Issues in development lending on the increase
According to Brightstone Law, an award-winning law firm specialising in bridging mortgages and loans, there has been an increase in problem development lending cases over the last 12 months.
Brightstone Law has seen 150 % increase in such cases in the last year, partly explained by the rush into the development lending in the last five years; developments failing against a backdrop of difficult market conditions for sale and refinance; and a growing recognition that some developers were not up to the task. Many lenders only now appreciate how important continuous close monitoring of developments as they progress is, to ensure successful recovery.
A recent High Court case highlights the issues which can arise with development lending and the circumstances in which a lender will fail to recover losses from its monitoring surveyor. Governors and Company of Bank of Ireland & Others v Watts Group (2017) is one of the first cases which looks at the responsibilities of monitoring surveyors in development lending and provides important guidance as to good practice on when to lend and how to manage drawdowns.
At first glance, this case may not appear helpful to the lending community. However, it can prove valuable by in highlighting development lending as a lending area with increased risk, a new litigation trend, and offering guidance on good practice.
In this case, Bank of Ireland approved a £1.4m facility for a development of 11 apartments in York in 2007. Its customer was a SPV owned jointly by a key client and a development contractor. The Bank had a £20m exposure to its key client. The loan was made up of £210,000 for the land purchase, the balance for development costs. The lender relied upon a Savills report (who had already been commissioned by the borrower) for the loan approval and monitoring surveyors reports for loan drawdowns. In addition to its charge, the Bank took a capital guarantee from its key client, the long-established client and the contractor entered into a costs overrun agreement and interest shortfall guarantee.
The contractor entered into a fixed price contract for the construction works. The cost of the development was c £1.8m. The GDV was c £2m, leaving a profit margin of a mere £200,000 on the development, if all was successful and everything ran to plan. Notably, the lending exceeded the Bank’s own underwriting parameters on loan to cost, loan to GDV and site value to development cost ratio.
Post loan completion, the Bank instructed an independent monitoring surveyor to report on the developer’s costs construction estimate, the developer’s build programme time estimate and the developers cashflow. The report was intended to provide the Bank with comfort as to the feasibility of the project before further drawdowns were sanctioned, the land acquisition having already taken place. Acceptable report was received and the Bank proceeded to advance drawdowns.
By 2009, the key client entered into administration. This resulted in the developer becoming insolvent and the construction ceased. The security was realised and the bank suffered losses of c £750,000. The Bank claimed its losses from the monitoring surveyor, who it said, had underestimated construction costs, the time required for construction and who failed to identify discrepancy between drawings of the proposed scheme and planning permissions granted. According to the Bank, had they competently reported, drawdowns would not have been made.
The Bank based its claim on the original report, but made no claims in relation to the subsequent monitoring inspections and reports. On the expert evidence, the court concluded that the monitoring surveyor had not been negligent. The monitoring surveyor received a fee of just £1,500 which suggested that it had not been expected to perform a detailed forensic analysis at that price.
The Court did confirm that the Bank could place reliance on the report and determined that the loss that could have been recovered if negligence had been proven. This would have been reduced by 75% as a result of the Bank’s own contributory negligence.
Jonathan Newman, pictured, Senior Partner at Brightstone Law commented:
“There are a number of key lessons to be learned from this piece of 2007 lending, albeit, by an institutional source. Every lending piece should be underwritten on its own facts and circumstances and must meet documented tried and trusted underwriting criteria. A monitoring surveyor does not underwrite the risk where criteria are ignored.
“At the end of the day, you get what you pay for. Depending on the nature of the development and the character of the developer, detailed forensic analysis may very well be necessary, well advised and is what is required. A commensurate fee is appropriate and operates to indicate the significance of the report and reliance. When instructing a monitoring surveyor, lenders should always provide detailed instructions which should outline exactly what is required. Instructions should include a full suite of documentation, including development plans, up-to-date planning permissions and drawings.
“Following the first report, regular reports should be commissioned on the same basis and understanding. A lender will often have a more intimate knowledge and engagement with the development, so consider attending inspection to avoid confusion and misunderstanding.
“Had the Bank conducted itself in this way, then its prospects of recovering the loss of drawdowns would most likely have been good. But that would not have resolved its major omission, which was to advance its facility based on the relationship with its customer and not its own lending proposition parameters.”