Five Ways to Beat Falling House Prices and Fund New Developments

Over the last two years, the Bank of England’s attempts to control inflation by raising the base rate have caused house prices to fall. To keep monthly payments affordable, homebuyers have been taking out smaller mortgages and sellers have been settling for less.

If you’re a property developer who’s brought a new development to market recently, chances are your profit has taken a hit. If you haven’t lowered your prices, you’ve probably chosen to refinance your development loans and pay more interest, while waiting for the market to turn around.

But while there’s been a lot focus on developers’ bottom lines, less attention has been paid to the impact of falling house prices on funding.

Impact of falling prices on funding

Falling prices are reducing the amount of debt you can borrow to fund new developments, making it harder to get new projects off the ground.

This is because senior debt (as bank loans are called in the development finance industry) is usually agreed at a certain proportion of GDV (Gross Development Value, or the total market value of a completed housing scheme).

Let’s take an example. At the top end of the market, you might be able to borrow senior debt at 65% loan-to-GDV. If the GDV of your scheme is £2,000,000, the senior debt would total £1,300,000. If project costs totaled £1,650,000, you would need to inject £350,000 of your own money into the project.

However, if we knock 5% off the GDV to reflect falling house prices, you can now only borrow 65% of £1,900,000, or £1,235,000. If your costs remain the same, you now need to inject £415,000 of your own money into the project: an extra £65,000.

The less debt you can borrow, the more money you need to put into new developments. As cash is often tied up in ongoing projects, this can mean that otherwise viable projects don’t get off the ground.

However, there are solutions to this problem. Here are five creative ways for you to beat falling house prices and get your developments funded.

1. Offer extra security

Sometimes, lenders will allow developers to offer extra security, in return for higher leverage (the ratio of debt to GDV).

Normally, senior debt is secured against the site on which a new development is going to be built. If something goes wrong with your project and the houses are not completed and sold, your lender can recoup their loan by taking possession of the site and selling it. Lenders limit their leverage to guard against the GDV falling during the project and leaving them out of pocket.

Offering extra security against a second property (an investment property, for example) removes risk for your lender, who can easily recoup their loan by selling two properties, if things go wrong. In return, your lender might agree to increase their leverage and cover more of your costs.

2. Negotiate a land price reduction

Another option is to negotiate a reduction in the price you pay up front for the site you want to buy.

You can do this by establishing trust with the vendor and proposing that the balance of the transaction be paid at the end of the project, out of sales proceeds (sometimes called a ‘deferred payment’).

Often, deferred payments are accompanied by profit share agreements, which compensate the vendor for the risk they’re taking (if the houses are not completed and sold, they don’t receive all their money). These profit share arrangements are often called ‘overage agreements’ and usually award the vendor a certain amount per sq ft of housing sold.

By negotiating a price reduction, you can reduce the amount of senior debt you require and enable your lender to stay within their ordinary leverage limits.

3. Enter a joint venture

Joint ventures (JVs) are agreements between two parties to a development deal. Each party brings something to the deal – whether land, finance, construction experience or project management – and profit is shared between them. Developers can enter JVs to reduce their costs.

For example, you could enter a JV with a vendor. In this scenario, you would oversee the build and probably source finance for it. The vendor would retain ownership of the land, meaning you wouldn’t have to use senior debt to buy it. At the end of the project, you would share the profits.

However, it’s worth underlining that JVs with vendors are more expensive than deferred payment agreements. This is because JVs carry much more risk for vendors, who could lose their land if things go wrong (the senior debt lender would take the land as security). If you enter this type of JV, you should be prepared to give away a large chunk of profit.

You also have the option of entering a joint venture with a main contractor. If you’ve worked with your contractor for a while and have developed mutual trust, you could propose a JV in which the contractor does the work at cost, in return for a share of the profits.

As contractors usually build a 20% profit margin into their quote, this has the advantage of bringing build costs down substantially and ensuring enough costs can be covered within a lender’s ordinary leverage limits.

4. Enhance planning

You can increase the amount you can borrow by enhancing your project’s planning permission.

With extra units or greater square footage for your existing units, your GDV will increase and so will your loan amount. As long as your build costs don’t increase by too much, this should allow you to cover enough costs with senior debt.

However, applying for enhanced planning permission can be risky, time-consuming and costly. There’s always the risk that approval won’t be granted and, even if it is, it could be delayed. If you adopt this strategy, you should secure your site with an option agreement and be prepared to lose money on planning costs if things don’t go your way.

5. Source mezzanine debt

Finally, you also have the option of sourcing mezzanine debt (or ‘mezz’) to increase your borrowing.

Mezzanine debt ‘tops up’ senior debt and allows you to cover a greater percentage of your costs. While senior debt might cover 70-80% of costs, mezz might cover an extra 10% on top of that, taking you to 80-90% of costs covered. So you would only have to cover 10-20% of costs with your own cash.

But mezz is expensive because it carries greater risk for lenders than senior debt. Like senior debt lenders, mezz lenders take the land as security. However, they can only recoup their loan through the sale of the land after the senior lender has recouped theirs. If the senior lender sells the land at too low a price, the mezz lender doesn’t get their money back.

Interest rates for mezz reflect this high level of risk: generally, you’re looking at 18-25% p.a. for a mezzanine loan.

Author bio

Jake O’Leary is Director of Communications and Sustainable Finance at Mackenzie Byrne, a development finance brokerage based in the UK. Mackenzie Byrne sources and structures debt and equity for SME residential property developers.