The Funding Landscape Is Changing

Real estate developers are finding the funding landscape for their projects through traditional channels is increasingly challenging. Banks have retreated, realising that development lending is complex and not a tick-box exercise.

02 October 2019

Real estate developers are finding the funding landscape for their projects through traditional channels is increasingly challenging. Banks have retreated, realising that development lending is complex and not a tick-box exercise. It takes familiarity with the real estate project process as well as the unforeseen hurdles from A-Z.

The Ups And Downs of P2P

The P2P bucket of capital that has been on the rise over the years is also showing signs of strain. And, in my opinion, this model doesn’t work for projects above £1mm. There are plenty of these platforms out there. Few have the capability to take on meaningful, properly underwritten development financing. Quite a few “alternative” lenders have imploded or simply shut down recently. They’ve left investors high and dry and created an even bigger gap in development funding. Mainly through poor underwriting procedures, a complete lack of understanding of the development process and complexities, and no investor transparency.

The Times published a report on 27 September citing that 275,000 people have cash in P2P platforms. In a letter to 65 firms, they issued warnings and highlighted problems. The report sites weakness in underwriting and disclosure to clients. Investors are being attracted to “headline-grabbing returns in a low interest rate environment”. The City Regulator is investigating the “lack of depth of due diligence on borrowers, monitoring of projects, and default rates”. Two well-known failed platforms, Lendy and Collateral, could trigger more platforms closing.

The Scourge Of The Minibond

Finally, to add more pain and injury, the funding source that gives the industry a bad name overall comes from the rising sales of unregulated bonds sold to investors by unscrupulous bucket shops and developers. These bond issuers provide almost zero information to investors because they have none.

Bottom line: the funding market for good SME developers and the investor suffers. The solution is 1) to provide professional real estate and financial backend skillsets, clear underwriting processes and strategies to help protect investors and 2) bring alignment in the process to incentivise all parties.

The Jockey and Horse

There’s a lot said in the world of private equity about whether investors should back the jockey or the horse. It’s a good question. Normally I’d prefer to back a great management team with a sub-par idea, than a super idea with sub-par management. It’s basically the same for real estate investment. That said, in reality both are important. Personal opinion is it’s better to form relationships with great management team. A great management team will always eventually find the better deal and be able to deliver.

You can’t expect a P2P funding model to make that kind of call, and they don’t. They connect the dots only. It’s impossible to take a view. And unregulated bucket shops can’t make that call either. They don’t have the team. Just phones, a script and a call sheet.

So if SME developers find funding complicated and challenging, how do they access property development finance that understands their business and strategy? And how do investors get access to professionally written, quality deal flow, that protects their investment and provides real time information?

The Need For Smart Capital

As traditional capital from the market has retreated, and as most SMEs have neither the time nor skillset to piece together a capital stack of traditional senior, mezzanine and equity, there is an ever-growing need for smart capital to step in and take the initiative.

Most SME developers we talk to in this space can get the job done and can find good deal flow. However, they can’t pull the financing together effectively and don’t have the time or even knowledge of where to start. Most start with structuring the equity piece, which in all likelihood doesn’t work. They then have to unravel or try and fit the rest around it. Also a lot of developers are lured by savvy platform headline rates. They then find out 6 months later their funding package that originally seemed reasonable, is actually more expensive than expected. Or maybe one of the pieces of the funding falls away altogether. Whatever the case may be, piecing it together is complicated and requires the financial skillset and rolodex of contacts.

An Emerging Alternative Source of Capital

In its present format, bringing together capital and professionally underwritten deal flow is a “bits and pieces” dog’s breakfast. Without doubt, what developers need is certainty and the ability to close deals, not to become finance professionals.

At Hilltop, we see the real estate investment and funding landscape a bit different than most traditional sources of capital. Having been on both sides of transactions certainly gives us a more comprehensive knowledge base to work from. Our model brings financial, asset management and property development skills in addition to capital to the SME developer in a simple, incentive-aligned funding model and gives our investors full transparency. That said, we are not entirely alone. At larger funding levels, this is the norm. And slowly in the smaller SME market size there’s a growing contingency that thinks the same as we do. But pulling all these components together is no walk in the park.

A part of textbook private equity has always been to back management teams to create value and a successful exit. Simplistically, the newer model for SMEs looks for alignment of interests with management incentivised to perform, and where both sides want the same thing. Taking that kind of private equity approach rather than the traditional lending model can be a new funding paradigm for SME developers. It may also save a lot of time, resources and headache.

We think this is the most viable approach to lending.