Report on Access to Finance for Construction & Development
CONSTRUCTION 2020: REPORT ON ACCESS TO FINANCE FOR CONSTRUCTION & DEVELOPMENT 4th March 2015 Executive Summary 1. The Government’s construction sector strategy, Construction 2020 A Strategy for a Renewed Construction Sector, identified access (on a sustainable basis) to finance for new housing development as an issue that needed to be explored in further detail. The Department of Finance was given responsibility to lead and report on this task. 2. Prior to the property crash, construction and development projects were funded by high levels of senior financing made available by the banks. This funding model was unsustainable and did not fully account for the risky nature of development and contributed greatly to the severity of the financial crisis in Ireland. The return to a sustainable financing model for construction and development in Ireland requires both senior debt finance (typically provided by banks) and equity finance (typically provided by developers and investors), but the transition to this new model is proving to be a slow process. 3. With this in mind, the Department has prepared two reports; the current Report examines issues around access to equity finance for construction and development and builds upon a first report which explored the availability of senior debt finance. One of the key findings in the first report was that banks are willing to provide senior financing up to c.65 per cent of development costs in respect of shovel-ready projects with proven demand (which is an entirely appropriate financing model not least from a financial stability perspective). It is clear that senior financing will not be made available to finance construction and development without the necessary risk capital also being invested. 4. This Report explores the issues around accessing that necessary risk capital to bridge the c.35 per cent funding gap. To this end, the Department engaged in a series of meetings with equity providers, property developers, urban planners, architects, NAMA, industry representatives, academics and other relevant stakeholders. The focus of the discussions was to: understand if there is a sufficient amount of equity and/or mezzanine finance (i.e. “Risk Capital”) available to finance viable construction and development projects; identify any potential bottlenecks or impediments to this risk capital being deployed; understand where coherent, pragmatic solutions could be developed; understand if innovative models of financing are emerging in the Irish market and explore how best to improve access to such innovations; and discuss other interacting factors. 5. A number of key findings have emerged from these discussions. It is clear that there is a sufficient supply of equity financing to complement the senior debt finance for viable development. Importantly, a number of intermediaries are emerging who can access capital from large investment funds and allocate across smaller development opportunities. 6. NAMA has become the main source of development finance for many of its debtors. Due to its significant exposure to its debtors, NAMA will provide development finance to debtors where such further investment will maximise its ultimate overall recovery from those debtors. Page 1 of 10 7. It is also clear that as the economy and the property sector stabilises, an orderly rotation from relatively short term (3-5 year) transitional capital to longer term (7-9 year) capital with lower return requirements (institutional, sovereign wealth, pension and insurance capital) will become increasingly important for market stability. 8. Regarding the demand for equity financing, a number of developers hard-hit by the crisis do not have sufficient levels of their own risk capital to invest and must access third party risk capital to undertake development. However, some developers are slow to accept the (appropriately priced) higher cost of equity funding, while other developers lack the necessary experience and information to access equity funding. 9. It was apparent throughout our discussions that access to development finance cannot be seen in isolation. Ultimately, it is the profitability of development that will determine whether or not it is financeable. A number of inter-related factors impacting negatively on viability and the construction supply response include inter alia: inflexibilities and cost pressures associated with the planning system; the weak balance sheet situation of developers, rigid construction costs (reducing the viability of development); capacity constraints (including skilled labour shortages). These impediments are also being addressed under Construction 2020. 10. It is evident from the discussions that there is a need for a greater awareness of the interconnectedness of all stakeholders. To this end, the Department of Finance has organised a conference on 4th March to bring together debt and equity providers with developers in order to help educate the developer community as to the sources, forms, pricing and structures of construction and development finance available in the market. This should lead to a better alignment of shared incentives and a more rapid deployment of risk capital (equity and mezzanine) in support of construction and development activity. The forum will enable developers to gain a better understanding of the debt - equity financing model; the cost of equity financing, how to access such funds, etc. The conference should help facilitate a speedier transition of the current underdeveloped equity finance market to a scale that is appropriate for Ireland’s development needs. Page 2 of 10 Introduction and Background The construction sector strategy Construction 2020 A Strategy for a Renewed Construction