Residential finance: Capital housing in the UK

London’s residential market has endured a volatile two years, hit by increases in stamp duty tax as well as the uncertainty created by the UK’s Brexit vote. However, demand remains strong, while the acute undersupply of housing that is affordable to many in the capital seems a perpetual factor.

Lenders are willing to back the residential sector. However, many are eschewing the luxury end of the market, focusing on product on the fringes of central London which is aimed towards a more local clientele.

“We often judge the market relative to the good times but it is currently in a more robust state than people probably think. Prices are stable, sales are continuing and development activity is still going on,” argues Neil Chegwidden, head of residential research at JLL.

The prime central London residential market looked overheated by the middle of 2014, with pricing hitting a post-crisis high. In response, the government brought in two successive reforms to the stamp duty tax on residential transactions.

The second, in April 2016, imposed a 3 percent investor and second home stamp duty. Soon followed by the Brexit vote, it hit the market hard. “In the six to nine months that followed the second stamp duty change, the demand side of things certainly slowed and developers began accepting discounts on their schemes,” recounts Chegwidden.

In his latest budget, Philip Hammond, the UK chancellor, abolished stamp duty for first-time buyers of homes under £300,000. Its effect is yet to be felt. Several developers have kept faith with the market, as seen in the bounce-back of new starts in 2017, rising from 11,000 units at end 2016 to more than 13,500 by Q2 2017, according to JLL.

Luxury slump

During the first three quarters of 2017, 18,000 units were sold in London, of which more than 6,000 traded in Q3, according to residential research provider Molior. At the end of September, 64,000 units were under construction in the capital, up 8 percent from the end of 2016, Molior figures show. However, 28,000 of those units were unsold, an increase of 15 percent from end-2016. A record number of units under construction was matched by a record number of unsold units.

The more expensive the accommodation, the less likely it is to sell, the Molior figures showed. Nearly half – 46 percent – of unsold units were priced at between £1,000 (€1,122) per square foot and £1,499 per square foot. Since 2015, the number of unsold units priced at more than £1,500 per square foot has risen by 48 percent.

By Savills’ reckoning, prices in the prime housing market – an average value of £4 million – softened by a further 1.2 percent in Q3 2017. Price adjustments have been greatest in central London, where prices are now 15.2 percent below their previous high.

“We’ve seen quite a lot of people coming in to buy second homes from abroad, backed by equity or low leverage often from international banks,” argues Naomi Heaton, chief executive of investment company London Central Portfolio, one of those firms which operates in the high-value sector in prime central London. “Whatever happens with Brexit, central London will always be a key global location of choice and it’s become more affordable thanks to the devaluation of sterling.”

However, Heaton admits that developers bringing new luxury pads to the market have met softer demand. “The new-build market is struggling, particularly south of the river between Battersea and Vauxhall at Nine Elms where there is a huge amount of stock in the pipeline. All the tax changes have taken the wind out of the sails; there have been significant price falls and it will take a long time to find its way back to growth.”

The wisdom of bringing almost 20,000 mainly luxury homes out of the ground in the Nine Elms regeneration area has been questioned by many. In June, Bloomberg reported that the oversupply of new property in the area contributed to a 16 percent drop in prices by March in the SW8 postcode.

Not all top-end schemes have ground to a halt. Indian developer Lodha recently secured a £517 million whole loan from M&G to finance its redevelopment of
No. 1 Grosvenor Square, located in the capital’s Mayfair area, which will deliver 48 luxury flats by the end of 2019.

“In total, we probably had about six lenders that showed serious interest in the form of offers of financing, although naturally these weren’t all for the whole amount so one of the things we needed to look at was how to get to the debt quantum that we needed,” says Ab Shome, finance director at Lodha UK, noting debt is harder to come by post-Brexit, in general.

What’s affordable?

Most lenders say they are happy to lend where the proposed sales prices are positioned for the wider market, rather than rich foreign buyers. Many might balk at the term, but ‘affordable’ schemes are typically categorised as £1,000 per square foot or less. Below £700 per square foot is regarded as ‘mid-mainstream’ by Molior.

“There is greater focus on capital value price points than ever before and while there is still liquidity for landmark schemes, banks are more wary where average values exceed £1 million or £1,000 per square foot unless there is an obvious selling point,” says Chegwidden.

Developments that are likely to qualify for the government’s Help-to-Buy scheme are also well received by lenders, given how this can stimulate demand and therefore rate of sale.
“We’ve always been mindful of affordability; we think the amount of buyers there are for very expensive flats is relatively small, whereas there are a lot of statistics to suggest that many parts of the UK mainstream housing market face an enormous shortage so it’s always likely to have some kind of active buyer universe,” says Michael Acratopulo, head of origination at Wells Fargo.

