|Insider Knowledge Feature
Property Funding - Challenges of the New Paradigm
Strata works primarily with property developers and investors to structure and project manage the delivery of debt, mezzanine and equity across a broad range of real estate transactions. Advice is also provided to individuals or companies with cash who wish to invest in property via mezzanine or equity participation.
The banking market has slowed rather than stopped: assertions that the debt market has closed are more for press headlines than intelligent debate. Most lenders do, however, wish to contain their exposure to property and, after years of expansion, some need to reduce their property loan books due to a combination of liquidity restrictions and heavy losses resulting from falling property values.
Good clients with viable developments (pre-let with acceptable tenant covenants) can still obtain senior debt, but at lower loan to value ratios. The LTV for a pre-let scheme has typically fallen from 70-75% to 55-60%. Debt pricing has also increased.
Developers are, therefore, required to commit additional equity to sustain activity, although some either cannot, or do not want to provide more of their own cash. As a result, they are seeking mezzanine finance to ‘top slice’ senior debt and reduce their equity position.
For mezzanine lenders, the climate is favourable in context of where the market is now, relative to a few years ago.
In the previous market cycle, mezzanine often reached LTVs up to 85-90%. Since the peak of the property market in late 2006, property values have declined by about 40% per the IPD Index. Hence for some deals completed in recent years, the value of equity and mezzanine has been destroyed.
IRR’s for mezzanine would have been around 15% a few years ago, although current IRR’s are no less than 20% and often higher due to the dynamics of supply and demand.
With property values corrected, loan to values reduced and pricing increased, the starting point now for a new mezzanine fund is very favourable. Mezzanine LTV’s are unlikely to exceed 75% for the best deals and hence this type of funding merely takes up the space previously occupied by senior debt, but at premium pricing and any downside in security values is largely checked.
As only the better quality developments are able to obtain senior debt, the risk in the mezzanine market has been improved with little or no speculative content. Multiple occupier schemes may not be fully let on day one, but have sufficient Agreements to Lease contracted to ensure viability at PC.
Developers are also generally those with more experience; the recent new entrants who arrived to make money in a rising market have been flushed out.
The supply of mezzanine is currently split between Funds which are few in number and High Net Worth individuals, or cash rich companies that provide mezzanine ad hoc to specific deals.
With supply lagging behind demand by some margin, there is an opportunity for new mezzanine funds, or those with surplus cash to enter the market. If supply does not increase then development activity, particularly that undertaken by mid-sized privately owned companies, will be restricted for several years.
With LTV’s also reduced for investment loans, refinancing no longer provides certainty for exiting mezzanine. Investment loans generally see no more than 65-70% LTV, which does not provide an exit route for a 75% LTV development funding package. Accordingly, mezzanine lenders have to ensure that the completed scheme will be sold after PC and undertake the necessary due diligence on the investment market regarding exit.
In addition to lower LTV’s, investment lending has also seen other restrictions imposed by lenders. Interest only loans are difficult, if not impossible to find, as are capital repayment holidays. Where lenders are comfortable with the sustainability of income, they are sometimes prepared to amortise loans over a profile up to 20 years, which demonstrates a willingness still to accept some re-letting risk.
When making an application for funding, Capital Allowances and other tax relief’s can often be used to improve the post tax cash flow position. Wherever possible, therefore, they should always be factored into the financial appraisals at the earliest opportunity, and indeed this is something some funders are now requesting.
The property market is likely to see constrained levels of funding for several years to come, and where credit is available, terms will reflect a paradigm shift compared to recent years.
David Smith is a director of Strata Real Estate Consulting LLP. For more information on funding options please contact David Smith at email@example.com or firstname.lastname@example.org.