Sector identified access (on a sustainable basis) to finance for new housing development as an issue that needed to be explored in further detail. To accomplish this, the Strategy included four actions concerning sustainable financing for the sector (Actions 44, 45, 46 & 47). The Department of Finance (DOF) was tasked with the responsibility to lead, and report on, two of the actions (Action 44 and 45) that centred on bank and non-bank financing respectively (Actions 46 and 47 relate to NAMA). As the need for alternative forms of financing arises to the extent to which existing levels of financing are not available to fully finance construction and development projects, efforts first focused on examining bank financing (Action 44) before exploring non-bank financing (Action 45). The findings of Action 44 on bank financing, which are summarised below, was completed and presented at an earlier meeting of the Cabinet Committee on Construction 2020. Building on that analysis, this Report presents the Department’s findings on the issues that are affecting the development of sustainable non-bank sources of construction and development finance in Ireland. Action 44 A High Level Working Group chaired by the Department of Finance, bringing together the banks, NAMA and other key stakeholders, will be established to explore the issue of sustainable bank financing for the construction sector. In the first instance, this Group will bring an interim report in Quarter 2 to the Cabinet Committee on Mortgage Arrears and Credit Availability and a final report in Q3 that will; • • • • Establish current level of development finance provision; Identify obstacles to increasing development finance provision, and means to remove them; Explore how best to facilitate the resolution of disputes over the availability; and Terms of development finance. To address the action on sustainable bank financing, a High Level Working Group (HLWG) chaired by the Department of Finance brought together representatives of the National Asset Management Agency, the National Pension Reserve Fund, Allied Irish Banks, Bank of Ireland, Ulster Bank, the Irish Banking Federation, the Construction Industry Federation and Property Industry Ireland. A questionnaire was circulated to working group participants focussed on understanding the current financing conditions for development and the impact of other possible interacting factors. Following a general discussion of the key issues, external stakeholders were invited to provide a submission detailing responses to the questions posed. Building on this work and in order to get a more in-depth understanding of the issues, a number of bi-lateral meetings were held between the Department of Finance and the individual banks over the course of summer 2014. To briefly summarise, the HLWG key findings on bank financing issues were as follows: It is evident that the high levels of senior financing made available by the banks for construction and development projects were unsustainable and contributed greatly Page 3 of 10 to the severity of the financial crisis in Ireland. A return of this financing model is not in prospect; moreover it would be highly undesirable not least from a financial stability perspective. The financing of construction and development requires both senior debt finance (typically provided by banks) and equity finance (typically provided by developers and investors) – one will not be made available without the other. To be sustainable the structures, levels and pricing of financing for construction and development projects must appropriately reflect project specific risk return profiles. Broadly speaking, financing of shovel ready development projects with proven demand typically involve a c. 65/35 debt-equity split. This financing structure is considered to be entirely appropriate and sustainable. At present, senior debt finance is available from the banks for shovel ready projects with full planning permission and proven demand, and where there is sufficient equity investment at risk ahead of the senior debt investment (as per above). The issue of development finance cannot be seen in isolation and other factors affecting development include site availability, the level of construction costs and uncertainty regarding the viability of development. Action 45 The High Level Working Group will also specifically examine non-bank financing options including: • Addressing gaps between the amount of development finance being offered by banks, and the amount required to execute a project; • Drawing on international best practice in relation to new and innovative financing structures, including the hybrid models involving non-bank actors; • Supporting the availability of complementary sources of financing for housing and commercial projects, e.g. mezzanine finance and equity finance, on viable terms and facilitate the provision of financing by specialist funds, NAMA, and ISIF; and • Exploring the scope for attracting more foreign capital into the development finance area. Approach Given the findings from the bank financing report, particularly the fact that banks are willing to provide senior financing up to c.65 per cent of development costs for shovel ready projects with proven demand (which is entirely appropriate), the Department of Finance began the next stage of investigation (as per Action 45) on issues related to non-bank finance and how developers could bridge the c.35 per cent equity gap and how developers could finance projects earlier in their development without access to senior finance. The DOF engaged in a series of meetings with equity providers1, property developers, urban planners, architects, NAMA, industry representatives, academics and other relevant stakeholders to discuss in 1 These included