Earlier this year, an industry survey reported that only 48% of the specialist lending market thought their cost of origination was likely to increase over the year.
That figure has undoubtedly increased more recently; with record inflation and an ongoing cost-of-living crisis, the market is feeling the squeeze across the board. Naturally, developers are in the eye of the storm and weathering it is a challenge we need to collectively tackle.
In addition to material costs rocketing, the cost of borrowing is also creeping up, reducing project profits in the overall capital stack. This is mostly due to rising central bank base rates. However, further factors are at play that are influencing this, and the increased costs may be the tip of the iceberg when it comes to the threats this poses to commercial finance markets.
Funding for lenders comes in several forms. Whether it is from depositors’ funds, wholesale funding lines, private capital, crowdfunding, open- or closed-ended funds, there are a myriad of sources. However, a major source is the securitisation of debt.
Many of the US’s and the UK’s largest operators of bridge, ‘fix and flip’ and buy-to-let (BTL) finance rely on securitisations. For the uninitiated, these lenders write loans on their balance sheets, then sell tranches of them to institutional investors (often with different risk ratings and pricing) and continue to manage the loans on the new owners’ behalf. The liquidity generated enables the lenders to write new loans, which in turn are sold on, and the cycle continues… until it doesn’t.
There are two obvious reasons for this. The first is practical. For example, fixed-rate loans at 5% per year are quite hard to sell to investors when, thanks to interest rate rises, comparable CMBS tranches are now selling for closer to 6%. The second is due to a perception by investors that risk has increased in more general terms and only the best-quality credit will be bought by the market.
Accordingly, perceived higher-risk lending such as commercial investment, development and non-prime BTL loans have become harder to securitise and sell to institutions, reducing liquidity for lenders in that space. The effects are already apparent, with some major US lenders closing, and operators on both sides of the Atlantic reducing loan-to-value ratios, tightening credit criteria more generally, thereby reducing the supply of capital available.
What does this liquidity squeeze mean for professional property investors? The situation amounts to a perfect storm of reduced liquidity, increased pricing, material costs rising and potential falling property values. For commercial investors, several market dislocations are playing out, particularly in offices and industrial, to add to the equation.
As usual, the answer is not black and white. With potential distress comes opportunity and many investors take a very long-term view when it comes to investment decisions. It is also important to remember that if a lender ceases to lend, their own future will be in doubt. Support can be found in lenders with a strong range of funding lines, offering diversity across products.
We can only hope 2023 will offer some relief for us all, with more opportunities created.
Michael Dean is director and co-founder of Avamore Capital