England, Wales, Scotland & Northern Ireland
UK Housing Market
Renewed optimism but smaller developers still face a challenging year, says new report
White paper into prospects for UK resi developers launched by Davon, mezzanine finance specialist.
Smaller residential developers have a sense of renewed optimism this year, says specialist lender Davon, but they still face perennial challenges.
In a new report on the State of the Market, the mezzanine finance provider warns that SME developers will have to wrestle with obstacles such as planning, land acquisition and supply issues in 2024.
David Norman, Director at Davon, says:
“We detect more positive sentiment among developers as interest rates have eased. The goalposts look more firmly in place than has been the case, so developers can plan projects with more confidence, but they still face economic, regulatory and logistical fallout.”
David Norman
The white paper makes three recommendations to stimulate smaller housebuilders, whose share of the new home market has fallen from 40 per cent in the 1980s to 12 per cent today.
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The government and the finance industry need to change the funding landscape in light of new and persistent challenges facing SME developers.
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The planning system is too slow and must be improved. The latest regulations look good on paper but planners need to put them into practice.
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Mezzanine finance gives smaller developers a way to overcome obstacles, deal with delays and free up capital for future projects
Challenges
SME developers operate in a UK housing market for new homes where the goalposts rarely remain in the same place for long.
But many other factors come into play that make basing a small business on building new homes a tricky proposition.
When it comes to getting projects up and running, we can sum up the situation in one short phrase: Everything takes longer.
It takes longer to find and acquire land, it takes longer to get planning permission, it takes longer to get bank funding and it takes longer to get materials delivered. Successful developers know they must build in an allowance for those delays, which inevitably increase costs, on top of higher inflation and borrowing rates.
The Department for Business and Trade reported a 4.5 per cent increase in materials costs for new housing in July but some materials eclipsed that with insulating materials notching a 29 per cent rise, ready-mixed concrete up 19 per cent and screws a third more costly than the previous year.
Cashflow is an issue for SME developers. That’s true for most small firms but especially so with a speculate to accumulate business model. It means small developers must lay out large sums of cash up front and throughout the construction life of each development, if not beyond. What’s more, those funds are typically tied up for many months and often years.
Even a small development of, say, two houses can incur upfront costs of £30-50,000 in planning and professional fees.
For more complex projects, that number can easily top £100,000 when you factor in consultancy fees for a broader raft of planning hurdles such as right to light and environmental studies. Another big-ticket pre-planning bill can be option fees for the landowner.
Unfortunately for developers, banks dislike lending against developments pending planning applications as there are no assets in the project, which means the developer has to find the cash.
And the cashflow strain doesn’t necessarily go away once a developer gets through the planning process and has agreed a bank loan.
With many suppliers now demanding upfront payments, small developers increasingly find themselves dipping into their pockets to secure deliveries. Once again, it happens because banks typically dislike releasing funds that aren’t secured against tangible assets, in this case materials that are yet to arrive on site.
All this means that SME developers are often locked into their current project, unable to move onto their next because of lack of cash until the development completes and sells.
Planning Delays
There was barely a day in 2023 when we didn’t have a discussion with a client involving planning. The industry’s frustration with the ponderous UK system is palpable.
It’s particularly galling for SME residential developers because they have fewer resources to deal with the bureaucracy and face more intense financial pressures than the big hitters, notably on cashflow. When you are stretched on a project having shelled out for a parcel of land, planning delays pile up your bank interest. Time is money.
For years, successive governments have promised action to tackle the housing shortage and streamline the planning system. Yet the industry, seeing little or no progress, has become at least sceptical if not cynical.
The latest government initiative is the Levelling Up and Regeneration Act which became law in autumn 2023. It is supposed to speed up the planning system, hold developers to ” account, cut bureaucracy, and encourage more councils to put in place plans to enable the building of new homes.
That sounds great, but will it happen?
One criticism we often hear is that national and local planning is not joined up. To some extent this is addressed in the Act with new joint spatial development strategies to bring together planning authorities across boundaries where there are strategic reasons to do so.
But at the local level where our clients operate, it is the promise of a speeded up, streamlined planning service that is most appealing.
Previously mooted planning overhauls have met with reticence from the planners themselves but this time, at least publicly, they are being supportive.
The Act has been backed by the planners’ professional association, the Royal Town Planning Institute, although its chief executive, Victoria Hills, said if it is to be successful, the government must engage frequently with planners to ensure that new regulations and policy work as intended and deliver on those promises.
That is the crux of the matter. There have been too many initiatives for change in the system that have fallen by the wayside as well as promises to deliver on housing and regeneration that have been little more than re-hashed versions of existing policies.
What the industry desperately needs is action, and that means ensuring that planners are on board with the spirit of the new law.
Change the funding landscape
Lenders and the government need to overhaul conventional funding models for smaller housing schemes. Action is urgently needed as smaller developers across the UK face crippling supply chain issues causing delays and cancellations of residential projects.
Already squeezed by planning delays and rising costs, developers now find themselves trapped between suppliers wanting upfront payments and lenders unwilling to hand over cash for them.
We want to see the finance industry more open to so-called offsite payments, and we think the government should consider a scheme to back lending for some kinds of materials.
We fully understand that banks and other senior lenders want to see materials safely delivered to sites before releasing funds, but we all have to recognise that the industry has changed with many more suppliers requiring to be paid in advance of shipping materials.
Holes are opening up in the funding stack. We need to be more open to the challenges of offsite payments and cashflow shortages in general and find a way to adapt.
Building regulations and the drive to net zero are leading to more system builds using big-ticket materials such as timber frames and prefab components. That means developers need more cash to pay for materials upfront.
The building industry is being expected to change to meet carbon targets, so we need a government-backed system for financing materials that contribute to that goal.
We think there is a particularly strong case for making such a scheme available to SME residential developers who are building new homes in a housing shortage but do not have the deep pockets of the big housebuilders.
What is mezzanine finance, how does it work and is it right for me?
Here’s our simple guide for smaller developers, advisers and funders.
Next to planning, the biggest obstacle facing SME developers is usually funding. And even when projects do get underway, smaller firms are held back because they cannot afford to move on to new ventures until their current builds complete. Mezzanine finance could be the answer.
What is mezzanine finance?
Smaller residential developments depend on a mix of the developer’s own money and a loan, often from a bank.
Mezzanine finance provides another loan on top of the bank’s to reduce the amount of money that you tie up in your project.
It’s called mezzanine because like a mezzanine floor in a building, it’s a midway level. It’s also known as second-tier finance with the first tier being the main bank loan on the project.
Like the bank loan, mezzanine finance is paid for by interest on the loan.
Both bank and mezzanine loans are secured against the property being financed. If anything goes wrong, the bank has first claim on the land and building materials with the mezzanine lender having a second charge.
How does it work?
Let’s say you’re planning to build a property at a cost £1 million (including bank interest) and you plan to sell for £1.2m.
You might borrow £650,000 from the bank including interest. You then have three options to finance the rest.
If you fund it yourself, you’ll have £350,000 tied up in the development until it’s built and sold. If it goes for the forecast profit, you’ll make a 57 per cent return on your investment. You could bring in an investor partner, but they’ll usually want a hefty share in the profits. With a £200,000 mezzanine loan, you’ll only have £150,000 of your own money invested. Let’s say the interest on that second-tier loan is £60,000, you’ll still make £140,000 profit, which is a 93 per cent return on your capital.
For More Information: State of the Residential Development Market 2024
David Norman, Director