Fringe central London locations including Canary Wharf and Southwark have proved popular with developers targeting the less rich. Wells Fargo, for instance, is financing a Lone Star-backed residential scheme at 251 Southwark Bridge Road, south of the River Thames. “We have a strong relationship with Lone Star, and there were a strong volume of pre-sales on the scheme. At modest exposure of £500 million which, to us, feels robust,” says Acratopulo.

“We saw the heat coming out of the luxury market prior to Brexit, when there was a growing realisation that the homes being built in London did not match demand in terms of price-point,” says Martin Wheeler, co-head of ICG-Longbow, which provided a £135 million loan for the development of The Madison residential tower, priced at around £1,000 per square foot but including 104 affordable homes, adjacent to Canary Wharf in January.

“As such, the market’s behaviour post-referendum has been an extension of an existing dynamic which has been exacerbated by the prospect of Brexit. We’ve committed to our first two London developments post the referendum but, even if the market cools further, we are unlikely to take part in the high-end market,” he adds.

Such schemes can only be regarded as affordable in comparison to the types of apartment buildings pitched to the uber-wealthy. However, projects are required to contain 30 percent of units at £500 per square foot sold to social housing providers.

New-build flats in the £400 to £700-per-square-foot price band are relatively rare, tend to be on a small scale and are typically financed by niche specialist lenders, sources say. The lack of supply of such stock at this price point has encouraged several lenders to look at the growing build-to-rent sector.

PRS and co-living

By the end of September 2017, 10,900 build-to-rent units were under construction in London, according to Molior, accounting for 17 percent of all new homes under way in the capital, a figure consistent with the end of 2016. In June, Knight Frank predicted that the UK PRS market would grow to £70 billion by 2020, from £25 billion today.

“Every institutional PRS investor in the UK is looking for opportunities in London; however, the high watermark of land values set over the past several years makes it difficult to find projects that work on a rental versus capital value basis,” comments Adam Hayner, head of development at ICG-Longbow.

A growing trend in the market is the rise of co-living apartment blocks, designed to overcome affordability issues for young professionals. Brands such as The Collective are pioneering a new asset class crossed between PRS and student accommodation through schemes such as Old Oak Common in west London which contains 323 small, rented flats with shared living space.

However, the sector remains small-scale and yet to attract an institutional following. That makes it difficult for lenders to get comfortable.

“Many investors see a lot of logic to co-living but it’s a bit early to know what yield – and therefore what value – to put on it. Because of its design, under the planning act you can’t assume C3 residential use. This raises issues of exit/end sale strategy; it can’t be as a block of C3 if it’s more like hostel use, so it falls between two stools,” says Chris Lacey, founder of Lacey Capital Partners, an advisory firm dedicated to residential capital markets.

The fact is that London remains an extremely expensive city in which to buy or rent a home. While many lenders want to finance new-build stock, which appeals to the average Londoner, little such product is in the pipeline.

INTO THE REGIONS

The regional UK residential development market is dominated by the private rented sector, a market for which there is growing debt liquidity.

Chris Lacey of Lacey Capital Partners believes PRS makes for a sustainable sector to lend against because “it offers good security as well as growth. Most of our cities need more residential accommodation and most regional councils are up for a major increase in supply but it’s not happening fast enough. For sale house builders have been wiped out and have not returned in any real scale in regional centres so the majority of supply will come through rental flats in the regions,” he says, pointing out that few houses traded during 2008 banking crisis but rents held up.

“Given the lack of comparable evidence, valuations and project underwriting have to be at cautious rental levels and quote high gross to net rental income leakage assumptions. Often, the only comparison we have is rents on lower quality stock that is poorly managed versus what will be well managed, good quality stock with various amenities. There isn’t much PRS stock that’s been delivered so far in the regions but the examples we do have show a 10-20 percent premium on rentals,” says Lacey.

The schemes that have attracted funding tend to be situated in large conurbations, like Wells Fargo’s financing of The Slate Yard in Salford for Legal & General. “It’s a big city with lots of young people with the right level of earnings so there should be reasonable demand for rented product,” says Michael Acratopulo, head of origination at Wells Fargo.

However, there are underwriting issues to navigate. “The key risk of financing in the regions is that each city is subject to its own dynamics and so requires underwriting individually – any lender who takes a one size fits all approach to the regions is likely to get its fingers burned,” says Martin Wheeler of ICG-Longbow, which has conducted most of its residential development funding in the regions.

The supply of the right kind of schemes coming through is still quite slow, however. “It’s a question of how many opportunities are flowing out there for banks to get at,” says Lacey.