Real estate developers are finding that funding 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 and the unforeseen hurdles from A-Z.
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, but few have the capability to take on meaningful development financing that has been underwritten properly. Quite a few of these “alternative” lenders have imploded or simply shut down recently, leaving investors high and dry and creating an even bigger gap in development funding – the main drivers being poor underwriting procedures, a complete lack of understanding of the real estate development process and complexities, and no transparency for investors.
The Times published a report on 27 September citing that about 275,000 people have cash in P2P platforms and, in a letter to 65 firms, 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 authority is investigating issues such as “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.
And 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 being 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 always been a lot said in the world of private equity about whether investors should back the jockey or the horse. It’s a good question, and normally I’d say I’d always prefer to back a great management team with a sub-par idea, rather than a super idea with a sub-par management team. I guess it’s 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 teams, because a great management team will always eventually find the better deal and be able to deliver.
A P2P funding model can’t be expected 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 capital that understands their business and strategy, and how do investors get access to quality deal flow that has been professionally underwritten, where their investment is protected and where real time information is available?
As traditional capital from the market has retreated, and as most SMEs don’t have the time or 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 are people that can get the job done and can find good deal flow; however, they can’t pull the financing together effectively and they 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, then have to unravel or try and fit the rest around it. Also a lot of developers are lured by savvy platform headline rates and then find out 6 months later that their funding package that at the outset seemed reasonable, is in fact much more expensive than expected. Or maybe one of the pieces of the funding falls away. Whatever the case may be, piecing it together is complicated and requires the financial skillset and rolodex of contacts.
Currently, in its present format, bringing together capital and professionally underwritten deal flow is a “bits and pieces” dog’s breakfast of problems. What developers need is certainty and the ability to close deals, not to become finance professionals.
An Emerging Alternative Source of Capital
At Hilltop Credit Partners, we see the real estate investment and funding landscape a bit different than most traditional sources of capital might. Having been on both sides of transactions gives us a more comprehensive knowledge base to work from. Our model brings financial, asset management and property development skills and 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 with a view of creating value and getting a successful exit. Simplistically, the newer model for SMEs looks for alignment of interests whereby management is incentivised to perform, and where both sides want the same thing. Taking that kind of private equity approach as opposed to the traditional lending model to real estate development funding can be a new funding paradigm for SME developers and may save a lot of time, resources and headache.
We think this is the most viable approach to lending.