discussions with existing or potential providers from banks, non-banks, equity and mezzanine providers, developers and others, including the ISIF. Page 4 of 10 greater detail the issues concerning the availability of equity and/or mezzanine finance. The focus of these meetings was to: understand if there is a sufficient amount of equity and/or mezzanine finance (i.e. “Risk Capital”) available to finance viable construction and development projects; identify any potential bottlenecks or impediments to this risk capital being deployed; understand where coherent, pragmatic solutions could be developed; and understand if innovative models of financing are emerging in the Irish market and explore how best to improve access to such innovations. The discussions explored the alignment between senior debt, mezzanine and equity providers within the sector. As with earlier discussions other interacting factors were also examined in more detail. The findings of the discussions are summarised under a number of headings; Availability of risk capital; Providers of equity financing; and Other interacting factors. Findings Availability of risk capital Discussions confirmed earlier findings that the traditional banks are providing 60-70 per cent of financing in the form of senior debt for “shovel ready” developments with proven demand. It is clear that the pre-recession funding model (where up to 100% senior finance for development was available) is not viable and should not be expected or encouraged to return. Under this unsustainable pre-crisis model, banks were making senior debt available at inappropriately high advance rates (up to 100%) and also for much earlier, higher risk stages of development projects (pre-planning and pre “shovel ready”). This resulted in the banks achieving only senior debt returns for taking on significant levels of construction and development risk which would historically have been borne by the developer / equity investor and rewarded with much greater returns. This resulted in developers achieving highly leveraged returns without significant levels of equity investment, while the senior debt issued by the banks took on most of the risk. The sector is adjusting to the fact that an appropriate level of risk capital is once again a required component of the total development financing arrangement. Developers can no longer expect to achieve equity type returns without investing their own risk capital. Page 5 of 10 The financing structure for a project and how returns are allocated across providers of risk capital, providers of debt and developers is emerging as a key determinant of development viability. o A number of equity providers have entered the market and there would appear to be a sufficient supply of equity financing to complement the levels of senior debt that are available in the market for viable development. o A number of developers hard-hit by the crisis do not have sufficient levels of their own risk capital to invest and must access third party risk capital to undertake development. o Developers without sufficient levels of risk capital of their own to invest may be slow to accept that (i) high levels of low cost senior debt financing will not return and that they must access significant levels of third party risk capital at significantly higher cost, and (ii) they must cede some level of control to the third party risk capital provider. o A further impediment to the return to sustainable financing structures, which was identified during discussions, is that many developers lack the necessary experience and information to access equity funding. Developers who do not come to appreciate the reality of this financing structure will be left behind and eventually replaced by developers who either have access to risk capital or are willing to accept more realistic returns. There is an opportunity to help educate some members of the developer community regarding the need for risk capital, current project financing structures and known providers of such risk capital. Efforts to seize this opportunity should help accelerate the transition to a new fully developed and functioning financing structure appropriate for development activity. Providers of equity finance Many equity investors in the market have invested in loan and property acquisition through funds with a three to five year investment horizon which, due to the risk profile of the investment, demand double digit returns. An orderly rotation from this transitional capital investment to longer term (7-9 year) capital with lower return requirements (institutional, sovereign wealth, pension and insurance capital) will become increasingly important for market stability. The introduction and entry of REITs into the Irish property market was considered an important development to attracting large scale and long term professional investment in the property sector. Many viewed the entry of REITs as a positive step that would encourage stable investment and also lead to the professionalisation of the private rental sector. However, the investor base in the equity of the REITs must also transition over time from its current shareholder base to lower cost, longer term institutional equity investors. However, unlike the case of private equity funds, such rotation of the REIT Page 6 of 10 investor base will not require a change of ownership in the underlying REIT property investments. While the main channel through which investors have entered the property market to date has been though investments in loan and property acquisitions, there is now growing direct investment in construction and development. NAMA has become the main source of development finance for many of its debtors. Due to its significant exposure to its debtors, NAMA will provide development