December 20 2023

Building returns: Development finance

Kathryn Gaw Features, Property, Top 3 Apex Group, Blackstone Real Estate, Katten Muchin Rosenman UK, Keith Miller, Kumar Tewari

Development finance is continuing to flourish despite economic challenges, with alternative lenders poised to benefit, reports Kathryn Gaw…

Property development is a notoriously difficult business to navigate, mainly due to the lack of mainstream, easily available funding. Before the 2008 global financial crisis, banks were happy to lend to both new and established development businesses, but the housing crisis spooked these major lenders and caused them to pull back.

Post-crisis regulation around liquidity and capital requirement ratios saw most banks review their risk profiles and many have opted to simply stop lending to small- and medium-sized enterprise (SME) property developers altogether. It didn’t take long for alternative lenders to identify this gap in the funding market and tap into the opportunities it presents. 15 years later, the property development funding space is dominated by private lenders, and business is booming.

Earlier this year the Blackstone Real Estate Partners X fund closed with $30.4bn (£24.22bn) of total capital commitments, making it one of the largest real estate fund managers in the world.

While details of the fund’s allocation split are not publicly available, Blackstone has a history of backing multi-million pound development projects in the UK from its real estate debt funds.

“We’re seeing a slight increase in volume,” says Keith Miller, global head of product, private debt at Apex Group.

“Real estate debt funds have obviously been through a period of shoring up their portfolios every year, making sure that they are secure. But we’re starting to see a couple of fundraises now in that space. So that’s a sign, hopefully, that there’s a little bit more optimism on the way.”

Kumar Tewari, partner and head of European private credit at law firm Katten Muchin Rosenman UK agrees that the real estate debt fund market is “buoyant” at the moment, despite challenging macroeconomic conditions and high interest rates impacting property sales.

While there has been a slowdown in property purchases post pandemic, there is still a shortage of new builds, and property developers are seemingly in constant need of new sources of financing.

Real estate debt funds have traditionally taken an opportunistic approach to allocations, which allows them to take advantage of these current funding gaps and build out their position in the market.

“We have seen a really healthy share of private lenders, extremely well-known names really stepping up and having a good pipeline of really strong mandates with strong property assets, with good tenants, with a good receivable underlying the real estate,” he says.

In short, if you are an SME property developer planning a new project for 2024, private debt funds may represent the best chance for funding.

Banks have been extremely slow to return to property development lending post-2008, and private lenders have seized the opportunity to extend their presence in the sector. These funds have a long track record of performance, and they have earned the trust of institutional and high-net-worth individual investors along the way.

They have done this by focusing on solid credit underwriting, specialising in specific segments of the market, and making opportunistic investments. For example, Tewari notes that some lenders were able to take advantage of the low occupancy rates in offices to up their investment in commercial real estate in the aftermath of the pandemic.

Other fund managers have recommitted to the residential side of the market, in an effort to address the ongoing housing shortage in the UK and Europe.

“When it comes to residential property, the government is still trying to build affordable new homes,” says Tewari.

“And I think the private credit market to a large extent, has really begun to play its part in funding the right sponsors to deliver the right schemes.”

Property development finance can offer higher returns but also comes with the threat of higher risk.

Property developments are fraught with potential issues, from delayed planning permissions to weather-related stoppages, to supply chain shortages. The challenge for property lenders is to manage these risks on behalf of their investors. This is usually done by taking security against new projects and conducting detailed due diligence on the project managers.

Some lenders are choosing to make funding available in tranches, which allows them to establish pre-agreed milestones and manage the risk of the project more accurately. Tranche funding allows the lender to have more control over the project and when done effectively, can minimise the risk to the investor.

This in turn enables more funding to be made available more quickly, bolstering the property market at a time when financing is in short supply.

“Typically for development finance, you may have your primary financing, acquisition financing or some other working capital finance,” explains Tewari.

“It may be refinancing, but the development tranche is really a specific loan product, often within a wider loan offering.

“The ability to utilize that loan largely depends on agreed milestones and the delivery of what we call conditions precedent (CPs) and project deliverables. So against your receipts or your milestones, a sponsor is typically able to draw down all or some of that development tranche in tranches or as a whole loan.

“But the requirements to be able to borrow under that development tranche are fairly evolved.

“Lenders will go through a CP requirement where they tick off certain deliverable rules that need to be met. They number crunch, they look at the forecasting, the budget, and if all those things are met and other conditions within the facility agreement are met and are likely to continue to be met, then a drawdown of that next tranche or that entirety of that development loan is permitted.”

Some alternative property lenders have also opted to make affordable housing and energy-efficient housing a priority in their business, in response to the growing demand for environmental, social and governance (ESG) friendly investments.

According to recent research from the CBRE, property lenders are increasingly focusing on ESG issues, with many lenders refusing to fund housing projects which come with an energy performance certificate lower than a B.

As a result, new build developments are taking preference over refurbs, as lenders can have more control at the blueprint stage, ensuring that affordable housing and energy efficiency are embedded in the project from the very start.

“The reality is there is a shortage of affordable housing,” says Tewari. “There’s a shortage of housing generally.

“There are old buildings that, frankly, probably need to be retired. There are new buildings that need to come up in order to meet current ESG thinking and other environmental credentials. And I think lenders are fully on top of that.”

Real estate debt funds are offering something else that investors want – double digit returns.

Property development sits at the high-risk, high return end of the investing spectrum, with dedicated property development lenders often targeting returns of 13 per cent or higher. Real estate debt funds can benefit from this upside by including more development loans within their portfolios, while enhanced due diligence can minimise the associated risks.

On the borrower side, real estate debt funds offer a lifeline during a prolonged funding crisis. For SME developers seeking funding of $100m or less, private debt funds are often the only option available.

Meanwhile, for smaller developments, P2P property development lenders can bridge the funding gap by providing up to 100 per cent of the funding of smaller projects which may not have the scale to attract larger debt managers.

“There are different genres of real estate and different ideas around what constitutes real estate finance and the type of risk that goes with that,” adds Tewari.

“But if you are looking to construct a scheme, for example, in the private rental sector, or the purpose-built student accommodation sector; if you have a concept that works well within that geography and there’s a clear need for it, and from a credit perspective, it’s something that can be banked, I think lenders will look at that.”

In a recent report on the property market, the law firm Macfarlanes commented that the current market environment, characterised by diminishing credit supply, rising interest rates, and higher margins, has led to what many managers believe to be a unique opportunity in real estate debt, “not seen in the last decade”.

Development finance is most certainly a key part of this unique opportunity, which is set to benefit debt funds and investors alike.

Building returns: Development finance

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