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Lending to property developers: how safe is it?

Financing a mezzanine loan to a property developer could earn you an impressive 12%.

Lending to property developers: how safe is it?

Offering mezzanine finance to property developers can generate impressive returns, but it's not without risk, says Lorna Bourke.

Balancing risk and reward

The hunt for a decent return on investment inevitably means taking more risks. But there are still opportunities around offering some security – surprisingly in one of the most bombed-out sectors, property. 

Property developers, like everyone else, are suffering from a shortage of finance as the banks have cut the amount they will lend in relation to a property’s value. This has hit developments in progress, both residential and commercial, particularly hard, and the banks have left many firms high and dry.

Before the credit crunch, property developers could typically expect bank funding of up to 85% of the cost of development. But as with all sectors, the banks have become more risk averse. Bank of England figures for the fourth quarter of 2010 showed that bank lending to the property sector experienced its largest drop in a three-month period since 1987. 

As a result developers can only expect to fund around 60-65% of the cost of development from the banks, or ‘senior debt’ providers. This means the developer must put up more money themselves or raise additional finance from another source, inevitably at higher interest rates.

Mezzanine finance

Other lenders are stepping in to fill this gap. ‘We are always open to having new sources of lending,’ confirms Simon Gammon of Knight Frank Finance, which provides mortgage finance for high-end properties with an average loan of £2.8 million. ‘We would obviously want to do due diligence on any investor, but you can get returns of around 12% on mezzanine finance, which tends to be short-term lending of up to 24 months,’ he says. 

The minimum amount required would be about £250,000, so this is only suitable for wealthy investors. Many of Knight Frank’s wealthy clients invest individually on a project-by-project basis, which means they can structure the exit strategy – something that is more difficult to do with a property investment fund.

‘There is a lot of interest in mezzanine finance, and we tend to do it by matching residential property developers with wealthy investors looking for a better return on their money,’ says Mark Harris of SPF Private Clients, which also specialises in mortgages for high-end residential property of £2 million or more.  

‘They come to us with deals and they are looking for a return of around 20% so they can offer clients, say, 12%.’ This sounds like expensive borrowing for the developer, but as Harris points out ‘this is short-term funding, and if the borrowing enables the developer to unlock several million in potential profits it is worth paying’.

Funds versus individual projects

Harris says SPF is not really interested in investors with less than £500,000 to commit to an individual project, and he prefers to match investors with a developer because it keeps down costs. ‘There are a range of private equity funds in this area who will offer a spread of investments,’ he says. But he says that like all funds you may not be able to realise your investment when you want to.

Virtually all property funds have a clause that allows the managers to suspend redemptions in adverse conditions – as many investors in property mutual funds found out to their cost in 2008. The appeal of financing of a specific development directly is that the exit route is written into the deal. 

How safe is it?

So how does mezzanine finance work, and what is your security? When the banks lend they take a ‘first charge’ or mortgage on the development. Mezzanine finance typically involves a second charge on the development. This means that in the event of default by the borrower the property is sold and the bank gets paid out first; mezzanine financiers only get paid after all the bank debt has been paid off. The loan is riskier, but is still secured lending.

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11 comments so far. Why not have your say?

Michael Peters Fenwicks

Oct 28, 2011 at 12:26

Biggest observation is transparency among all parties subject to how commission structure is set up.

The devil is in that detail subject to any exits and other particulars with other points Lorna being on the money.

Best advise for any investor wanting a slice of this know what you're buying no matter what other parties say.

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Anonymous 1 needed this 'off the record'

Oct 28, 2011 at 12:29

Mezz funding works extremely well. Its senior Debt that we cant get here in Cornwall Seems the world ends once you get out of the M25

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Simon Taylor

Oct 28, 2011 at 14:30

If you want a better understanding of where lending money to property developers gets you, take a look at the share price of HBOS then Lloyds Banking Group.

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Charles Zub

Oct 28, 2011 at 15:38

Bank lending after the last depression in property prices (1990 to 1997) was 70/30 (based on total project costs -- land + construction costs). This base was established because house prices never dropped by more than 30% (I believe the actual decline was 27%, but don't quote me on that) in the post 1990 period. It seemed like a reasonable standard. As the market heated up, and the banks became more greedy, the financing banks were prepared to loan went up to 85%, 90% and in some cases 100%. These were very high amounts, but even then, in the worst case scenario the banks exposure was 30%, and likely to be much less. We haven't seen house prices decline by anywhere near that amount.. So far the banks have not seen house prices in the UK fall by even a fraction of that amount. Property development and housing are not areas of risk for the banks.

