Development Finance Market Review Q2 2018
In our new, regular, quarterly bulletin on all things development finance, we provide our readers with a real time update on marketplace trends, so that you know what’s really going on and how best to tackle this ever expanding marketplace.
Most developers and associates understand how important this info is in order to make the right decisions quickly.
With over 50 senior debt lending options, 20 mezzanine options and a small but increasing number of equity and JV options, the choice has never been greater. But with more choice, comes more confusion in selecting the right lender/funding for your projects.
Not only that, but lender products also change regularly. Around 25% of lenders change some part of their policy every 3 months, so it literally ‘pays’ to stay on top of what is going on!
Below we will breakdown the different variables, and see what changes may be occurring that you need to know about. We will then take a look at current trends and provide general market sentiment. By reading this, you will be able to go away armed with up to date information from industry insiders that will help you make better funding decisions.
Liquidity in the marketplace remains strong in both the debt and equity markets, as reported in the previous quarter’s report (click here to view Q1)
This has been further demonstrated by the continued increase in the number of lenders and funders, backed by more investment into the marketplace.
3. Geographical Appetite
This is one of the biggest changes in recent times. Many lenders who remained focused on London and the South East have found that deals often struggle to “stack up”. This is due to sky-high asking prices, rising construction costs, reduced GDVs, and ultimately greatly reduced margins, as developers will be well aware.
With cash squeezed, many developers are struggling to come up with the cash deposits required, and so lenders, with increased liquidity, have to look further afield in order to lend funds.
Several lenders have opened new offices in cities in the North of England, and are looking further afield into Scotland and Northern Ireland as well. This trend is likely to continue as locations previously sunned by lenders are given more consideration, resulting in other lenders following suit into those said areas.
4. Headline Interest Rates
Little movement this quarter on rates, with a number of lenders having made the move in the last quarter or so.
To recap, a number of lenders now offer cheaper products for reduced ‘Loan to GDV’ requirements using a tiered approach. For example, 10% per annum remains at 70% of GDV, but can reduce to 6% per annum at the 55% of GDV mark. The upshot is that there is more competition now for the cheapest lending rates than was the case even 6 months ago.
Please also take away our cautionary note re: interest rates. That is to say comparing the rate of interest for development finance is not best practice when it comes to choose lenders.
Lenders can use up to 3 different methods to apply rates of interest. What happens is development finance lenders with the same apparent interest rate can actually be charging very different amount of interest! Most lenders also do not use the developer’s cashflow as the constant. If 3 different lenders are modelling using differing cashflow schedules, how can you truly compare the interest from them? The answer is you can’t.
5. 'Loan to GDV' Thresholds
GDV Thresholds are quite interesting at the moment, with a variety of views in the marketplace resulting in different movement. Alongside last quarter’s info, many lenders are taking a conservative view of GDVs, with percentages reducing by between 5% and 10% on this time last year. We have also lost two lenders recently at 75% of GDV, so that end of the market is becoming less competitive.
However, a good number of senior debt lenders remain at 70% of GDV, and whilst you may pay a little more in interest at that leverage, this often offsets very well against the extra cash you don’t have to put in at purchase (if buying) for cheaper rates, albeit subject to your own risk profile and philosophy on debt and leverage.
6. 'Loan to Cost' Thresholds
LTC ratios are pretty constant compared to the last quarter. 90% is holding up well with most lenders at the leveraged end. However, the more conservative lenders are pushing down towards 80-85% of the total project costs.
Again when working out your numbers remember that the LTC ratio is the total project costs excluding finance and disposal costs.
7. Cash/Deposits Needed
How much cash needed for development funding is very much in line with the LTC ratios, and whether your risk profile and debt appetite affects what you like to put in.
In general, if you’re rate sensitive, cash deposits have risen in line with more conservative GDVs and Loan to GDV ratios over the last 6 months. The minimum you can still get away with is 10% of the total project costs. However, equity investment has certainly become fashionable, and needed by many, particularly if previous project stock is failing to shift.
If the equity requirement is high enough, it is possible to fund up to 90% of that slice, meaning only 1% of the total project costs needs to be found by the developer.
8. Arrangement & Exit Fees
Arrangement fees are still constant at the 1% to 2% mark, although beware about how these fees are applied, they can vary wildly against the gross or the net facility amount. Always dig deeper than first appears!
