Property development finance is a notoriously high-risk proposition for lenders. The sector is more than usually vulnerable to supply-demand dynamics, construction cost overruns, and the potential for lengthy regulatory approvals.
In the halcyon days before the 2008 financial crisis, banks readily extended credit to both new and established development businesses. However, post-crisis regulations around liquidity and capital requirement ratios have caused banks to review their risk profiles, with many opting to stop lending to SME property developers altogether.
In this new environment, several new trends have arisen: the rise in alternative financing, the rise of sustainability-linked “green loans”, increasingly selective lending criteria, and lenders’ preference for mixed-use developments.
1. Alternative financing is on the rise in the realm of property development
Rising interest rates are applying the brakes on traditional bank loans, creating a fertile ground for alternative financing in property development. This trend mirrors what is happening across other economic sectors.
With banks tightening their belts, developers are seeking innovative funding solutions. This has opened the door for a wider array of options, such as crowdfunding, REITS (Real Estate Investment Trusts), and peer-to-peer (P2P) lending.
Private credit funds, in particular, have deep pockets and are increasingly seeking opportunities to commit their capital to new projects, as debt becomes a more attractive way to put money to work in property. According to Prequin data, the proportion of Limited Partners targeting real estate debt – including property development debt – grew significantly in both the US and Europe in 2023.
Lenders that have recently introduced development lending facilities include Together, which announced its inaugural securitisation facility for development lending in March. The £150 million facility will unlock additional finance for experienced SME developers undertaking housing schemes, student accommodation, care homes, social housing and mixed-use projects.
2. Sustainability and environmental regulation will increasingly affect access to development finance
With stricter building regulations like the Future Homes Standard on the horizon, lenders are placing a growing emphasis on the environmental credentials of property development projects.
Several development finance “green loans”, for example, have entered the marketplace. These loans reward efficiency, with better rates being offered for high SAP (Standard Assessment Procedure) scores and EPC (Energy Performance Certificate) ratings. Lenders are offering up to 2% discounts on loans for developments that achieve EPC A and slightly less of a discount for EPC B.
Lending terms might also consider low carbon materials in construction practices.
Examples of sustainability-linked “green loans” include Paragon Bank’s “green development finance” and Triodos Bank’s sustainable development lending facilities.
3. Funders are becoming more selective in their lending criteria
Even as interest rates ease, banks are reporting reduced risk tolerance, imposing more selective lending criteria on property developers.
Robust financial reserves and a healthy debt-to-equity ratio are crucial, while for residential developments lenders may require a significant level of pre-sales (confirmed purchase agreements) before approving a loan.
In light of this, developers ought to adopt robust risk management strategies to protect their investment including diversifying funding sources, conducting feasibility studies (market demand, construction costs, project timelines), and maintaining contingency reserves.
First-time developers, in particular, may wish to seek the support of a qualified finance broker to support with securing finance on favourable terms. Finance brokers like Hilton Smythe can work to structure a financing package that minimises risk for the lender and maximises your access to capital. This might involve exploring innovative solutions like mezzanine financing, which bridges the gap between senior debt (traditional bank loans) and equity.
4. Mixed-use developments are increasingly favoured by lenders
Mixed-use developments with a strong residential component are increasingly favoured by lenders due to their lower risk profile and greater potential for returns.
A mixed-use development offers diversified income sources, such as residential rents, office rentals, retail space leases, and potentially even hotel or entertainment revenue. This diversification means that even if one sector experiences a downturn (e.g., retail vacancy), the others can help offset the losses and provide more consistent cash flow.