finance where such further investment will maximise its ultimate overall recovery. The Department is engaging with NAMA around the levels and pricing of this debt and equity investment to ensure this financing is being provided on competitive terms. To achieve economies of scale and deploy sufficient amounts of equity, many equity providers have minimum project investment thresholds and are unlikely to provide equity funding for smaller projects or to smaller developers. A number of intermediaries are currently present, willing to enter or are building capabilities in the Irish market. These intermediaries can play an important role in providing or channelling equity for smaller projects. Trusted intermediaries are able to access capital from large investment funds which they can then allocate across smaller development opportunities. The ISIF, through its commercial mandate, may be in a position to provide development finance in much the same way as NAMA and other providers and is exploring ways to support financing projects through, for example, a house-builders investment fund. There is an opportunity to introduce these intermediaries and providers of equity to the development community to facilitate development financing discussions. There is also an opportunity to establish and strengthen partnerships between equity providers, developers and senior debt providers. Other interacting factors The viability of development was a key area of discussion throughout our engagement, as it is the viability and profitability of development that will determine whether or not it is ultimately financeable. In light of the commentary regarding the cost of construction, specific potential impediments were explored in greater detail including relatively high construction costs, delays and other concerns with the planning system, and industry capacity constraints. The increased challenges in financing the construction of apartment buildings relative to residential housing developments was also explored. The capital intensity (i.e. the required level of risk capital) of apartment development is greater than that of housing development given the limited ability to recycle capital through a staged delivery of apartment units as in housing development. This requires a greater level of equity Page 7 of 10 investment over a longer period for apartment development which is proving challenging. Regarding the historical acquisition cost of land purchased at the peak and whether it was constraining the perceived viability of development, the general view emerged that most land holdings had been marked-to-market to reflect current value. As a result historical acquisition cost of land does not seem to be a significant impediment to development. However, in light of expectations of increasing rents and house prices, buyers are beginning to price future house price appreciation and rental increases into land acquisition costs. This is placing pressure on viability resulting in a requirement for higher required prices per developed unit or required rental yields. As a consequence, the current price of land does not reflect a market price of land in equilibrium but rather includes expectations of future unit price and rental increases. Labour costs adjusted marginally during the downturn and evidence confirms that a 30-40 per cent average hourly wage differential exists between Ireland and Northern Ireland. There were consistent assertions throughout our engagement that current planning regulations as enforced by local authorities in the Dublin region are preventing the construction of required housing units. Specific regulations in the Dublin region were cited that significantly increase construction costs and prohibit viability of required housing stock including: o minimum open space requirements; o dual aspect requirements; o effective prohibition on open plan apartments; o required number of lifts per apartments; o underground car park requirements. It was asserted that the planning regime does not fully appreciate the trade-off between stricter planning regulations and affordability. As in any product market, housing stock must be produced to accommodate multiple price points to accommodate the needs of a varied pool of demand. It was further asserted that the planning regime tightened during boom times without a significant impact on the viability of development due to the high prices being achieved in the market. It was asserted that to achieve viability under a tightened planning regime, prices would need to rise further, with the commensurate adverse implications for Ireland’s competitiveness. It was suggested that Local Authorities should adopt the National Guidelines set out in the DECLG “Quality Housing for Sustainable Communities- Best Practice Guidelines for delivering Homes & Sustaining Communities” (2007) which is seen as a very well thought through piece of work. Page 8 of 10 It was further recognised that the additional tightening of planning regulations by local authorities over and above these national guidelines had not undergone the required cost benefit assessments or regulatory impact assessment (RIA). Many felt that the new Building Control (Amendment) Regulations (BCAR) introduced in March will not solve the problem of sub-standard developments and will only increase development costs. Some indications were given that the BCAR have added 5 – 7 per cent to the cost of a development projects. Conclusions Discussions have confirmed earlier findings that banks are willing to provide 60-70 per cent of the developmental cost of shovel-ready, viable projects and that there is a need for the remaining risk capital (equity and mezzanine) to be provided by developers themselves or sourced from third party providers. This