Lenders tighten grip on developer costs squeezed by labour and materials spikes

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property developers

Development finance news is still full of multi-million pound deals but the wider picture is one of struggle, primarily because of soaring costs.

Developers have been dealing with “very high levels” of inflation exacerbated by the Ukraine conflict for months, the (catchily titled) Construction Leadership Council’s Product Availability working group said in July. From March to May inflation on the price of materials increased massively, by 10-15%, according to the CLC.

Prices have stabilised, but have yet to fall, keeping developers – and their finances – under pressure. Some softening in demand, particularly at the retail end, has moderated inflation for some products, but this is unlikely to result in lower project costs in the short term, the CLC says.

It adds: “The general view is that inflation will persist at a lower level across most product categories for the rest of the year.”

Squeezed property developers pose extra risks for their bridging lender financial backers.

Steve Smith, director of sales at Roma Finance, says inflation has already had a “huge impact”.

“It obviously affects how we assess cases and make lending decisions, but, as always, we adapt to the market we’re in,” he says.

While it hasn’t yet impacted demand – “which remains extremely strong” says Smith – Roma Finance is proceeding with caution. Alongside strong underwriting to ensure customers’ costings are accurate and up to date when it assesses cases, it requires developers to have a contingency of at least 10% on top of their budget, “and preferably 15%”.

As higher materials costs settle, it has become clear that is only one part of the story, and for Chris Gardner, joint CEO of the development lender Atelier, not the most important part.

Gardner says: “You can’t manufacture labour, and to my mind the chief inflationary threat now is the rising cost of employing people, rather than materials.”

He adds: “The jobs market remains exceedingly tight and skilled construction workers are still able to demand – and get – big pay rises. And as they grapple with the rising cost of living at home, I expect their wage demands will only increase.”

The gathering economic clouds are already beginning to change some lenders’ appetites.

Gardner says: “Increased turbulence in the market may lead some lenders, especially those who provide other forms of lending too, to step back from development lending for a time.”

Even Atelier, which specialises in funding property development, has “recalibrated” its approach to risk, in two important ways.

Firstly the lender will be looking hard at the developer’s chosen location for their scheme as part of its due diligence.

Gardner says: “If the UK does dip into recession, property prices in some areas may correct – so we’ll want to be certain that a scheme will deliver the right sort of properties in the right area to achieve the best possible sale value.”

The other factor Atelier is reassessing is lender margin. The Bank of England’s Base Rate is forecast to rise to 4% or even as high as 4.4% in the coming months, from its current 1.75% (a level already the product of six rate hikes so far this year). This will make wholesale borrowing more expensive.

Gardner says: “Lenders will want to think carefully about how to manage this and how to protect the margin on which their business relies.”

Developers now face being squeezed on several sides, he points out – rising build costs, and the looming downturn could drive some of the building contractors they rely on out of business.

“Nothing adds to delays or costs like a contractor going insolvent, so this is a significant worry for many developers,” Gardner says.

To ward off problems Atelier offers ongoing support to all its borrowers, with an in-house team of surveyors, lawyers and finance experts ready and willing to offer help and advice throughout the construction phase and beyond.

The year started with such promise – in May, accountants EY issued its UK Bridging Market Study 2022, based on surveys carried out between 15th February and 4th March this year, which “despite some credit concerns, there is appetite for larger loans with 28% of respondents looking to offer larger facilities over the next 12 months”.

In the current world of CPI at 10.1% – which only goes some way to describe the levels of goods and services inflation being felt in the development sector – Tom Branson, director of lender Charterbank Capital, says scrutiny of cost management for property projects has become absolutely crucial.

Yet he says: “Expected costings and budgets seldom include any allowance for any increase during the build programme – I think I have seen one this year!”

Part of the lack of planning for the worst is because developers by nature are usually optimists, he says.

“We like to combine optimism with a good blend of realism and therefore build in an allowance for increased costs into our LTV modelling,” says Branson.

In terms of its current customers, Charterbank is seeing increasing numbers requesting further advances to cover not only the increasing cost of materials but, echoing Atelier’s market view, increased labour costs, especially skilled labour.

Branson says: “Lenders like ourselves that are in complete control of their funding and decision making will have no issue in providing additional funds, subject to satisfying their own criteria, but not all lenders benefit from being structured this way.”

The current cost spirals will for some jeopardise completion of the development – where the lender cannot provide the extra funding required, and the borrower has come to the bottom of their own cash.

Lenders and developers will have to decide whether the development is better completed over budget and over LTV thresholds, or stopped.

For Branson the solution in this admittedly undesirable position is being pragmatic and open minded.

He says: “We are always on hand to talk to our customers. Being approachable and realistic is the key with a willingness to help but within the parameters of doing so diligently.”

“Assessing and reassessing what we can do for each and every existing customer, being proactive and using our experience to sense any issues they may be encountering has always benefited us and our customers – this period will be no different.”

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