Property Development and Investment Finance

So it’s the New year, but has anything changed in the world of property finance? Dorothée Queyroux, senior broker at Red Chilli Structured Finance takes stock of the real estate funding markets.

Property finance in 2008 – a turning point

2008 ended in a pretty depressing mood across the board. As Britain now seemingly enters into recession and the British economy has a leaden feel about it, people were secretly hoping that confidence would pick up early in 2009. Trying to get a feel of what the market might be like is not easy. Certainly there is no lack of buying opportunities in Europe but will investors be able to borrow at all, even well heeled investors that have been hoarding equity? The cut in the interest rate does not seem to have encouraged banks to lend any more. The number of banks that were still lending during the last quarter of 2008 certainly dropped markedly; most of the others indicated they would be back in the market in the New Year. But now that it is 2009, who is really back and at what price?

Development funding and exit on completion

The situation has deteriorated markedly since the start of 2008. By the end of the year, spec development funding had all but dried up. Until quite recently, an experienced developer could obtain 90% development funding for a spec resi scheme with a blended margin as low as 225 bps and a lender exit fee equating to 15% profit share. Now, in early 2009, that same developer would do well to secure funding for 50%-55% of costs. And as completed developments come to the market and fail to find buyers, developers find their capital tied up in mature projects and have no choice but to refinance them on a long term investment basis, becoming buy-to-let landlords in the process.

However there too lie challenges. Before the summer of 2008, a developer would have likely been able to refinance a development facility on a completed block of flats at 70% of their market value. A lender might have required an interest deposit guarantee until such time the units were fully let but, this condition notwithstanding, a traditional investment loan could be secured. By QT4 ’08, this scenario, a no brainer 18 months ago, became “mission impossible”. Following meltdown Monday and the dramatic decline in the residential markets, developers (and mortgagees in possession) have increasingly found themselves left with vacant blocks of flats they cannot refinance because, as a result of the drop in values, the funding required can easily exceed 90% of the reassessed market values.

Commercial funding – the new parameters

On the commercial investment front, banks have traditionally been driven by income cover and tenant quality. The key to most lending decisions was the lender’s exposure to vacant possession at the term of the lease with the assumption that all but the weakest of tenants would perform throughout their leases. However, due to the difficult environment we are now in, more and more tenants have been defaulting and borrowers have been struggling to service their debts. As a result, lenders have significantly tightened their lending criteria and even prime assets with undoubted tenants are now struggling to warrant more than 65% LTV when 75% was achievable a year ago. A number of lenders are now capping any investment facilities at 60% of market value whilst increasing their margins to heady levels (the 150 bps of the fall turning into 175 bps before Xmas and the 200bps+ in the New Year). As for interest-only periods, they are truly a thing of the past - lenders now insist on aggressive amortisation profiles from day one and insist on full amortisation by the time the asset becomes vacant.

The return of the experienced property investor

Interestingly, we are now seeing the return of experienced buyers (sitting on large amounts of equity) who are back in purchase mode. The very low yields that we have been experiencing for the last few years were keeping those funds out of the market. Now that yields have softened, Stirling weakened and the swap curves been turned on their heads, those buyers see value in the market and are actively seeking suitable opportunities. With the yawning gap between interest rates and yields, mezzanine debt is also making a come back allowing investors to gear up to a possible 75% depending on the investment’s ability to service 13% to 18% coupons.

With property markets still in decline, experienced investors are however not rushing to the market. Indeed many have withdrawn from transactions they entered into in late 2008 in the belief that values would improve in 2009. We at Red Chilli have come across a number of lenders who had agreed to lend on a number of transactions which fell through in December as a result of buyers pulling out at the last minute. Ironically for the banks involved, they were left frustrated with credit approved undrawn facilities and surplus funds. So much for a lack of liquidity.

The valuation challenge

An issue which often surfaces when it comes to closing a deal is the valuation. With a lack of comparables due to a very small number of transactions on the market, it makes life particularly difficult for valuers to indicate a fair market value. It is common to find a 10-20% discrepancy between two valuations. How do you put a value on something you want to buy or refinance? Since a fair market value is the price that somebody is prepared to pay, how do you value an asset in a market devoid of transactions? These are the challenges that face property investors in the current market and which have driven banks, faced with such uncertainty, to repeatedly reduce their LTV ratios .

The year ahead

While 2009 will present investors with interesting acquisition opportunities, the constant tightening of lending and valuation parameters, the “wait and see” pattern the industry finds itself in, the likely worsening of market conditions and the absence of immediate resolution to the credit crunch will almost certainly ensure that 2009 will be one of toughest years on record. The turning point will likely coincide with the eagerly anticipated loosening of credit leading to improve liquidity in the property markets and resurgence in confidence. One thing few people believe though is that the days of highly leveraged inexpensive funding facilities will return any time soon.

Related

• The Re-emergence of Mezzanine Finance in the Property Industry
• Commercial Property Finance for Investment and Development Projects Snapshot
• Loan Facility for Commercial Property Investment
• Residential Development Funding QT4 2009 Outlook
• 100% development finance - a dead end?