Real estate must get to grips with fast-changing lending market

The following is an article written by Marcus Perry which was published in Real Asset Insight in early September 2022.

Before summer, real estate was proving resilient against the turbulence caused by geopolitics and financial markets. The hot sectors of BTR and industrial/logistics were continuing to make big headlines and the debt market was crowded with increasingly flexible lenders; the product of 10 years expanding liquidity in the debt markets.

Fast forward to autumn and real estate is experiencing a new environment and a market adjustment. Debt cost, availability and suitability has become more challenging and time consuming when assessing options for borrowers.

Fixed rate lending had become too cheap post pandemic. Global central banking policy pushed real estate fixed rates to new lows; the supply of available loans made some lenders desperate to deploy. This created opportunities for real estate developers to negotiate highly favourable terms.

Lenders, developers and investors are now taking stock. Headwinds of globally higher interest rates, general inflation and an energy price shock are impacting the decision of whether to progress individual projects, or on what basis.

For loans priced on a floating basis, the rate at which commercial and investment banks are prepared to fix interest rate exposure for borrowers, has risen sharply in 2022. Including lender margin, the absolute minimum cost to investors borrowing three-year money we have witnessed, on a fixed interest basis, is c. 500 bps. One year ago, the equivalent cost was sub 200 bps.

There are probably 250 active property lenders in the UK market, many of these are financed by private equity and fund managers. These lenders often offer fixed rate products – comprising their underlying investors required return plus margin and fees for the lender as arranger. In this more volatile environment, most lenders are wanting borrowers to take future interest rate risk rather than this risk being taken by the underlying investors.

We are also noticing an increase in lenders re-negotiating their terms at credit committee. This is partly due to speed of market change, but it also points to less liquidity in certain types of loans, and in some cases an opportunistic approach by lenders.

Lenders to development projects are requiring longer loan periods to reflect expectations of longer construction periods and sales periods, more onerous guarantee provisions, and construction costs contingencies often up to 10% of build costs, sometimes more.

Now widely appreciated, fixed price build contracts have shown their weaknesses in inflationary times. They do not offer a cast iron guarantee. Large cost increases experienced by a contractor open the door for a re-negotiation with the developer. If a contractor threatens to stop work or reduce quality, problems can be compounded by delay.

Helpfully, some developers are reporting a stabilisation in construction costs and a shortening of lead in times for materials. Some report the price of timber is down over 50% in 2022. The underwriting process has potentially become easier for construction costs and availability of materials appears to have eased. As a result of these factors, plus the fact that borrowers need to navigate an ever-changing lending landscape, we are seeing a pick-up in residential development funding enquiries to our capital advisory business

Development lenders have used this summer period to metabolise recent events. In our experience, those real estate opportunities that are strong i.e., by location, sector, product, sponsor track record and balance sheet, will find lenders willing to fund on competitive terms.

There are many lenders that need to deploy capital and overall there remains a great depth to the market. We suggest maintaining a wide pool of potential lenders, leveraging off the long-standing relationships of capital advisors and expecting twists and turns in the process prior to credit approval. It’s now, more than ever, imperative that borrowers are comfortable that their chosen lenders are happy to work with them should things not quite go to plan.