Residential Development funding in 2009

It is now over a month since the UK government announced its unprecedented bailout of the banking industry so how has that affected funding prospects for residential developers and housebuilders? Bernard Frazer, a partner at Red Chilli Structured Finance shares his views on the year ahead.

“Our perspective for 2009 is that developers will continue to find it difficult to raise finance for residential development projects. They are contending with two major and well-documented crises that feed off each other: the credit crunch that has turned lenders into hoarders and the continuing decline in property prices.

Although it started 15 months ago, the credit crunch is far from over. Whilst the government’s intervention last month was widely acclaimed as a bold and well thought out move to stem the banking crisis, we are not out of the woods yet. By going further than the US government and addressing both the liquidity and capitalization issues, Brown’s rescue plan had the merit of being a pragmatic and, on paper at least, effective solution to the crisis. It has however since become all too clear that the effects of this plan will take quite some time to be felt in the wider market, not unsurprisingly given the vast complexity of the problems the whole system finds itself in. LIBOR rates have softened somewhat over the last 3 to 4 weeks but the spread with base rate remains historically very high. This is simply a sign that, although the panic seems to be over as savers are no longer running for their savings and banks for their lives, confidence has not yet returned to the credit markets. How long it will take for some normality to re-establish itself is anyone’s guess but it is certain that it will be gradual and we are unlikely to see a return to past aggressive lending practises for a very long time.

Against that background, the real estate market has been tumbling (between 10 and 14% depending on whose views you heed) and likely to fall about as much again before we reach the bottom. When this is likely to happen depends again on which observer you talk to and which region you look at but it is a fair bet that we may be one to two years away. That makes development funding an extremely unattractive proposition for a lender. Not only is their cash tight and to be deployed wisely (if at all) but the residential market looks set to drop potentially another 15% from hereon meaning that any development undertaken today on the usual margin of say 20% return on cost (based on today’s values) may actually not return much of a profit on completion when the market has declined further. That is a fundamental issue in the business right now as, although RICS valuers will provide valuations at today’s values, lenders will immediately discount said values to reflect what they anticipate will happen 2 years down the line. As a result, it is becoming extremely difficult to achieve any kind of adventurous gearing through senior lenders and 50% to 55% of GDV seems to be as high as most lenders will go in the current climate. And that is assuming we are not talking blocks of flat. The mere mention of the F word these days and most lenders will simply hang up on you.

It is still possible to raise mezzanine or equity to sit on top of senior debt but such lenders have naturally lowered their gearing criteria too. While 100% funding was possible in early 2007, it is almost certainly no longer possible except for the very best of projects with additional collateral. In this climate and against a background of declining property values, 90% to 95% is the very maximum the best developments are likely to achieve on a non-recourse basis. Those lenders that are still in the market are also becoming extremely choosy and will only consider projects with higher returns, in safer sectors or geographical locations where demand remains sustained even in the current climate. And with little competition and so much demand, why should they not be choosy? £300k houses in the Home Counties or prime residences in central London are likely to fare much better than a tower of apartments in Liverpool. And at the risk of stating the obvious, lenders will now only back those developers that can demonstrate a solid track record and, ideally, a healthy balance sheet with the ability to inject equity into their projects.

We suspect things will get worse before they get better for developers. The current glut of unsold properties and the likely increase in numbers of distressed developments will affect developers adversely for some time to come. 2009 is likely to see a very tough credit market with lenders favouring property investments over developments as the spread between yields and medium term swaps start to look favourable again. For those lenders that are still in the market, the lure of good margins on steady income producing assets is likely to deter them from taking on any development risks for some time. We all have to contend with the new reality of a tighter and far more discerning credit market. There are of course some lenders (senior or otherwise) still prepared to underwrite new developments and we at Red Chilli continue to successfully arrange development facilities for our developer clients”.

Red Chilli Structured Finance is an independent property finance advisory firm specialising in arranging funding for property projects in the UK and all over Europe.

Call us on 0845 210 5000 to discuss your funding requirements.

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