Where the problem comes in is that the banks have all become dysfunctional. Regulations were relaxed, worldwide, for banks over the past 15 years. Where at one time banks had to have equity that was at least 10% of the loans they had outstanding, and could not lend more than 10% of their equity to a single customer, these requirements virtually disappeared. Banks became geniuses at risk management - there was no need to have more than 1% - 2% equity to loans, and banks bragged about how good they were and their amazing risk management skills. It does not take a great mathematician to know that no one is that good. However, what this permitted was for the banks to strip the assets out of the banks, taking that home as bonuses, or dividends. To compound the problem, banks became totally reliant on short-term financing. When I studied banking, one of the key elements was balancing long-term loans against long-term finance, and the same for short-term, plus you held a reserve for funds that depositors would want on a daily basis. It appears that this is no longer taught at university. Things have changed so much that when I found some of my old books on banking, I just threw them away. Compounding this, the banks are dysfunctional and not lending to home owners.

If you combine the above items, all it takes is a butterfly down in Brazil, flapping its wings (chaos theory) and the banking system would collapse.

Why did we save the banks? They are still dysfunctional three years after they were bailed out. They do not appear to be "suitable for purpose". If they had been allowed to collapse, we would have a new system evolving by now, one that was not dysfunctional. We would probably be looking at the prospects of growth emerging. Instead we are probably looking at stagflation, with very little prospect of growth for the next five to seven years, and a period of very rampant inflation somewhere in that period.

I guess we have our politicians to thank for this. If you fill up the trough, pigs will go and stuff themselves.

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Anonymous 2 needed this 'off the record'

Oct 28, 2011 at 16:50

Charles. Just to add to your points. The 70/30 rule really only applies to straight resi investment as houses don't tend to drop by >30%. However, in resi development you have to factor in the land, which I've seen drop by 90% in some cases. Commercial properties again can drop exponentially you only need to lose a tenant (e.g. woolworths). As a rough rule 70/30 works but only when you tie in repayment capacity. During the boom I saw Buy to letters getting 85% LTV loans a level where the rent barely covered interest and would never repay, really LTV should have been 60% max. This has been the fundamental issue with lending during the boom LTV became king, with repayment capacity ignored.

PS there are good development opportunites out there but they are otunumbered by the bad so be careful. Even if the numbers stack up you still have to worry about whether the contractor/subcontractors will be around to finish it. Most of the uncompleted schemes i know are due to the contractor going pop not the developer (though they unfortunately followed).

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Oct 28, 2011 at 17:08

You can also buy bank Tier1 and Tier2 debt at around 12% (Tier1 is 9-10%, but carries a tax credit and tax free inside ISA etc wrapper).. My guess is bank debt is a tad safer than mezannie debt of developers...

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Jeremy Bosk

Oct 28, 2011 at 19:09

Or you can buy shares in investment companies that buy bundles of mezzanine and other corporate debt. Thus getting a spread of assets to compensate for the risk inherent in high yield debt.

Greenwich Loan Income Fund is an AIM quoted investor in US syndicated loans that yields nearly 10%. Intermediate Capital Group is a main market quoted provider of mezzanine finance, currently yielding 7% forecast to rise to 10% by 2014. There are plenty of other specialist lenders out there suitable for the average investor with less than £250,000 a pop to play with.

Or, still on the theme of non bank finance, there is Private Equity e.g. on the main market, Private Equity Investor PLC. There are also Venture Capital Trusts, Enterprise Investment Schemes...

For the curious, I hold shares In GLIF, ICP and PEQ.

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Oct 28, 2011 at 23:36

I would not want to take the top-side risk for 12% without a profit share.

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Oct 29, 2011 at 08:38

I don't think I've yet seen a High Street which had a Woolworths shop in it which hasn't had the blank space filled by other shops. The difference is that the new shops are smaller.

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Jeremy Bosk

Oct 30, 2011 at 00:23

High Street is doomed by the small size of the available spaces and the high business rates. The majority are now full of charity shops, pound shops, bookies and slot machine arcades. Suburban arcades serving local needs like hairdressing, take-aways and florists are doing better. Local Shopping REIT looks good for yield. Article in this weeks IC.

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Anonymous 2 needed this 'off the record'

Oct 31, 2011 at 09:53

Maverick, say you had a small woolworths at £100kpa on a 6% yield (£1.6m) funded 70% by the Bank (£1.12m) and someone else put in 10% mezanine (£160k). Said shop is now let to a phoenix (woolwroths Lite) or as a couple of smaller units. My guess is your rent is only £80k now and your yeild is say 10%. Therefore bank LTV now 140% and mezzanine has gone forever. Thats the problem with invetsment property.

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