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Real estate finance spring news

15 February 2012

In our last bulletin, we focused on a report on UK development finance undertaken by the Property Banking Forum, a joint initiative between the Investment Property Forum and the Association of Property Bankers. The report posted some interesting results which we continue to examine below, together with our predictions for what the rest of 2012 has in store for development finance and, in wider terms, for the property finance market generally.

Development finance

Availability of funding

Development finance is becoming increasingly difficult to obtain and, for those who are able to secure funding, increasingly expensive. This is set to remain the case for 2012 and beyond. Indeed, pricing is on the general increase and, whilst clarity on Basel III is still awaited, it is agreed that new capital adequacy requirements will have a substantial impact on future development lending and its associated cost. In addition, there is more recourse required with development loans than ever before, with cost overrun and interest shortfall guarantees often being unlimited, thereby placing an additional slice of risk on borrowers. While developers argue that borrowing costs are too high, lenders have argued that margins are still too low to reflect the true risk and cost of financing developments.

Pricing and alternative methods of raising funding

Loan-to-value ratios hovered at 55-60 during 2011 and should remain at similar levels during 2012, meaning that the average borrower now has to find substantially more capital to contribute to their scheme than in previous years. Borrowers have stated that this has resulted in developments being delayed and, alternative sources of finance are often sought. Borrowers with stronger balance sheets might rely on corporate banking facilities to bridge any funding gaps, whilst others will look to equity, internal cash flow or joint venture arrangements, but the concern still remains that many operators are simply unable to raise the finance necessary to get their developments built. In many instances now, borrowers are delaying development until they have secured a pre-let. This is a risky strategy however as in a difficult market a would-be occupier may use their market advantage to negotiate a reduction in the premium and/or rental income they are paying to the developer, which may result in the project becoming economically unviable. On a more positive note, there are strong signs that forward funding deals may increase in popularity during 2012, with institutional investors providing the necessary financing upfront. In the long run, this may prove to be a more viable option for many borrowers than relying solely on debt finance. Mezzanine finance is also posed to make a big impact in 2012 with mezzanine providers stating that they have been swamped with enquiries over the last quarter. As most European banks now need to think seriously about deleveraging and recapitalising, there is more opportunity than ever before for mezzanine providers. Loan-to-value ratios are stabilising at around 70 here.

Sector preferences

During 2011, office, retail and industrial tended to be priced at the lower end of the margin spectrum (assuming water tight pre-lets and/or pre-sales were in place), whereas hotels, residential and speculative office space attracted higher rates. This is unlikely to change during the course of 2012, although early indications suggest that, relatively speaking, development finance for boutique hotels may be slightly easier (and cheaper) to obtain. Residential lending remains difficult, however, unless it is central London based and small enough to be funded on a bilateral basis. High demand from wealthy non-UK investors continues to make central London a very lucrative market and this is unlikely to change for the foreseeable future. Unfortunately, however, it looks unlikely that this level of interest will extend outside the capital, at least for the time being (and certainly not in the absence of pre-sales where the banks are concerned). With regard to speculative office space, there is a degree of appetite in this sector, but it is still highly selective in nature.

Economic climate

Most borrowers are confident that the availability of development finance will improve over time, albeit slowly, and may take up to five years to fully recover. Borrowers are, becoming increasingly realistic and accept that recovery will not return to pre-2008 levels, either in terms of availability or price. The main concerns are the ongoing impact of the European sovereign debt crisis and the new regulatory environment. The winners in this market will be those who have the cash to invest upfront and who can devise creative solutions to the liquidity crisis.

The future of development funding

In the future, it is likely that institutions will take the place of the traditional banking sources in the development finance arena. Presently, however, institutions are engaging more actively in property investment, rather than development. For many, development funding does not fit well with the returns demanded by their investor base. It also requires a very different skill set and uses up far more resources than direct investment acquisition. In time, specialist debt funds may emerge to fill the gap and fully exploit the opportunities in this sector.

Bank funding in 2012 - a repeat of 2011 or the dawning of a new era?

2011 must be viewed as a year of two halves. Whilst the first half suggested that many European economies had started to pull out of recession and, in property, UK capital values were rising, the second half revealed poor GDP growth in Europe and fears of a much deeper crisis as the Euro contagion spread from the smaller Eurozone countries to Italy, Spain and even France. As we enter 2012, there are fresh concerns that the end of 2011 may have been the calm before the property storm. With banks now unloading unwanted real estate loans in ever greater amounts, it is clear that there are a large percentage of problem property loans on their books which they cannot shift. The latest De Montfort report on UK Commercial Property Lending states that half of all UK real estate loans, worth approximately £100 billion, "could not be refinanced on current market terms". Provided banks are prepared to take the real market price, they may simply have to off-load this debt. Distressed loan buying is gaining popularity in Europe, although the actual amount of distressed debt is underestimated as so few deals are made public. This current wave of debt investment opportunity is luring new investors across the spectrum, from US private equity houses and pension funds, to insurers and CMBS buyers. For some, business is certainly booming.

The lending landscape is changing rapidly, with major banks such as SocGen, Eurohypo, DG Hyp and WestImmo having recently exited the real estate finance market. Basel III is driving banks away from property lending just as quickly as Solvency II regulation is attracting insurers by rewarding diversification. There is certainly plenty of opportunity for new players to enter the market in 2012 and fill the void left by the banks.

Our real estate finance team are at the forefront of market developments and are well placed to assist you with any of your funding needs. To find out more, please contact Nina Armstrong or Paul Ray.

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