2014 saw a substantial re-emergence and growth of industry confidence in the real estate sector. This continued into 2015 with investment in real estate increasing from c.£30bn in 2014 to c.£45bn in 2015.
With property prices on the increase and yields averaging 3% to 5% above gilts, real estate is a more attractive asset class for investors. This has meant that banks have been able more easily to sell down the loans that they no longer want and carry out a series of 'mopping up' transactions during 2014/2015. This will allow the focus to return to origination.
However the banks will be returning to a much changed market:
Emergence of alternative lenders in the real estate market
During the 2008 to 2014 period, mezzanine lenders, private equity funds, insurance funds and pension funds stepped in to fill the void from traditional bank finance and considerably increased their respective market share. Alternative finance providers were responsible for 50% of all new property lends in the last 3 years meaning that there is a far greater spread across commercial real estate lends.
Banks now sit within a heightened regulatory environment. Basel III (which aims to limit the potential risk and impact of a future crisis) requires banks to hold a greater proportion of higher quality capital against more conservatively risk weighted assets (RWA) which will largely influence the areas / properties into which the banks can invest.
The banks are further restricted by CRD IV under which they must hold a capital reserve equating to a minimum of 8% of their RWA's and at least 4.5% of their RWA's must be common equity tier 1 capital i.e the most secure assets.
The London office market was the first to recover post-recession in terms of capital value, rental value and attracting investors (both debt and equity). Debt investors tend to view London prime office space as a liquid investment which has added to competitiveness in this part of the market. As a result of this, margins have been squeezed with yields down from 11% to 6% meaning that funders / investors need to consider riskier lends (eg higher loan-to-value (LTV) ratios, less stable geographical regions, higher debt to equity ratios, weaker covenant businesses and developments), if wanting higher returns.
How does property impact upon growth on a macro-economic level?
The main areas in which real estate finance can impact on macro-economic growth are development, asset management and wholesale renewal of assets with new injection of capital e.g. refreshing the stock of real estate available for businesses (Development Finance). The development and renewal of properties is what drives increased efficiency and productivity levels of the real estate available.
Development Finance is a comparatively risky investment in the real estate market - there are a raft of potential uncertainties / risk exposures in unbuilt schemes including issues obtaining planning permission, unanticipated construction costs and units / buildings that are vacant for lengthy durations following practical completion. Whilst the higher risk profile is what makes this area attractive to certain investors seeking higher yields it is also the main contributing factor to lack of funding in this area of the market.
For example, under Basel III, banks are required to hold greater capital against Development Finance lends due to the increased risk profile. This makes Development Finance a comparatively less cost-efficient form of lending for banks. Research from the Investment Property Forum shows that banks still dominate the market for senior lending on pre-let and pre-sold developments but the appetite for less advanced developments is lacking.
Additionally, insurance funds (which have an increased stake in the real estate market) favour stable investments with known cash flow patterns in order to meet annuities and are therefore more likely to provide investment facilities with stable income from a quality tenant base. There is an inherent cash flow uncertainty in Development Finance due to undrawn commitments.
On this trend, Land Securities (Britain's largest plc developer) announced last year that it would not commence work on any further developments without pre-lets in place.
The fall in Development Finance available since the recession is considerable; the total stock of real estate lending available has fallen from 11% in 2007 to just 3% in 2014. The concern with the lack of investment in development is that this will lead to a lack of productive / efficient spaces available to businesses. The amount of new industrial space available over the past six years has fallen by 80% and, increasingly, occupiers are left with no option but to design and develop their own space or continue in outdated, non-efficient spaces.
If this continues it is anticipated that overall productivity levels will remain stagnant or begin to decline which in turn will have a direct knock-on impact upon the economy.
Small developers have particularly struggled from a lack of access to finance with neither banks nor alternative finance providers having much appetite for investment in these businesses.
The emergence of peer-to-peer lending platforms is likely to provide access to capital to small developers. It is anticipated that c.£87m of Development Finance will be raised via peer-to-peer lending platforms this year.
Investing in development
The market view is that now is a good time to invest in development. The UK is currently in an upwards cycle and the recovery is mirroring that of the previous crash in the 1990's. This suggests that there is a significant time period until the next peak in which to inject capital and make an exit before the next economic downturn.
The current pricing in Development Finance should be attractive to investors. Investment margins are about half of those in development and development LTV's are much lower (typically sub-50%).
This document is for informational purposes only and does not constitute legal advice. It is recommended that specific professional advice is sought before acting on any of the information given.