Exit fees have always ranged more widely than arrangement fees because it is here where some lenders ‘hide’ some of their interest or total return model. It is worth noting as well that several lenders do not include exit fees in their total cost structure, because they are not deemed project costs, only disposal costs. Be sure you are comparing like with like; often you aren’t.
As a recap, exit fees can be as low as zero and as high as 3% of GDV. The exit fee content is different from lender to lender because some are invested in by debt sources and some are invested in by private equity lines, with the PE lines typically requiring much higher overall returns. Lenders understand the difference it can make at the outset, and is why lenders often advertise a much cheaper rate to win business without initially disclosing the exit fee structure. However, when it comes to the crunch, exit fees reduce in the face of competition, from 2% to 1%, or from a % of GDV to a % of the loan.
9. Change in Marketplace Appetite
In times of uncertainty, development finance lenders tend to move towards the most vanilla of schemes i.e. those projects that have the best chance of selling out or holding value.
The type of schemes we are talking about involve properties priced up to the £700k to £800k mark. Higher risk sectors such as prime luxury, or unique propositions, have far fewer buyers and are therefore less desirable to lend on, particularly with the changes at the top end. Surveyors also tend to down value this end of the marketplace if they cannot see clear comparables.
Finally, the conservative lenders in particular are looking for larger project margins, on top of greater cash deposits. Minimum margins considered are usually 20%, but 25%+ is helpful to some.
10. New 'Quick Build' Technologies
The quick build era is gaining momentum amounts developers due to its ability to greatly increase profitability. This is because the build period is much quicker, so total costs reduce dramatically.
Whilst these technologies gain momentum with builders, the surveying community is struggling to provide enhanced GDVs in order to allow a good number of lenders to really be of help.
Quick builds need a greater, earlier, amount of finance due to the quicker build timeframe. Unfortunately there have been recent instances where extra site value is not being recognised, meaning a lender cannot fund, and the builder has to fund the cashflow shortfall themselves.
It’s important therefore to have honest and open conversations with lenders if you are a quick build technology user. Make sure you have lenders who are happy to fund advance payments.
Further to last quarter, we are keeping a close eye on this sector, with the hope finance and valuing with eventually catch up to allow builders to profit in the ways they would like, without needing the cashflow to survive. Ultimately, if they have the cashflow, why need the finance?
11. Prime/Luxury Market
This sector remains the same as last quarter in that there are limits to funding. To define the sector, developed individual unit sale prices from £1m upwards, or £1,000 per square foot.
Most will be aware now that sales of prime property, particularly in London, have virtually ground to a halt. This has been due well documented government policies to dis-incentivise the target audience e.g rich foreign buyers and landlords. Decline rates are extremely high as a consequence unless a pre-sale is in place.
If you are a luxury property developer, ensure you have thoroughly researched your funding options before committing to any projects. Of the luxury developer clients we know, most are using private investment sources or are building to spec, stage funded by the buyer.
12. Joint Venture Finance
The 100% JV funding market is beginning to expand as well, which will be a relief to many developers with funds tied up in current projects, or simply lacking the resources to complete on a solid project.
On top of a couple of mainstream options, three other structured funding options have entered the market on a private basis, so competition is increasing. This should begin to drive down profit share arrangements, which are anywhere from 50-50 up to 70% in favour of the lender.
13. Development Exit Finance
Due to the current plight of slow sales, a number of lenders now offer this product in some form. Many lenders are now having to extend facilities in the hope that the marketplace in some locations pick up. This clearly results in developer’s margins being further eroded and the ongoing worry that the lender may want them to service interest and capital in the near future.
Developers can take that pressure off by changing lenders on a rolled up basis for 12-24 months, should the costs not outweigh any potential benefits.
With the uncertainty over Brexit continuing, it is likely that particularly London sales will remain slow for the foreseeable future and that this product will remain in demand for a good while yet.
14. Summary and Sentiment
As of the end of Q2 2018, our summary is that we continue to have strong liquidity, a growing marketplace with cheaper funds offset by increases in cash inputs in the more conservative quarters. In the last 3 months, there has been a stabilising of positions on Q1 as discussed in last quarter’s review.
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