Mid-year market update - July 2022

Whilst the newspapers focus on the inflationary impact across the economy, it is very easy to forget that construction has faced shortages and increasing material price pressures for the last two years. The current situation, whilst clearly adding to this, is only a marginal impact on the cost side. There is also the potential for an impact in the sector on the value of the end product and when considering the viability of developments during our underwriting process, we need to look at the complete development lifecycle in assessing which projects to back.

As during the pandemic, we continue to discover more about the global supply chain and where dependencies lie. We all know computer chip supply was a factor in reduced car production last year but now learn that about half of the global supply of neon (used in chip fabrication) comes from Ukraine, exacerbating the situation. The impact of the war on oil products and diesel in particular has clear repercussions for construction, both in the cost of operating machinery as well as the logistics cost of transporting all materials to site. The government's removal of the use of red diesel in construction vehicles at the same time heightens this increase.

Even where local spot prices are lower, the global market and procurement routes taken may mean we cannot take advantage - the example is the low wholesale gas prices in the UK (the consequence of our low gas storage capacity as we import more Liquid Natural Gas (LNG) through our LNG terminals than the interconnectors can export to Europe) which do not flow though to domestic prices set on longer term supply contracts.

Stepping back from the meandering set of examples above, the overall impact of the crisis in Ukraine - along with the ongoing tail of the pandemic (and the impact of Brexit) - is of inflation in the economy at levels not seen in decades, with consequential impacts on disposable incomes and assessments of affordability. Gross Development Values (GDV), the value of the end product in the residential sector, have increased over the pandemic and this has offset to a degree the cost increases in construction, maintaining profit margins and keeping developments viable.

With disposable incomes getting squeezed and banks rightly regulated to only lend a limited multiplier of incomes for regulated mortgages, there must come a point where mortgage lending becomes more constrained with an impact on what purchasers are able to offer for property. This is particularly noteworthy as banks stress test applications against new increased future projections of interest rates, something rapidly increasing with the recent sharp uptick in central bank rates and forward guidance of faster rate rises for the rest of the year than previously thought.

There is also a natural caution about making significant financial investments when the economic outlook is uncertain, which is reflected in lower recent levels of mortgage applications. Ultimately, people do need to move for work or life events and with the ongoing lack of new supply coming into the market compared to demand, the fundamentals of the residential property sector remain. Despite the noise on house building, recent legislative announcements seem to reflect the limited political capital and leadership available in government rather than meaningful proposals with little prospect of markedly increased supply in the short to medium term.

With these underlying fundamentals, and absence of a global recession (still a possibility), it might seem likely that house price growth slows rather than falls and transactions (and mortgage applications) will pick up again as people factor in the current situation. However, with construction costs still increasing, this will likely squeeze development margins. There is still some hope that this increase will soften, with futures for timber for example dropping more than 50% in America from a peak in January to where they are now.

We are seeing these factors play out in site values that are being achieved in the market and the residual valuations for sites we get from our RICS registered valuers. Developers are starting to be more cautious about the value they pay for sites and risk adjusting their project appraisals (if they are sensible). The depth of knowledge and more than 250 years of property experience embedded in our team enables us to review the fundamentals of each project during our underwriting process, ensuring we back projects that make sense and have appropriate costings and contingency built in.

As always, there are winners and losers. Some developers will be coming to the end of projects now where they were able to incur and fix costs prior to the significant increases, and will therefore benefit from the asset price increase as they now sell the end product. For others, the timing will be more problematic with the asset price increase slowing whilst their cost base continues to rise. Some will find they cannot continue, either because they give up or because they are backed by financing that cannot cover the gap. This will create some opportunities for developers to buy sites at good prices over the coming year.

Once projects get underway, site values tend to lag behind spend on site with money spent getting out of the ground not reflected in increases in the value of the security. It is only later, as projects progress beyond shell completion and in particular first and second fix stages, that site values increase and converge towards the GDV. This value gap is the primary reason why it is usually better to find a way to complete a development than send in the receivers and sell (which is the route most funders take, lacking the property expertise that we have in-house). There is also the issue of warranties and step in rights that need arranging prior to loan start, if a funder is going to be able to step in and sell a site mid-flight without purchasers having to factor in redoing works (with a consequential impact on what they are willing to pay for a site).

Looking ahead to a potentially difficult year, what are the solutions to protect investors' money and also help developers complete projects? First and foremost, up front due diligence combined with appropriate documentation like warranties is key to choosing the right projects to commit investors' funds to and also providing the proper legal framework to step in if the worst happens. We keep our underwriting criteria under review and give a lot of attention to cost plans at the moment, ensuring these are appropriate and have sufficient contingency built in. Additionally, applying our property expertise up front is also part of the value add we provide to developers we work with - helping them pick the best projects and risk manage their delivery, as well as providing a challenge where they may have optimism bias in their project assessments.

Where projects experience issues after getting underway, as happens in construction, we are often able to help developers come up with solutions to overcome these and keep projects on track. If faced with cost increases that exceed the contingency in the budget, it may be that increasing GDVs allow us to revisit the loan and rewrite a facility to cover the increased costs whilst keeping within our loan to value limits.

Where this isn’t feasible, it may be possible to provide top up funding via a junior second charge facility - with the launch of?CP Capital?this year, CrowdProperty is now able to provide these facilities ourselves. Providing both senior and junior finance under one roof is more efficient than obtaining these from different lenders and avoids duplication of legal and other costs for developers. Bringing junior facilities in later on in a project, as a top up after the riskiest construction activity has taken place getting out of the ground, also generally represents a good risk profile for investors in the junior facility who have the comfort that we are also the senior lender. It may well be that even where we could rewrite a senior facility, it is quicker and more cost effective for the developer to incur the marginal cost of the junior loan than fees on a new senior loan.

Where it isn’t possible to provide top up funding within assessed values and the developer cannot access the equity to plug the gap, our attention then turns to applying our experience to help manage out the project. Developers as equity holders (and usually with personal guarantees on top) are the first to lose in default and are motivated to complete a project in order to create the value to return their invested funds and generate a profit. Often by focusing work on parts of the site, we can add value to get the project into a position to refinance or complete enough units to repay investors which is preferable to the delays and cost that receivership would generate. This is where the experience of our team and in particular our Property Director, Andrew Hall, is invaluable and sets us apart from other lenders. Where developers do not engage, our experience also provides the ability to step in if needed and we think it best for our investors to complete the development.

Taking a longer term view of risk mitigation, much of our thoughts are focused on sustainable construction and developing products to incentivise and reward developers carrying out projects with good sustainability outcomes which de-risks the exit from the project in an era of increasing environmental and energy performance legislation.

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