Property Development Insights

Posted by Mesa Financial on 4th October 2022 -

Kwasi Kwarteng delivered the governments 'mini-budget' last week and as they say, "the rest is history". The purpose of this article is not to shed any opinion, political preference or negative summary. The purpose is to stay focused and work closely with clients to solve problems, because there isn't a shortage of them in the development world. 

Last week was consumed with site visits, endless phone calls and Friday spent with a number of property developers at our annual event. There were lots of interesting conversations and one real point became apparent upon reflection. The sheer amount of optimism, experience of previous recessions and the understanding that there will be plenty of opportunities over the coming months.

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Bank of England Base Rate. It’s been rising and doesn’t appear to be slowing down anytime soon. It’s been set at 2.25% with speculation that 6% is on the horizon. Debt facilities that are floating over BoEBR are now costing developers more in interest and the more they continue to rise, profits will continueto erode. “But if house prices keep rising then they’ll outpace or balance the books with finance costs?”. In theory it makes sense but we also need to consider construction costs. 

There isn’t a definitive way of completely avoiding a rise in rates but there are certain points to consider:

• There are still development finance products with fixed rates giving clarity over total finance costs.
• Most development appraisals should include sensitivity analysis for fluctuating build costs and GDV’s. It’s now quite important to stress development facilities that are floating so if rates do peak at 6%, you can see the real overall cost for the duration of the project. The original rate of 8.25% over 0.25% may have been attractive. However, 8.25% over 5-6% will be quite unwelcome for the majority, if not the majority, every single developer that wants to continue trading.
• There are a few developers that are simply sitting back and not taking on any new projects until there is more economic stability.

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Construction costs. The most prominent reason for rising costs is certainly inflation. Over the same period, CPA figures show construction materials and component prices have increased by an eye-watering 42%. In part, that is due to supply-chain issues coming out of the pandemic, but it is also a result of Russia’s invasion of Ukraine.

A fixed-price contract will most likely have been signed six, twelve months ago, possibly even further back. Essentially you have a whole year of price inflation. For all materials, you’re looking now looking at 25% year on year. It has to be delivered by contractors on fixed-price contracts. However, without the option to pass the cost on, it’s not long before firms realise they can’t trade and make a reasonable profit, hence the sheer increase in administrations. Furlough and business loans have been described as life support for some contractors but it’s also been proven that some businesses that weren’t being run properly in the first place have just eventually been found out.

There are some fantastic articles that shed more light on soaring construction costs and a more detailed analysis of labour and skills shortages. There’s even the mention of BREXIT and the impact it’s had on the construction industry. With the global chaos that’s materialised over the last two years, I actually forgot about it and it rarely crops up in conversations anymore. BREXIT.

• Increase contingencies to at least 10% in your appraisal. Don’t worry if it slips your mind, the banks monitoring surveyor will remind you in the initial report.
• A question I tend to ask is, ‘if there is a cost overrun, is there cash in the background to fund the cost overrun?’. There are some banks that will forward fund construction costs, especially in the current climate. No party benefits from a part-built project.
• Partner with the right lender that will actually support you as opposed to chasing the initial rate. Rate seems to be a real driver which is completely understandable in the current economic climate. However, please don’t let this be ‘the’ defining factor. During the midst Covid-19, I witnessed a 10-year banking relationship wither away as the lender wouldn’t support the borrower through a tough period. Rates were good though…
• The overall professional team on a project is fundamental. I looked at two development projects last week where contractors were appointed based solely on their ‘cheap’ quote. They haven’t delivered and that cheap quote will translate into something very expensive. Increased construction costs, delays on the project, delays which end up requiring a lending facility to extend and accrue more daily compounding interest.

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Mortgage products. Article upon article of negative press on the withdrawal of mortgage products. “More than 40% of mortgage products withdrawn”. Stay focused on the solutions as opposed to the panic.

• There are still 2,661 mortgage products available in the U.K. and those removed mortgage products last week are already returning to the market now the volatility is starting to subdue.
• The same knee jerk reaction unfolded during Covid-19. 
• Seek advice from an independent broker if your mortgage is coming up for renewal and you need more clarity.

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House prices. Articles as of this morning make for interesting reading. “U.K. house prices are flatlining”. Is that actually the case? Where’s the data?

• The fact that does remain and will for the foreseeable future is this. Not enough new homes are under construction in order to meet the governments annual target of 300,000 new homes. Supply and demand.

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Opportunities. This certainly isn’t reinventing the wheel but the developers I witness thriving seem to be operating in a similar fashion.

• Planning plays and option agreements. Designing a pipeline of projects that can avoid any construction risk in the current climate and emerge when the property market has settled. Agreeing option agreements at the correct residual value now could prove quite profitable in the future when construction costs stabilise to usual market levels thus increasing profit margins in the project. 95% of sites with planning permission being marketed just aren’t stacking up as the land prices have not adjusted with increased construction or finance costs. Land prices need to correct in real time as opposed to pre-Covid or inflationary market conditions. There’s always the other option. Distressed assets. lenders will want these off the books.

It goes without saying that the current climate for developers could be considered tough. In actual fact, it could be described as a prefect storm. Unfortunately, there are forces that just can’t be controlled and as we always have done throughout historical recessions, we adjust and work with the tools we have at our disposal. 

 

Chris Treadwell - Senior Associate