After 14 years of ultra-low interest rates, a new environment is emerging that is set to test the business models and underwriting of small-ticket real estate lenders – a diverse group including specialist financing platforms, fintech firms and challenger banks, which typically lend to small to medium-sized developers and property investors, often in the residential sector.

Such businesses emerged in the aftermath of the 2007-08 global financial crisis, particularly in the UK, as clearing banks pulled back from smaller loans and short tenors, creating a gap in the market, particularly in development and bridging finance, for loans ranging from less than €1 million to around €15 million-€20 million.

Most small-ticket property lenders have only operated in a low interest rate environment. But now, as well as dealing with rates that have jumped sharply this year, and will rise further, small-ticket lenders also find their borrowers under pressure from rising costs and the prospect of weaker real estate markets.

Early interest rate rises this year were absorbed by lenders. However, they are now increasing margins and passing on rising costs to borrowers. Tiger Craft, president and chief operating officer at UK development finance specialist Hilltop Credit Partners, says: “Overall, interest rates on these development and bridge loans are rising fairly considerably. This is pushing up returns for floating rate lenders; it’s clearly less favourable for alternative lenders with large fixed-rate loan books.”

Guy Harrington, chief executive of London-based bridging loan specialist Glenhawk, adds: “We held back for a while but have now increased rates and passed on our increased costs to our customers. Our average rates have risen from 0.7 percent a month to 0.89 percent a month.”

Meanwhile, loan-to-value ratios are set to be squeezed, with typical LTVs moving down across the market from 65-70 percent to 55-65 percent.

Non-bank lenders are facing pressure from their funding providers, some of which are said to be cooling on parts of the market. For example, lenders say the prospect of a more difficult market is making high-net-worth investors, who typically back the bridging loan sector, seek greener pastures elsewhere. Raising new capital from investors is expected to be difficult. Meanwhile, some specialist lenders have floating-rate bank funding for their strategies, putting immediate pressure on them when rates rise.

“Our funding is linked to SONIA, so clearly we are exposed to any increase in rates,” says Harrington. “It’s been a challenging few months. However, this turbulent cycle has caused many of our smaller rivals and indeed some of similar size to us, to pause lending, or have their warehouse funding restricted. We closed a £200 million (€228 million) warehouse facility with NatWest Markets in September but there are lenders out there either with warehousing that is full or they do not have a warehouse at all.”

Craft adds: “I am told a lot of the senior/A-Note lenders who were in the market six months ago are just not lending at the moment.”

The double attack

Developers have been battling with rapidly rising costs and now face the double attack of rising borrowing costs and weaker housing markets. Residential market transactions have been slowing in both the UK and continental Europe. In the UK, there is evidence of pressure on house prices; in November, the latest house price index by building society Nationwide reported annual UK house price growth sharply slowed to 7.2 percent in October, from 9.5 percent in September. Across the wider market, falling share prices in the listed real estate sector – the main FTSE EPRA Nareit Index is down nearly 40 percent this year – show where investors believe markets are heading.

“Borrowers are very nervous, particularly if they have a major refinancing in the next 12 to 18 months,” says Gareth Williams, head of real estate finance at QSix, a specialist real estate asset manager which lends in the UK and the Netherlands. “If I was a borrower, right now, I would be trying to either de-lever my position – maybe by selling some assets – or trying to get my lender to extend the position, because I think liquidity is drying up quite quickly.”

Small-ticket lending in numbers

Small-ticket lenders within 76 organisations surveyed in Bayes Business School’s H1 2022 UK market report

Bayes defines smaller lenders as those who lend on loans up to this total

The 26 lenders’ aggregate outstanding loans at the end of H1, up from £14bn in 2019

Aggregate origination in H1 2022; Full-year 2021 total was £5.7bn

Pricing premium to large-loan lenders

Share of lending in central London, demonstrating a regional focus

Source: Bayes Business School

Lower leverage mean developers will have to put more equity into deals and anecdotal evidence suggests some are using 100 percent equity in order to sidestep the changeable borrowing environment.

