In the ever-evolving landscape of real estate development, developers are increasingly exploring the transition of newly completed residential projects from build-to-sell to rentals.
By Guy Norman, Lending Director, Pluto Finance
This is primarily in response to slower residential sales rates (in part caused by the rise in mortgage rates, though this is easing now). On the flip side, the rental market is performing well in terms of strong demand for units and high recent rental growth (private rentals have increased by 12% over the past 12 months according to Zoopla).
From the perspective of net operating income, the decision to embrace the rental market becomes even more compelling. Why not leverage the potential for increased rental income to counterbalance the impact of higher capital costs?
Until recently, the process of transitioning to rentals was relatively straightforward. Developers could readily refinance their existing development debt facilities with new investment term loans. This approach worked well, thanks in part to low-interest rates and the continuous upswing in property prices, which offset the loss of the new build premium.
However, the financial landscape took a turn when inflation spiked, and the Bank of England implemented multiple interest rate hikes. As a result, many lenders adjusted their net debt yield requirements, increasing them from 6% in early 2022 to approximately 8% by Autumn 2023. This shift has created funding gaps when it comes to refinancing existing debt facilities, despite the notable surge in rents.
Within the realm of Build to Rent lending, we frequently witness lenders adopting inventive approaches. These include the introduction of higher arrangement and exit fees, strategically designed to compensate for lower finance rates. This, in turn, leads to an enhancement in serviceability (during the loan term) and an increase in loan-to-value ratios (LTV), by as much as 5% (as serviceability is often restricting the LTV).
Furthermore, some lenders have chosen to relax their interest coverage ratio covenants (given we are near the peak of the interest rate forward curve), thereby facilitating more Build to Rent deals. Another viable strategy is to bisect the residential units (by selling a portion of these units and renting the remaining ones). This approach not only alleviates the slower sales pace but also bridges the refinancing funding gap (as up to 100% of unit sale proceeds can be used to repay the loan).
It’s crucial to recognise that each situation is unique, demanding a tailored approach. By carefully customising these strategies, it’s often possible to find mutually beneficial solutions that satisfy the needs of both borrowers and lenders. In this dynamic real estate environment, adaptability and innovation are the keys to success, ensuring that developers can navigate the shifting tides of the market with confidence and resilience.