Written by Tom Berry
The past 12 months have seen significant increases in development costs, which has forced developers to consider alternative funding solutions that they may not have previously.
Development cost increases can be first seen in the acquisition process. Covid-19, inflation and competition in the market has caused land prices to rise considerably. Inflated land pricing is causing developers to purchase expensive land which affects their profit.
In addition to this, increases in build costs have been well documented due to substantial increases in building materials. Developers are likely to find their profit margins impacted by the increases in price from their building contractors as a result.
From a lending point of view, developers will be required by lenders to increase their contingency budgets to mitigate potential cost overruns. This in turn reduces the amount of funding a developer may receive for their land purchase or construction.
Valuation’s have also been impacted by changes in the market. We have observed valuers becoming more cautious, reductions in valuation reports have become more common, as valuers respond to the threat in the sales market and risks of recession.
Thinking about the sales market, increased interest rates for mortgages have had an impact on the buyer’s ability to afford the house prices they budgeted for. In addition, the increase in the cost of the development debt which reduces the day one loan amount.
All the above factors come the same conclusion. Developers are facing a much harsher environment that will create an impact on their profits and growth. Understanding the different options in terms of finance is an advised way to prepare for any shortfalls.
If a developer faces a shortfall or simply needs more funds than a senior lender can provide, a junior debt lender is a good solution. There is some caution that should be exercised however, considering the tightening of profit margins, Junior debt can come with an expensive cost of interest which can further erode your expected profit.
The alternative solution is working with an equity partner. The right equity partner can fund development schemes up to 100% of the total cost, there would be a profit share split and a potential interest coupon to consider. However, the reduced equity saves profit erosion from high interest rates on mezzanine finance. A benefit of having a profit share, is the equity partner shares the pressure of waiting of waiting for their return with the borrower.
This gives the developer more flexibility with their own equity and cash flow, potentially allowing them to invest in an additional scheme. Arc & Co. works with several equity partners who consider partnerships with developers on a small and large scale.