Economic turmoil means sound project financing will need surveillance and diligence

Matthew Murray is director, asset surveillance at Mount Street

As the end of 2022 nears it’s worth reflecting on what has been, by any standards, a tumultuous year for development projects and consider what we can expect looking forward in the context of significant market headwinds.

Project risk

It feels like no part of the construction process is insulated from cost inflation right now. From increases in raw materials and energy costs to scarcity of labour and supply chain disruption, projects are getting more expensive across the board. Contractors are understandably reluctant to agree to fixed price contracts, and if they do they are so heavily caveated as to be effectively worthless, while initial quotes are only being held for a matter of days.

We’re seeing delays in all aspects of the construction process, from valuers taking longer to get to site, councils missing planning approval deadlines by months, delays in registering legal titles and even utility connection deferrals. Given the volume of backlogs, we don’t anticipate seeing any near-term improvement.

There are also counterparty risks to consider; margins for large contractors have been wafer thin for a number of years, meaning it is inevitable that we’ll see increased insolvencies as costs continue to rise. Likewise key suppliers are coming under cost pressure so it’s important payment terms are structured correctly to minimise the risk of loss. Costs overrun guarantees and liquidity should be carefully examined to confirm they truly mitigate these risks and that sponsors are in a position to inject further equity should it be required.

The end product has never been more relevant as it’s imperative to assess a developer’s ability to exit a finished scheme. As mortgage rates increase and the cost of living crisis continues to bite, we expect to see a significant softening in the residential sales market. Prices have dropped in developed markets around the world and although structural undersupply is still an ongoing issue, we’d expect to see the UK and at least some European markets follow suit. The end of Help to Buy, with the deadline for buyer applications due 31 October, will also remove a pool of potential buyers.

In respect of offices, it is still unclear the extent to which a widespread adoption of hybrid working will impact long-term demand, but we are already seeing the energy efficiency characteristics of new-build offices as a deciding factor for tenants looking to take out new leases.

Macro risk

The ‘I’ word is on everyone’s lips and is the most profound challenge we’ve seen, not only to financial markets but to our standard of living, in a generation. Federal Reserve chair Jerome Powell has been quite clear that the Fed will do what’s required to bring inflation under control, while the situation closer to home continues to spiral, meaning we have to assume a prolonged period of tightening will occur.

Intermittent lockdowns in Chinese cities are continuing, demonstrating that continued pandemic-induced supply chain disruption is not yet over and may take years to unravel.

The Ukrainian war looks to be headed for a potentially long stalemate situation, and opening up new and reactivating old energy infrastructure will take a significant amount of time. Meanwhile the dollar continues to strengthen, further reducing GBP and EUR buying power, while the US and China continue their sabre-rattling around Taiwan.

Impact on financing

These challenges have put off a lot of the larger clearing banks and insurers who are increasingly selective about which projects they will consider funding. Unless all their risk metrics are met they will generally pass on opportunities that they would have financed nine to 12 months ago. But the growth of alternative lending platforms over the past five years thankfully provides other options for developers and they can often be competitive on pricing.

On the face of it, the outlook for development finance looks fairly bleak. But there must be some good news out there.

Structural residential undersupply, particularly in the UK but also other European markets, hasn’t been properly addressed for decades and should underpin mid to long-term demand for housing. Demographically driven sectors that are seen as more robust in an inflationary environment, such as student housing, build-to-rent and elderly care, are generally performing well, and top rated sustainable office developments are continuing to attract significant interest from both tenants and investors.

The rising tide of low interest rates and inflated asset values will no longer lift all boats, meaning lenders need to ‘lean in’ to their due diligence process when originating new construction loans and deeply examine their asset and counterparty risk. Project specifics and market conditions move fast, and progress needs to be closely monitored so any issues can identified as quickly as possible.

Ultimately, construction projects will always require financing throughout market cycles, but what fluctuates is the necessary investment in asset diligence and surveillance to defend a facility’s performance.

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