Institutional investors are starting to provide forward funding for pre-let development projects in the UK. Lynn Strongin Dodds investigates whether it might feasibly fill the financing gap left behind by the banks
Forward funding has come back into vogue in the UK, as the traditional sources of finance remain scarce. Both developers and investors can reap the benefits, but it is not a risk-free exercise. As always, the devil is in the detail and contracts must be carefully constructed.
"Forward funding comes in waves, particularly during certain economic conditions," says James Knox, partner at Berwin Leighton and Paisner. "There was a burst of activity in the late 1980s and mid-1990s when developers found it difficult to obtain bank finance for their projects. The same environment exists today."
Russell Stewart, development director of Dawn Group, one of Scotland's largest independent property and construction groups, says: "Forward funding fell out of favour a few years ago when bank debt was easily available. It has come back but there remains a dearth of funding for speculative development. What we have found is that the key to secure funding today is that the building needs to be pre-let to a strong tenant who will take long lease - the minimum is 15 years."
Although the transactions differ, they usually involve investors buying a bare site, providing the finance during the construction phase, with the developer receiving a final balance payment based on the value achieved after deducting the development costs. Charlie Walker, director of Legal & General Property, believes that forward funding can be attractive because "it is a useful way of achieving a higher margin than on standard investments". He adds: "It also provides access to new stock that meets our ever-increasing sustainability requirements. Older properties have to be adapted and this can be more expensive."
The other major advantage is that there is less competition for these types of transactions, according to Renos Booth, fund manager at Aviva Investors. "We would normally see about five to six funds chasing the same stock on the direct investment side, but with forward funding there are only two or three," he says. "This is because they are more complex deals and therefore more risky, so require the fund manager to have the experience and expertise to manage the risk."
The major risks are that interest rates or development costs could fluctuate, plus the developer could go bankrupt. This is why investors are advised to conduct stringent due diligence, focusing not only on the developer's track record and ability to manage the costs, but also the structure of the deals, contracts, controls, risk management and exit strategy.
Investors are also advised to put a cap on the funds that can be drawn down during the development period. It is often based on the likely capital cost, while an agreed margin is determined to cover realistic cost overruns. The theory is that this will keep the developer incentivised and the investor will avoid having to pay over and above the odds during the build period.
At the moment, there is more talk than actual deals being done, according to Jonathan Dick, associate director of CB Richard Ellis. "We are seeing interest, though, from investors. For the developers, it is a trade-off. They may need the funds, so are willing to accept a lower price in exchange for the certainty of getting the projects off the ground. This will protect their downside, but they may lose the upside if values rise within the time it takes to complete the building."
To date, the activity has centred on England and Scotland, with brand-name hotels, supermarkets, distribution centres, as well as City councils, featuring prominently. The main participants tend to be insurance companies or German open-ended funds with cash to burn.
Aviva Investors' Lime Property Fund has been one of the most active, completing four development funding transactions totalling almost £120m (€137m) over the last year. These included a 64,000 sq ft supermarket pre-let to WM Morrison in Leigh, a 350,000 sq ft industrial warehouse in Washington pre-let to BAE Systems, and a 400-bedroom hotel in Heathrow pre-let to Premier Inn Hotels. In addition, it invested £15.5m in a forward funding of the development of a new 55,000 sq ft office building by Dawn Group, pre-let to Glasgow Community and Safety Services in the Clyde Gateway regeneration area in Glasgow.
Dawn has also struck a major forward funding deal with Standard Life for Collegelands, one of Scotland's largest regeneration projects. The project includes a 90,000 sq ft office block for Glasgow city council new offices, pre-let to Glasgow City Council, 599 student accommodations and a 2,170-space multi-car park.
"We worked in partnership with Standard Life Investments whereby the institution effectively bought the site for the office block and the car park, and put in place a facility to allow Dawn to draw down the finance required to construct the buildings on a monthly basis," Stewart says. "You pay interest on anything you draw down, so you actually never want to overdraw, and only take enough to pay your sub-contractors. You are using the institutions funds to put up the building and there is no equity requirement from our point of view. Effectively, it enables Dawn to develop using other people's money."
Looking ahead, forward funding is expected to remain a small albeit important part of the alternative finance market for property. Although the bulk of the deals are expected to focus on pre-let buildings, there are stirrings in the speculative development market. Union Investment, one of Germany's largest property fund managers, is reported to be in advanced talks with developer Allied London to forward fund the speculative development of a £150m, 300,000 sq ft office building in Manchester.
If successful, the deal could mark a turning point in the speculative market, which
has been moribund since the financial crisis hit three years ago. It would reflect the faith that overseas investors have in the long-term growth prospects of the UK's regions, despite a lack of demand. Under the terms of the deal, Union would provide development finance for the Foster & Partners-designed block and, in return, would receive a discount on its end value, which is estimated to be in the region of £180m if fully let.