Residential Development Funding QT4 2009 Outlook

Two years into the most severe credit crunch in living memory and a year after most lenders pulled the plug on any kind of development finance, Bernard Frazer, Partner at Red Chilli Structured Finance, looks at the funding options available to small and medium sized residential developers in the current market and paints a surprisingly positive picture for some sectors of the market.

Residential development funding: a long two years in the cold

The collapse in residential development funding in the UK has been all too well documented. The lending institutions’ hangover has caused untold difficulties to the vulnerable building and development sectors, particularly at the entrepreneurial end of the market where companies have traditionally been overly dependent on one or a small number of projects at a time and have not had the benefit of large corporate balance sheets nor the ability to raise equity from the financial markets to weather what has been an unprecedented storm.

Over the last couple of years, lenders which had gorged on development projects buoyed by ever increasing property values and easy credit have had to reverse course brutally and simply pull out almost overnight from any funding activities. The reversal in property values pretty much killed prospective development funding and seriously jeopardised ongoing projects. The mere mention of a development of apartments in the northwest of England was sure to give a lender heartburn, if not heart failure. Never mind 100% funding, any kind of funding was simply not going to happen.

Resumption in development finance?

Fast forward to QT4 2009 and things are looking up. Of course, oversupply of certain types of properties in some parts of the country will not be resorbed for some time. There is no getting away from the fact that ill conceived (with 20:20 rear view vision) flat schemes designed to be pre-sold to buy-to-let investors en masse and representing the worst excesses of the property bubble years will overhang some local markets for some time. However, the UK’s fundamental demographics and the ongoing imbalance between supply and demand remain and there is increasing evidence that lenders have regained appetite for well designed family housing projects.

The Red Chilli team has been working over the last few months with a number of lenders who are now able to offer some interesting funding solutions with a variety of gearing options for qualified residential development projects.

Funding criteria

The overriding criteria relate unsurprisingly to strength of the principal and to demonstrable market demand for the finished product. Any lender these days will carry out extensive due diligence on a developer seeking finance and want to assure itself that there is a solid and appropriate track record. It will clearly be essential that the borrower is able to show experience in successfully developing schemes of a similar or larger size for the type of property he intends to build. Furthermore, proposed build costs and professional fees will be scrutinized to ensure that they are realistic, reflect current market prices and leave enough room for a respectable profit. 20% return on costs is considered an absolute minimum these days, anything short of that number is likely to kill a deal unless the exit is secured by solid arm’s length pre-sales.

Similarly, the lender will want to satisfy itself that there is solid demand in the market for the proposed product and a great deal of attention will be paid to recent comparables and RICS valuers’ views on the product and the local market. It will be a surprise to no-one that lenders will favour houses (especially if developed in phases) to apartments but well conceived blocks of flats targeted at the owner occupier market are acceptable provided there is not too high a concentration in the same location. Mixed use developments are also acceptable provided the commercial element is no more than 20%. And in such cases, it is likely that a lender will either dismiss or discount heavily the value of the commercial component in his evaluation unless it is pre-let or pre-sold.

There is no getting around lenders’ strong geographical bias when it comes to residential development funding. London and the southeast are clearly of much greater appeal than provincial towns in those regions deeply affected by oversupply. Generally, commutability from London makes a project a lot more attractive. However, there are pockets of the country which will also find favour with some lenders (e.g. Bristol or Bath) so there is no hard and fast geographical rule: it is all about demonstrable demand.

Finally, lenders are still working hard to spread their lending capacities and hedge their risks. This means that smaller projects are likely to be of interest whilst larger project are not, especially where there is great concentration of similar properties reaching the market at the same time. As a rule of thumb, lenders’ comfort zone seems to be in the £3 million to £20 million GDV range.

Residential development funding options:

Provided a project meets the above criteria, there is a broad range of options for the developer seeking funding.

Traditional senior funding:

Developers who have access to equity or may own a site free and unencumbered will not necessarily seek highly geared funding options. For such borrowers, a straight forward senior facility may be sufficient with gearing up to 55%-65% of GDV. Red Chilli has a number of lenders active in this segment and such funding facilities can be arranged relatively easily provided the fundamentals of the project are sound.

Structured funding facility:

For those developers that have limited equity to inject into a new project, a structured facility might be more suitable. This consists of the combination of two loan facilities, a senior loan with first charge on the project and a mezzanine loan ranking behind with a second charge. This is quite a common structure which Red Chilli has been very successful in putting together over the last few months. Higher gearing of up to 70%-75% of GDV can be achieved but will clearly cost more. The senior facility will charge the usual interest rate (between 2 and 4% over Libor or base) but the mezz slice can be priced in a number of different ways from a fixed rolled up coupon to a look back IRR, a fixed priority exit fee or any combination of the above. This type of structure is very flexible and allows developers to spread their equity more thinly without having to pledge a portion of their profits. The number of mezzanine lenders in the current market is however limited and they tend to be small institutions with well defined lending criteria. It is fair to say that different lenders will have appetite for different types of projects but Red Chilli can help borrowers find the appropriate funding partner for their project.

Naturally, genuine arm’s length pre-sales are always going to make a residential development project more attractive and help a borrower achieve higher gearing however, provided demand is healthy, they are not necessary.

100% residential development funding:

This type of funding is clearly very popular with developers whose equity is committed in other projects but has become very difficult to obtain due to the current market woes. Red Chilli is working with a particular fund that continues to have appetite for 100% funding for projects within the greater London area (although projects in strong regional centres will be considered).

Borrower track record and strength of the project are clearly critical in this case and the funding will be structured as a JV with the developer into which 100% of the funds will be committed as equity. No debt is involved in this arrangement and no interest is being charged: the terms of the JV will simply see the profit being shared between the fund and the developer on percentage to be agreed from the outset. The maximum deal size for this structure is circa £8 million total costs and there is a minimum 25% ROC requirement.

In cases where a developer already owns a free and unencumbered site but wishes to make use of this structure, the fund will generally recognise the existing site value as equity and provide a priority return to the developer on exit before the profit being shared.

This structure is not suited for fully pre-sold projects but a small element of pre-sales is acceptable.

Residential development checklist:

As we approach the end of 2009 and with whispers of a stabilisation and possible moderate recovery in the residential property markets, it is encouraging to see that broader funding possibilities are being made available once again to developers. Should you wish to explore with Red Chilli those options for one of your projects, here is a checklist of what we required to enable us to evaluate your funding options:

• Developer’s track record
• Planning status of the project
• Detailed development appraisal and cash flow
• Details of any pre-lets or pre-sales
• Funding requirement (gearing level)
• RICS valuation of project/GDV if available

Bernard Frazer is a Partner at Red Chilli Structured Finance, an independent property finance advisory firm specialising in arranging funding for property projects in the UK and Europe.

He can be contacted on 0845 210 5000
www.redchilli.com

Red Chilli Structured Finance
Minories House
2-5 Minories
London EC3N 1BJ

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