As rising interest rates present an obstacle for property developers across the UK, Peter MacAllan, director at J3 Advisory, explains how to reassess strategies amidst a rapidly changing financial landscape
Since the end of 2021, the UK Bank of England Base rate has risen upwards from the historic all-time low of 0.1%, to the current 5.25% as of March 2024.
The reasons for this turbulence are well documented, but the impact has been significant for property developers and the UK property market more broadly. The last 18 months have seen the bank base rate rise by 3%.
Rising interest rates have only been part of the issue for developers. Developers have also had to contend with rising build costs, lower-end values, and lower unit sales velocity!
Increased costs
Most developers can surmise that borrowing money in a higher interest rate environment is going to be more expensive than it was before. The knock-on effect of higher interest rates is that a developer can borrow less and will have a “gap” of equity to find.
Gross development loans
In the realm of development lending, it is common practice for lenders to provide an overall gross loan divided into distinct tranches. Lenders want the project to be fully funded from day one. This funding is split into tranches and comprises interest & fees, build costs & land loan.
Visualise this arrangement as a pie chart with a fixed circumference—if the interest tranche expands, it encroaches upon the land/day 1 tranche, reducing its share.
This dynamic presents a significant challenge for developers. With a larger interest tranche, they may be required to inject more of their own equity into their projects. However, most developers do not possess an unlimited reservoir of cash.
Consequently, they face a difficult choice: either scale back the number of projects they undertake, find third-party, often more expensive equity, or halt development altogether.
The implications of this situation are far-reaching. A reduction in development activity can lead to a slowdown in the construction sector, job losses, and a stifled economy.
Additionally, it can exacerbate the housing shortage, making it more difficult for people to find affordable places to live.
Lender minimum returns
We also need to consider that lender credit committees are still seeking similar minimum “profit on cost” returns on the projects they finance. This means that even if a developer can source the extra equity, a funder may now turn down the deal because the minimum profit hurdle isn’t met.
This situation means that sites that would have been built out and brought to the market before are not, which again hurts supply and demand.
Adaptation of land prices
You would expect that if finance costs go up, land prices go down, but land prices are notoriously slow to reflect to changes in finance costs. This is because land is a relatively
illiquid asset, and it’s not easily bought and sold. As a result, land prices tend to be sticky, not adjusting quickly to changes in the market.
Over the last 18 months, land valuers have assumed higher interest rates in their residual land value appraisals. This drives out a lower land value. So a developer might be buying land at £X, but the funding could be pegged to a lower land value at £Y, creating a funding gap.
Land is also relatively inelastic, with the amount of land available for development not easily increasing or decreasing in response to changes in demand. This is compounded further by long-term cash-rich investors who can hold out for a higher price and not bend to shorter-term market trends.
How to approach development funding in an uncertain interest rate environment?
- Overly stress test and sensitize all your assumptions (GDV, build costs, finance costs)
- Understand your contractor’s financials
- Don’t over-leverage if you can help it
- Understand the financial covenants you are bound by and what happens if you breach them
- Take advice and weigh up the pros and cons to determine whether it makes sense to float or fix. If necessary, seek independent hedging advice outside of your lender/bank
- Look out for minimum interest covenants
- Work with lenders who work with their borrowers and treat them well
- Keep an eye on the mortgage market – it is usually the key to your exit
- Overly communicate with your lender regarding any projected funding shortfalls caused by rising interest rates and/or costs.
How have development lenders acted with their borrowers over the last 24 months?
We surveyed a number of our key development lenders & borrowers regarding the impact of rising rates.
There have been a variety of different levels of support:
- Some lenders have turned their attention to investment loans rather than development loans
- In the main, lenders have been supportive and have allowed borrowers additional “headroom” in their development facilities. So rather than request further cash equity to be injected, they have increased their “loan-to-GDV”
- In some instances, where the projected “cost overrun” has been significant, the lender has given the borrower enough time/flexibility to source additional equity or mezzanine finance to plug the gap
- We don’t have a huge amount of evidence of lenders “enforcing” on their security given cost overruns (unless they are dealing with a poorly behaved & uncommunicative borrower)
- Some lenders have only offered fixed rates, so there is no “interest rate risk”.
Market stabilisation
The market has shown signs of stabilisation in the last 6 months. The Bank of England has voted to keep the base rate unchanged at 5.25% for the last 6 months.
The fear of ever-increasing interest rates has dissipated. The economic picture looks brighter and market sentiment is improving. The overall sentiment at March’s annual MIPIM real estate conference was one of “cautious optimism”.
Outlook for the rest of 2024
It’s fair to suggest that the market predicts that the bank base rate will be reduced this year. We could see a first cut by the end of the summer or sooner.
Looking at the SONIA “forward curve”, we could see the bank base rate at 4.5% or less by the end of 2024. Market predictions are great, but an actual physical cut would be very welcome for market confidence!
Despite the likelihood of interest rate reductions on the horizon, developers should always stress test any variable rate facilities. We live in an age of global uncertainty, and developers should always be mindful of the economic “butterfly effect” of non-UK events.
