Written by Oliver Holden, Senior Broker at Arc & Co.
The property development sector carries plenty of variables. With land values showing no signs of abating, plus labour and material costs continuing to rise exponentially, understanding how finance is priced is one way for borrowers to protect their risk.
The cost of a typical loan facility is usually referred to as an ‘all-in’ cost of funds. ‘All-in’ refers to the two sides of an interest product, the first being the ‘margin’ which is simply the value of risk perceived by the lender, their profit & overheads and the second, the cost of raising liquidity, the price they’re charged either by private investors or institutional markets. This will take the form of SWAPs, GILTs and pre agreed coupons for fixed rates and Sterling Market indexes for variable loans such as SONIA and the Bank of England Base Rate.
The escalating cost of fixed rates is providing borrowers with a dilemma over whether to continue with a rising variable offering or risk paying a higher rate now in the hope that the variable rate surpasses this within their loan term. Depending on term, SWAP rates are currently c3% which means that a variable product offers quite a saving on a 2-year SWAP development facility. An example project with a total loan facility of £2,970,250 has a total interest cost of £242,250 over an 18-month period assuming a variable 6% interest rate. Using a higher fixed rate of 9% would increase this cost by 34% to £367,875.
Development projects accrue interest based on the funds they draw, typically referred to as an ‘S-Curve’ profile. Rising variable rates expose borrowers to increased cost at the peak of their borrowing. Specialist debt funds recognise this and offer facilities based upon IRR hurdles, giving the borrower a clear line of sight on the actual cost of a loan. They can maximise lending capabilities to give a developer the most efficient use of equity possible. Banks on the other hand will need to underwrite rising costs in the future, this will have an adverse effect on the maximum available loan amount due to the interest reserve needed to cover expected rate increases in the loan, restricting the developer.
There will always be a fixation on rate vs margin. The escalating cost of fixed rates is leaving room for value in shorter term variable rates even if they continue to rise. The base rate will need to increase a further 1.75% before it reaches current fixed levels, even then, we expect fixed rates to increase accordingly. Understanding the finance sector is critical to a client’s success, and as a multi award winning debt advisory firm, Arc & Co. are extremely well placed to help borrowers navigate the uncertain times ahead.