This gives rise to a potential squeeze on borrowers if values fall, says Williams. “There is a very large gap potentially in the refinancing market. For example, a loan at 65 percent LTV today, could be at 80 percent as values drop and when lenders want to be at 60 percent. That gap could be very interesting for providers of preferred equity or mezzanine finance.”

Hilltop’s Craft notes that rising rates mean developers are at risk of breaching loan-to-gross-development-value covenants for loans with rolled-up interest. “Many loans on paper are going to be in breach of their LTV covenants. In some cases, lenders are insisting on more equity going in but are also often agreeing to covenant waivers in exchange for small penalties or fees.”

However, Chris Gardner, joint chief executive at M&G-backed lender Atelier, is still seeing a relatively healthy dealflow. “Professional developers and intermediaries in this market recognise there is going to be a readjustment as rates rise,” he adds.

In the bridging loans sector, larger and more experienced developers are pushing ahead and therefore seeking short-term financing for their projects, while smaller-ticket borrowers have stepped back, says Harrington. As a consequence, Glenhawk had seen its average loan size rise “30 percent in the past eight weeks” by the end of October.

The picture in continental Europe is similar to the UK, albeit rates have not risen as sharply, with a 200-basis point differential in three-year swap rates at the time of writing. “The hit to people in the eurozone has not yet been as dramatic as it has been in the UK, aside from residential, where prime yields have tightened significantly,” says QSix’s Williams.

He adds that the real estate market in the Netherlands has seen the same dynamics as the UK, with heavy investment in rental housing and logistics. However, there has been more caution in other sectors. “I think there are fewer issues than in the UK,” he says.

Responding to volatility

Anecdotal evidence suggests the new market dynamics are hitting one part of the small-ticket lender universe hard – crowdfunding or peer-to-peer platforms. These platforms allow retail investors to lend small sums to real estate projects across Europe. However, their structures are not suited to dealing with cost overruns or other complexities of development lending. Craft says: “We’ve seen some good opportunities to recap loans and that will be an interesting source of dealflow, over the next six to 12 months.”

The P2P sector appears to be in line for M&A activity over the next couple of years, lenders say, with the opportunity emerging to buy either lenders or discounted loan books. “There are some struggling lenders which means there will be M&A opportunities as we move to a new interest rate environment,” says Harrington.

Vulnerable lenders will be those which cannot support funding, which have been less careful in their underwriting and are less able to deal with adverse circumstances. The strongest real estate lenders understand the asset class and how to support borrowers and can deal with assets if they end up as the owner, market sources say.

“Lenders who are not really willing to roll up their sleeves and step into developments if things go wrong are exiting the market,” says Craft.

Fewer active lenders means less liquidity. However, this is not bad news for those still seeking deals, which have seen a dramatic rise in competition over the past five years. Gardner says: “The Bayes Business School UK Commercial Real Estate Lending Survey found around 180 active in the UK real estate market in 2017, but in the 2021 report, there were some 400 active lenders.”

The outlook for debt markets is changing all the time. The UK’s disastrous October ‘mini-budget’ which led to the departure of Prime Minister Liz Truss sent UK rate expectations rocketing, only to fall again when Rishi Sunak was installed. Analysts, including those from HSBC and Barclays, have produced bullish reports about the UK residential property market.

Craft says: “Predictions for peak interest rates have already come down and we think they may fall further. To a certain extent, central banks globally are fighting battles from [six to 12] months ago. Today, economies are in recession and unemployment rates are set to rise.”

Nonetheless, the days of ultra-low interest rates appear to be well and truly over and the economic prospects for the UK and continental Europe are not rosy. Atelier’s Gardner points out that the small-ticket non-bank real estate lending market is a new one and this is its first downturn. “It will be interesting to see how the sector responds.”