Development Finance – It’s Not Tick-Box Lending Anymore

by | Mar 22, 2019

Real estate development finance is a complicated business even in good times. Anyone who’s been on the development journey knows this, and undoubtedly has the scars to prove it.

Over the past few years, traditional lenders who have built relationships with local developers, have retreated from the market. That gave an opportunity for alternative lenders to fill the gap. The problem was these lenders were more driven by shifting capital and generating fees than the loans they were underwriting. Development lending went up and it was happy days for everyone.

Today GDVs have shifted lower and sales periods have extended by 16% in the last 24 months. Many development finance funders (and borrowers) are now feeling the pain, and many loan books are severely in default. The automated tick-box lending approach is a dangerous way to lend to something as complicated as real estate development. Because a variety of things can hiccup even in the best of times…

A New Wave of Change in Alternative Lending

But the landscape is changing. A new breed of lenders in emerging in the space just in the nick of time. Recently came the announcement of KKR recently teaming up with an alternative SME development lender. The alternative lending market is rapidly moving it up a notch. It appears that the early pioneers of P2P proved that the concept of alternative lending worked. This was followed by the household-name alternative lenders. And now the model is proven, a more real estate-savvy, institutional type of lender is emerging to solve the problem.

And why not. The SME lending market is vast. The UK needs roughly 300,000 new homes annually, and the funding requirement is a whopping number over the next decade. Add to that the overall social focus of bringing smaller SME borrowers back into the mainstream by government programmes. It’s a cocktail for opportunity and growth in this market. It’s no wonder so many institutional investors are paying attention.

Nationwide Building Society indicate that the funding gap for the next decade, based on annual new homes targets, is circa £208 billion

But…..many of these institutional and challenger providers of residential development finance may not have the skillset to underwrite smaller loans. These take time and oftentimes are done on a bespoke basis. Deals between ~ £3mm up to £15mm are falling through the cracks. Where “one shoe doesn’t fit all”, big institutional-type lenders are by their very nature “Big” and hence rely on automation and volume. This opens the way for smaller boutique development finance lenders to enter the market, backed by more risk-savy capital. These entrants, small and with skills and capital, will move faster and increase competition in sourcing and funding development projects.

It’s Not Tick-Box Lending

In fact, many of these new development finance lenders will probably have greater development, financial, technical and market research backgrounds. This will up the ante considerably. Additionally, some may have higher risk tolerances, different risk assessments or even access to different sources of funding. In turn, this allows them to undertake a wider variety of loans and establish more relationships than the larger newcomers.

With a focus on SME development finance, filtering better known developers is a “meet and greet” type of business. A lot of tire kicking, with a track record even more important than the project itself. Only getting out there and kicking the tires will do the trick. Understanding the highest degree of comparability on sales, costs and investment characteristics can determine the quality of the project. And this is precisely where smaller real estate savvy firms will have an advantage.

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