Written by Matthew Yassin, Director Structured Finance
As the finance world continues its recovery from the shock of recent worldly events, we continue to analyse the effect this is having on developers and the development facilities available to them.
Fundamentally, a development loan consists of a few key components including:
· Land Loan
· Construction Loan
· Interest charges
· Professional fees and contingency.
What factors can affect these?
1. Timescale
It is currently evident that lenders are extending the term on loans to compress the risk associated in delivery. Although a development has the potential to reach practical completion within a shorter timescale, it is prudent to allow some headroom so the scheme is not under pressure. The obvious effect this has is primarily on the interest portion of the loan. By having a longer proposed term the interest is naturally increased which creates more cost. The underlining concern regarding timescales is directly connected to the disturbance in the market such as; Contractor lead times, material shortages, potential labour shortages which are all supply chain issues. Considering the overall uncertainty, the lender must create some slack in the facility – and by the extending the term, it will give more comfort in delivering on time and not breach the loan covenant.
2. Material Costs
The increasing costs of materials has subsequently increased the build costs and therefore the construction facility amount. Due to risk, lenders like to ensure that the construction facility is 100% funded. Consequently, if the construction cost has increased, the impact is on the day one loan amount which inevitably will be reduced.
3. Contingency
Lenders need to ensure that their loans are viable to deliver the project for the developer. Consequently, by the running the numbers in today’s world they prefer an additional layer of protection for both the developer’s scheme and their loan, which is normally centred on the level of contingency. This is the facility that allows cover for any overruns in cost or timescale and other unidentified costs that may occur throughout the development. What we are seeing is this being increased from 5/7.5% - to a comfortable 10% or more in some cases dependant on the scheme. Again, this portion of the loan needs to be factored into the day one costs and consequently it is having a negative effect on the day one loan amount.
By extending the term on the loan, the rise of material costs and the increased contingency means the residual loan facility is significantly decreased. Below is an example of a £4.5m loan facility:
Previous Current
Facility £4.5m Facility £4.5m
Land loan £500k (50% LTV) Land Loan £0 (LTV)
Contingency £750k (7.5%) Contingency £900k (10%)
Interest Facility £250k Interest Facility £300k
Build Cost Facility £3m Build Cost Facility £3.3m
The direct impact being felt is the reduced land loan as a result of increasing the other elements of the loan. This means that we are increasingly seeing mezzanine and equity finance being required by developers.
With mezzanine and equity finance in higher demand, there has been huge growth within this space. It has become much more common for junior lenders to form part of structuring the debt, supported by positivity in the residential and investment sectors as well as readily available mortgages.
Ultimately day one loans are reduced as a result, but only time will tell if this is a short-term adjustment or if we are entering a new phase in the development world given the events of the past 2 years. It’s fascinating seeing the market adapt to new conditions and we continue to be bullish about the liquidity available throughout the capital stack and new products on the horizon.