represents an appropriate and sustainable funding model. However, this is premised on the project being able to provide a return on the capital invested commensurate to the risk to which that capital is exposed. Developers should not expect a return to boom time financing levels of close to 100 per cent senior debt financing from traditional bank sources. The fundamental challenge, in these circumstances, is to explore how the equity gap for viable development projects can be filled. It is the combination of debt and equity finance which will finance development; one cannot ensure development without the other. While underpinned by a general market recovery supporting project profitability, evidence from the discussions indicates there is a sufficient supply of equity finance available for development. There are signs that the funding market for developers (commercial development and house builders) is also adapting with fund managers becoming more active in looking to help finance activity where senior debt may not be available. This diversification of funding sources reduces financial stability risks and is a positive development. However, there is some evidence that developers are reluctant to access the equity finance market. Their reluctance arises primarily for two reasons: First, this equity requirement is new to many developers who had previously accessed close to 100 per cent debt financing. Many lack the necessary experience and information to access equity funding. Second, when compared to the low cost of debt financing available in boom time (a factor that contributed to the severity of the Irish crisis) developers generally perceive the cost of equity capital to be excessive. Partnering with third party equity requires developers not only to share the significant financial returns, which they would have captured exclusively with 100 per cent debt financing, but also to share control over decision making and the broader development process. However, it is appropriate that even without investment of their own equity, developers should and will be compensated for their expertise and efforts. However, unless development projects are seen as generally viable, discussions around financing structures and sources of equity are moot. There are a number of inter-related factors impacting negatively on the construction supply response including inter alia: the planning system; the weak balance sheet situation of developers, rigid construction costs Page 9 of 10 (reducing the viability of development); capacity constraints (including skilled labour shortages). Only a combined effort to address these impediments to viability, many of which are a legacy of the boom time, and access to appropriate development financing structures will ensure that a sufficient supply of housing stock is delivered in line with projected demand. In the meantime, there is a need to facilitate the introduction and deployment of this risk capital. Our discussions revealed that smaller developers may face difficulties in bridging the equity gap for viable development projects and may not be large enough or sophisticated enough to attract investment from the larger private equity investors which maintain minimum project investment thresholds. While intermediary fund managers are present in the market to invest in smaller projects, an opportunity exists to assist in educating smaller developers about the new development financing structures and sources of risk capital (equity and mezzanine). Conference: Financing Options for Development To the extent that informational asymmetries exist between equity provider and developers, there is a role for policy to address these market failures which are curtailing the development of the equity financing market. It is evident from our discussions that there is need for a greater awareness of the interconnectedness of all stakeholders. To this end, it was agreed to host a conference on financing options for interested developers to introduce important financing structure concepts conveying the need for risk capital and help set developer expectations. The conference will bring together interested developers and providers of debt, mezzanine and equity finance for construction and development. This should lead to a better alignment of shared incentives and a more rapid deployment of risk capital (equity and mezzanine) in support of construction and development activity. The forum would enable developers to gain a better understanding of the debt - equity financing model; the cost of equity financing, how to access such funds, etc. The conference would also allow banks and equity providers to better identify the funding requirements of developers. Overall, the conference should encourage developers to participate in the equity financing market and lead to a better matching of the type of funding supplied with what is demanded by developers. It should facilitate a speedier transition of the current underdeveloped equity finance market to a scale that is appropriate for Ireland’s development needs and thereby contribute to improving housing supply and achieving a better functioning property market. However, while the development of the debt / equity funding model is very important, the issue of development finance cannot be seen in isolation and must be addressed in conjunction with other factors affecting development including site availability, the level of construction costs (including those arising from building regulations and planning requirements) and uncertainty regarding the viability of development. The Government is actively addressing these issues through other actions as set out in Construction 2020. Department of Finance March 2015 Page 10 of 10
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