31 Jan Answer The Broker
Answer the Broker – Amit Majithia’s latest feature.
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. 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. Following this can ensure a property will qualify for a residential mortgage. 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. In most cases, these schemes are in cities and town centers. These can incur expensive site access issues. Also, stock that is being converted might have been originally built using materials such as asbestos which must be removed and disposed of, creating further challenges.
Additionally, PDR schemes are a necessity born of a slow planning process, limited land for build and an ever-growing population. A number of Avamore funded PDR scheme are affordable and mid-market in nature. 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. Historically, we have seen developers converting centrally located office buildings surrounded by residential properties. However, PDR consent towards office buildings, situated on the edge or within business parks, are on the rise. These are generally poorer in quality.
There has been some discussion around warehouses offering up the next opportunity for PDR schemes. Although, 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, it is important 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 money is spent, what costs are incurred before practical completion is achieved and whether or not the cost is overrun. Valuers can re-determine their residual calculation based on numbers that have been provided by the developer. However, 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. This was because of 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.
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. This requires the construction of national, regional and ‘last mile’ warehouses. This 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 can impact the feasibility of being able to rent or sell units.
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. With limited profitability, they want to ensure that reduced profit margins are accurate. Also, they are not subject to influence by unknown factors.
Amit Majithia is a Principal at Avamore Capital. He heads the underwriting and credit function. He 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. He also uses property experience developing city center mixed-use projects to bring a well-rounded perspective to the team.