31 Jan Answer The Broker
More and more developers are using off site manufactured frames for construction. Typically requiring payment prior to erection i.e. 10% on order, 50% upon delivery and 40% upon erection. As development finance is funded in arrears, this type of construction doesn’t lend itself to be funded with traditional finance methods. Do you feel lenders will adapt to this as It becomes more popular and what solutions to this can you envisage?
This is a difficult question, the most obvious solution is that the development lender finances the modular construction, but the developer finances the acquisition of the land – the lender can therefore assess its exposure against the value of the land even if issues arise with the off-site construction. Nevertheless, this is a very expensive solution for the developer and is more likely to work only in southern England where land values make up a significant proportion of overall development costs.
I’m seeing more and more steel framed builds for residential properties. Some lenders take a view that exits can be difficult due to It not being a standard construction method. (i.e. block and brick). Do the steel frame schemes give you cause for concern when the exit of development finance is considered?
When assessing a development one of the most important aspects of our underwriting is gaining confidence around the financial institutions that buyers will use to help them purchase. For traditional construction methods, the Council of Mortgage Lenders provide detailed guidance which can be followed to ensure a property will qualify for a residential mortgage, but steel framed buildings are considered non-standard construction. Nevertheless, most lenders further down the financing chain now understand that:
- steel components can corrode severely, especially at the bases of the wall and the joins to the concrete floor slab – which obviously can’t be easily detected post completion of the development
- steel framed buildings tend to have relatively poor insulation and energy efficiency – naturally of importance with current EPC requirements and rising energy bills
Over the last few years PDR schemes have been very popular with developers due to the general opinion that cost per sqft to construct is cheaper than building from scratch. In your opinion, do you feel this mirrors the schemes in which you have funded?
PDR schemes tend to have a lower construction cost – this makes sense given that there is an existing structure in place. However, costs can add up as these types of schemes tend to be in cities and town centres and can incurr expensive site access issues and, stock that is being converted may also have been originally built using materials such as asbestos which will need to be removed and disposed of, creating further challenges.
Additionally, PDR schemes are of course a necessity born of a slow planning process, limited land that can be built on and an ever growing population. This is reflected in the fact that a number of the PDR schemes that Avamore has financed have tended to be affordable and mid-market in nature and therefore the development costs, of which internal fixes and finishes represent a notable proportion, are understandably lower.
What do you think will be the new PDR trend in developments?
Office to residential conversions will continue for as long as possible; although, whereas historically we have seen developers converting centrally located office buildings surrounded by residential properties, very recently we are seeing PDR consents for office buildings that are situated on the edge or within business parks which are generally poorer in quality.
There has been some discussion around warehouses offering up the next opportunity for PDR schemes even though these rights will end in the next couple of years unless extended. However, there will be major challenges in terms of architecture, aesthetics and suitability of location.
On smaller schemes, some lenders are providing the drawdowns subject to residual valuations as opposed to QS sign offs. What do you feel the risks are when employing this strategy?
This seems like a risky strategy. No matter how small the scheme, the QS’ role is greater than simply certifying drawdowns. Instead at each stage, it is important that they take a holistic view considering compliance with the JCT, warranties, planning condition discharges and agreements with statutory bodies. Furthermore, a QS is more suitably qualified to determine mid-milestone how much has actually been spent, what costs are required to be incurred before practical completion will be achieved and whether or not there has been a cost overrun. Whilst valuers can re-determine their residual calculation based on numbers that have been provided by the developer, they are unlikely to have the professional expertise to deal with the other items highlighted above.
In the latest Bank of England Agents’ summary of business conditions (2019 Q3), it is noted that construction output growth weakened due to subdued public and
commercial activity. Do you think this trend will continue and do you feel it is making developers reluctant to start new schemes?
Brexit has undoubtedly been a trigger for subdued activity in the construction sector because of the uncertainty which it brings. August 2019 was the ninth month in a row that annual house price growth remained under 1% (they fell in London by 2.7% in the year to June 2019) and, naturally, it is easy to assume that developers will be deterred from starting new projects.
Nevertheless, at Avamore we have not seen a significant reduction in the number of transactions. Instead, there are clear signs of developers de-risking as far as possible to safeguard schemes. This includes conducting greater due diligence around sites and developers not feeling the pressure from sellers to transact quickly. It is likely that we may see the market moving more slowly as developers approach projects more carefully, however we are unlikely to see developers stopping completely.
The same report advised industrial and warehouse premises construction continued to grow what do you feel the risks are when lending against a project of this nature?
There has been a shift in buying habits in recent times and, so the decline in retail has been countered by the rise of industrial and warehouse premises construction. This shift in buying habits facilitated e-commerce businesses such as Amazon which requires the construction of national, regional and ‘last mile’ warehouses which should in theory provide alternative opportunities for developers.
The challenge behind funding any commercial scheme is that you are likely to be doing so on a speculative basis. Furthermore, owners/tenants of warehouses and industrial units have incredibly specific requirements including size, locations and equipment; even falling outside of required locations by a few miles can impact the feasibility of actually being able to rent or sell the units on.
Brexit aside, what do you think will be the main problems that developers will encounter over the next 12 months?
In general, developers are facing a number of headwinds:
- Land prices remain high in proportion to total development costs
- There is a lack of suitable development sites in areas where there is appropriate infrastructure
- The planning process continues to be a significant problem regardless of what is happening around Brexit
Developers are acting more cautiously, especially in terms of the amount of due diligence carried out on projects in order to de-risk them as much as possible. The thinking appears to be that they want to continue to purchase and develop but with limited profitability they want to ensure that those reduced profit margins are accurate and not subject to influence by unknown factors.
Amit Majithia is a Principal at Avamore Capital; he heads the underwriting and credit function and has successfully overseen the completion of over £150m worth of property finance deals at the firm. In addition, Amit played a fundamental role in creating Avamore’s market leading Finish & Exit product which was launched in early 2019 in response to the evolving needs of property developers. Amit draws upon his previous legal background as a property lawyer at Taylor Wessing and property experience developing city centre mixed use projects to bring a well-rounded perspective to the team.