to a degree. The chart on p.15 demonstrates what might happen should developments be curtailed to the same extent they have been during previous market slowdowns, using commercial space as an example, with the blue sections representing development that might be delayed as a result of a pending Brexit.
Commercial: Speculative vs pre-let
Speculative development will prove challenging. It was rare to find speculative finance even before the EU referendum, especially outside of London. Market uncertainty and caution of lenders will not improve this. Commercial speculative development finance will be predominantly available for the best schemes, in the strongest locations being built by the most desirable and robust sponsors. Strong sponsors will be of interest to banks which want to maintain relationship lending to such top-tier developers.
Pre-letting will be the preferred route for those developers which wish to obtain debt. The certainty over pre-let commitments will face even greater scrutiny as lenders seek to ensure that such protections do not fall away. This means a more forensic review on how pre-let agreements are legally drafted to understand if these could be at risk when the UK leaves the EU. For example, we may see clauses appearing to protect occupiers from what they may perceive as adverse market conditions in the future.
Residential: Speculative vs pre-sold
Pre-sold residential development will have the best chance of attracting debt, due to the de-risking of these sales, but also because there are so many alternative lenders in the market focussed on this asset class. We see four trends emerging for residential:
1. For residential pre-sold schemes: a strong requirement for UK purchasers instead of foreign buyers. These buyers can be verified more readily by lenders in due diligence and their commitments made more certain.
2. Larger deposits of up to 20 percent will also be looked at more favourably due to the stronger commitment this represents.
3. Restrictions on “flipping”: where a buyer pays a deposit but sells on their obligation, crystallising a gain (a particular issue where overseas buyers can borrow against their deposits).
4. No bulk sales: restricting a single purchaser from buying multiple units, as this constitutes a concentration risk where a diversified purchaser base is more desirable.
Private Rented Sector (PRS) schemes merit special mention as these residential schemes have become desirable amongst lenders particularly where they are lower cost and in locations of highest demand from renters. These assets are desirable amongst major institutions who wish to own them, further increasing their attractiveness to lenders.
In terms of who can lend, we are aware that several major lenders now consider themselves to be “full” for residential development, where they have met their targets and are not willing to take any more exposure, waiting until previous loans are repaid before writing new ones.
Debt for speculative residential schemes will be harder to find. Again, the number of alternative lenders in the market will help support this to a degree. However, most borrowers will need to go to more expensive lenders which can accept the risk.
To source finance, developers of speculative residential will need to be able to demonstrate three things:
1. Low supply – high demand dynamics for their schemes will be essential to prove viability of the units.
2. Sales price expectations at an appropriate and reasonable price per square foot for the micro location and intended purchaser base.
3. Higher degrees of cost certainty (particularly on smaller schemes where cost efficiencies may be harder to achieve).
Where these characteristics are satisfied, lenders will still scrutinise the break-even point to ensure suitable headroom between the target sales prices and the debt provided.
Availability not affordability
A significant difference remains between speculative and pre-let development in both cost of debt and leverage offered. This polarisation could be exacerbated in the post-referendum landscape as riskier speculative schemes attract higher costs of debt. Unsurprisingly, there remains a meaningful spread between development and investment loan margins. Comparative value will still be found in the premium margins that can be charged for fully-let development where the risk has been significantly reduced through pre-letting, compared to investment lending.
Increased conservativism from banks and other lenders means that leverage will diminish slightly, meaning lenders will advance less funding as a proportion of the total required. Speculative development could be the hardest hit by reduced leverage due to uncertainty as to whether those schemes will achieve lettings and therefore crystallise sufficient value.
Over the last few years, banks compressed margins at a faster rate than the increase in leverage offered. This is because leverage represents risk, whilst the margin represents returns. The latter is more willingly compromised. However, this trend was unlikely to continue and now appears to be reversing. From the second half of 2016 onwards, the increase in pricing of debt and further conservatism on leverage will have its impact.
How will schemes be financed if leverage is reduced?
Many new transactions originated before the referendum but advanced afterwards have seen their terms revised: a reduction in the quantum of debt offered and slightly increased margin.
If the availability not affordability of debt becomes the main concern, then sponsors will need to fill the gap left by reduced leverage. In such cases, borrowers must fill this with more equity or find alternative funding to fill the gap.
Finding a non-bank alternative lender to provide an increased leverage offer will inevitably come at a cost to reflect the risk premium. Filling the gap with mezzanine finance or preferred equity may be possible, though mezzanine finance for development has been particularly scarce recently and again this is often expensive. Finding more equity may be possible and acceptable to some borrowers, but there will be those who simply lack the ability to source sufficient equity or it could come at a high internal return hurdle.
Who is lending?
The diversification of the UK property lending market has been one of the most important changes to the property landscape and the number of new entrants to the market has been essential in providing alternative solutions in the face of reduced appetite from traditional funders since the global financial crisis.
Alternative and non-bank lenders are more open to development funding; 30 per cent of their aggregate exposure is to development compared to 11 per cent for banks.
Although they have an admirable appetite for development, their aggregate capacity is relatively limited in comparison to banks and their peers. Such lenders are essential to funding the new assets that will enter the property market, but the presence of traditional lenders and their capacity remains the backbone in terms of actual overall capital resources.
As development faces pressure, alternative lenders will be core to this market, because of their flexibility and attitude to lending. Debt funds are more willing to finance development largely due to the potential for higher returns. They will consider greater leverage (up to around 75 percent loan-to-cost, though this could contract to mirror the approach from banks) and they can also be open-minded on pre-sales and pre-lets, as well as even being willing to fund speculative development.
Many of these funds are highly flexible in the structures they can work with, providing senior, whole loans, mezzanine positions and preferred equity, depending upon the situation. However, such flexibility means they demand high coupons in return for this risk.
For lenders, a small increase in margin can produce a greater increase in the debt return. Therefore, if borrowers can tolerate paying more it can be lucrative for lenders. Together with constrained competition, this may attract new lenders to the market, including overseas lenders which may find these factors as well as a currency advantage to be attractive.
In summary, lenders will most definitely be exercising a greater degree of caution, particularly in relation to speculative development or development which carries with it a degree of risk in a period of uncertainty. While on the one hand, lenders are protecting themselves against undue risk, they are also aware of the potentially lucrative opportunity that has arisen.
A small increase in margin can produce a greater increase in the debt return and with availability of funding constricted, sponsors will be willing to pay more. It is therefore very much a case of availability over affordability in the post-referendum world, which will see the survival of the fittest.