Equity could replace debt as a means of funding

Equity could replace debt as a means of funding

As debt remains scarce, it is time for new approaches to finance

The below article has been taken from the Property Week website. For further information please visit  www.propertyweek.com or to view the article in full please view Property Week News Article

Difficult times require different thinking. Opportunities will emerge on the buying side, but with so little debt available, buyers could miss the optimum point in the cycle. Equity will need to take some increased risk again to bridge the funding gap.

The opening of Charles Dickens’ A Tale of Two Cities could be said to encapsulate the recent change in the real estate market: ‘It was the best of times, it was the worst of times … it was the spring of hope, it was the winter of despair.’

Buyers’ market

Amid all the legacy issues, the unprecedented rate at which yields have risen, combined with sterling’s decline, makes UK real estate look cheap, particularly for international buyers. Although swap curves suggest that yields will move up further, there is a sense that a huge buy-side opportunity is approaching. However, with debt still scarce, it is interesting to look at how buyers might execute acquisitions.

In short, can equity fill the funding gap?

In the development market, debt is unlikely to be available for speculative projects for some time. Therefore, I believe forward-funding may return to get projects started. This was the case during the early-1990s slump with schemes such as Capital & City’s Queensberry House in west London.

A forward-funding investor buys the land, provides the finance for the developer to build and pays the developer out at the end through a profit-erosion formula that takes account of value achieved and development costs.

Different types of investors – offshore pension funds, sovereign wealth, private equity – are now active in the UK market. Lot sizes are often larger. To spread risk, investors might club together to forward-fund larger development schemes, then refinance as debt markets improve and prelets are achieved.

In the indirect investment market we are seeing the emergence of UK-focused opportunity funds. While some of these still require debt to achieve predicted returns, many are expressing likely returns on both a geared and ungeared basis to demonstrate viability in both instances. Cash on cash is becoming the new internal rate of return. Desire for income throughout the life of the investment has led to some funds offering income and capital return.

For direct investment, the prospect of tighter yields for smaller lot sizes may cause the market to re-examine ways to break up assets through side-by-side leases where properties offer long-term income from good covenants. Although stamp duty land tax remains an issue, it may be possible to mitigate this through upfront tax planning.

Investors putting up more equity may also use real estate derivatives to hedge their exposure and protect their equity. Jon Masters, head of property derivatives at BGC Partners, expects sector-specific derivative trading to increase as investors take advantage of pricing differentials between various property sectors to boost returns.

Dickens continues: ‘We were all going direct to heaven, we were all going direct the other way.’ Hopefully, equity can enable the market to take its first steps towards the first option.

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