12.03.10

By Max Sinclair

The rally in the real estate sector over the last nine months has confounded many expectations.

Much of the rally has centred on tightening investment yields, but there have also been encouraging pockets of rebounding occupier demand and a few instances — larger, grade A City offices and south-east distribution units — where tenants are actually competing for space. This has prompted the industry to start thinking about new supply, rather than solely focusing on existing product.

This begs the question of how development will be funded. A limited few will have the luxury of the corporate balance sheet. Land Securities, for example, has announced it will progress three central London office schemes. It well may try to secure some external funding for these, but it can launch them on the back of its corporate facilities and cash reserves.

Those that do not have access to such resources will have to pursue other avenues.

Life after death: new form of finance could revive dead development market I was struck recently by an article that referred to a forward-funding arrangement between Gazeley and Legal & General Property (Sheds supplement, 26.02.10). On the face of it, there is nothing too unusual in this — forward-funding is a tried-and-tested way of financing development, although it slightly faded from prominence in the years preceding 2007 as the bank debt market facilitated developments on a more competitive basis.

No doubt, forward-funding will have an important role to play in the future development market, especially as institutions are net recipients of inflows at present, and may well be struggling to find affordable good-quality investment stock. However, it is precisely because they are usually mechanisms to purchase assets that forward-funding is not suitable for all types of developers.

When will banks return?

This made me think about how and when the banks may come back into the development-funding arena. Unlike institutions, banks are not in the business of property ownership. So there is no conflict with developers who wish to retain the completed assets.

Clearly banks need to be comfortable with the extra “take-out” risk at the end of the project. The trade-off for the developer is with respect to equity: 100% finance is possible for a forward-funding, whereas a much higher level of equity would be required for a bank-funded development.

As far as I am aware, institutions control the amount that they are prepared to lend on development projects through “internal” fund-specific guidelines. For a bank, the regulations are much more stringent. The new Basel II capital-adequacy regime was introduced for many banks in early 2008, and this increases the capital that has to be allocated against development finance. This will no doubt limit the amount of capacity in a market that even pre-credit crunch was substantially restricted to a small number of specialist lenders.

I suspect that, for many bank lenders, it is still too early in the recovery for them to contemplate meaningful development exposures. And even when banks start selectively to return to the market, they will require a much greater level of prelets than previously to mitigate the new capital requirements.

Nonetheless, I envisage a rising number of requests from developers for this type of debt. Banks will, of course, be selective about whom they support, but in my view there is a positive role for development finance in any bank loan portfolio, as long as the risks are properly managed.

Development should not be allowed to become a significant proportion of overall portfolios. For us at Eurohypo, depending upon the cycle, it will be no more than 5% to 15% of a total book.

Indeed, from the late 1990s through to the credit crunch, bank finance facilitated schemes across different sectors: the build-out of Canary Wharf at the end of the 1990s, and the construction of many large buildings in the City such as Tower Place — let to Marsh McLennan — and Moor House were all successfully funded with bank debt. Liverpool One, the large retail-led development by Grosvenor, is among the many shopping centre schemes that have been backed by banks.

Encouragingly, bank debt through this period did not fuel large volumes of speculative development, and the current credit and regulatory environment will hopefully ensure that this remains the case.

It will be interesting to see whether the combination of an institutional forward-funding market and a limited bank development finance market will be sufficient to oil the wheels of the development cycle. That will depend on demand, but it strikes me that it is possible for a different source of development finance to emerge. This could sit somewhere between an institutional market that seeks to buy assets and a bank debt market whose capacity will be limited by credit appetite, Basel II restraints and — no doubt — the legacy of existing portfolios. We will have to wait and see.

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Source: Property Week (www.propertyweek.co.uk)