Property development finance in 2021 - what to expect


13-01-2021
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Most of us will be glad to see the back of 2020. Nevertheless, 2021 looks set to be another year which will present challenges to property developers.

Howes Percival writes:

With such a rapidly changing environment it is challenging to accurately predict what trends we will see in the future. There are however a number of areas which we can be sure will be of relevance to developers throughout 2021.

  • Covid-19
  • Brexit
  • Interest Rates (Transition from IBORs)
  • Sustainability (Green Finance)

COVID-19

  • While a mass vaccination programme offers hope, it is inevitable that disruption will continue for some time. Developers need to ensure that appropriate contingencies are in place to avoid any breaches of loan facilities. For example, the unavailability of key members of staff may affect the ability to comply with information undertakings. Restrictions or sickness affecting the ability of construction work to go ahead may cause delays to build programmes. Developers should seek as much flexibility as possible when negotiating funding documents. If it becomes apparent that there are going to be issues that could lead to default, developers should engage with lenders as soon as possible with a view to ensuring ongoing support.
  • Contingency planning should also consider the risks associated with one or more parties involved in a project entering administration or other insolvency process. Due diligence on the financial strength of contractors and the wider construction team has never been more important.
  • Huge amounts of bank resources have been tied up in connection with the deployment of government backed lending (CLBILS, CBILS and Bounce Back Loan Scheme), both in terms of manpower and capital. Given the uncertain economic environment, this has contributed to reduced availability of debt finance from traditional bank sources for property development. Anecdotally, a number of banks are once again looking at new business opportunities, albeit selectively. A number of our clients with ready-to-go development opportunities have looked to non-bank lenders for funding, including funds and specialist lenders. This type of finance can be shorter term, more expensive and may include profit share arrangements, redemption fees and other returns on investment. However, when liquidity is restricted and bank appetite for risk is diminished, alternative sources of funding are an important part of the market. Developers may, in some cases, be faced with a choice of delaying a development, or proceeding with more expensive funding and reduced profit margin.
  • Of course, some developers will be focused on weathering the storm rather than embarking upon new projects. The old adage ‘cash is king’ holds true. Options to preserve cash may include disposing of assets (including undeveloped land), reducing or delaying expenditure or re-negotiating existing debt repayments. For those who are eligible, the government backed loan schemes have been extended so that applications can be made up to 31 March 2021.

BREXIT

  • Financial services was excluded from the recent EU-UK trade agreement. The UK and the EU have agreed to establish regulatory co-operation with regard to financial services by March 2021. The position may change as EU-UK negotiations take place with regard to financial services, but at this stage UK lenders do not automatically have the right to lend in EU member states. For developments within the EU, whether a UK financial institution can lend depends upon the regulatory regime within the relevant EU state. This may reduce availability of funding from UK institutions for overseas development unless a further EU-UK agreement can be reached. Similarly, EU institutions will require a permission under the Financial Services and Markets Act to be able to continue to carry out regulated activities in the UK. A Temporary Permissions Regime (TPR) is now in effect. The TPR will allow non-UK lenders to continue carrying on business in the UK for a limited period whilst they obtain authorisation from the UK regulators.

INTEREST RATES (TRANSITION FROM IBORS)

  • Historically, larger development loans have typically been priced as a margin over an interbank offered rate (generally LIBOR, or London Interbank Offered Rate, in the UK). For a number of years, regulators have been engaged with the industry to phase out interbank offered rates (IBORs) with “Risk Free Rates”. IBORs have in the past been the subject of manipulation (leading to a number of criminal cases and fines from regulators). The intention is that Risk Free Rates will not be susceptible to abuse in this manner. Development of the new rates and ensuring an orderly transition is a huge challenge for the industry. On the current timetable, LIBOR will cease to be used by the end of the year.
  • One challenge is how to replace LIBOR in existing contracts which will run beyond the end of 2021. A lot of work has been ongoing involving regulators and industry bodies (such as the Loan Market Association) as to how to replace LIBOR in existing loan facility agreements. Very few existing agreements will make provision for permanent replacement of LIBOR. More recent agreements may include some drafting to anticipate changes in the basis of interest rates, but may still leave scope for disagreement. The market is still working out how to deal with legacy contracts that will need amendment, and there may yet be a need for legislation.
  • Another challenge is in relation to loan agreements being entered into now. Whilst the issue is well understood, there is as yet limited drafting available to adequately deal with transition for loans which will cross over from LIBOR to Risk Free Rates. The Loan Market Associate has been working actively towards this, and there is now some drafting available to Loan Market Association members. It is expected that this will develop further as we move towards the phasing out of IBORs.

SUSTAINABILITY (GREEN FINANCE)

  • Environmental, Social and Governance (ESG) or sustainable finance is rapidly expanding and is subject to ever increasing regulation. Since the 2015 Paris agreement, there have been moves globally to align finance flows with the transition towards a low carbon economy. Banks and other investors are becoming more concerned in what they invest in, not just the returns. Many large investors have guidelines that increasingly take ESG factors into account.
  • We are approaching a tipping point beyond which being able to demonstrate the sustainability of development will be essential in order to secure financing. EU regulation (which the UK has committed to align with post Brexit) will require large institutions to make public disclosure of information on ESG risks.
  • Many banks have already announced that they are phasing out the financing of polluting or ‘non-green’ activities and this will increasingly impact development finance. It will rapidly become the norm that the nature of construction, the sustainability of the building and the use of the building will all be factors taken into account in a lender’s decision whether or not to lend.
  • The market is also starting to see ESG factors influencing loan pricing. At present, this is happening with some of the largest loans but is expected to filter down through the market. The Loan Market Association has published a set of Sustainability Linked Loan Principles which have been applied to some loans to implement step-ups or step-downs in the applicable interest rates depending on how the borrower performs against agreed sustainability criteria. In short, adhering to green principles will increasingly affect the cost, and indeed the availability, of borrowing.

If you have any queries regarding development finance or any of the issues raised in this note please do not hesitate to contact one of our team.

 

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